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Paul Nouri, CFP
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Paul has been managing Noble Equity Fund, LP, a healthcare-focused hedge fund, since January of 2008. In addition, he manages Noble Advisors, LLC, a Registered Investment Advisor. Prior to this, he worked on the sell side at Sidoti & Co. and Deutsche Bank covering various industries. Mr. Nouri... More
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  • Why Does Muddy Waters Move The Market? 0 comments
    Nov 29, 2011 5:18 PM | about stocks: FMCN, SPRD, CCME, ONP

    Everyday, there are hundreds of institutional investors that go on tv and radio and pitch stock ideas. For the most part, the stocks mentioned don’t move more than a couple of percentage points on the news. However, it has become the case that when Carson Block from the research firm Muddy Waters speaks on a name, the stock is headed for volatility and likely a significant decline. That is because Muddy Waters focuses on issuing negative research on Chinese companies.  Additionally, the company readily admits to being short the names it issues research on.


    Out of the 7 stocks that the firm has issued negative opinions on, 6 of them are down from the time the opinion was issued. Typically, the negative publicity forces the Chinese companies’ hands to form an investigative committee. Some companies have been de-listed and others struggle through a difficult trading market for their shares. Like any other investor/analyst, Muddy Waters will be right at times and wrong at times. The point of this article isn’t to break down how often the firm is correct in its analysis. It’s to question why the stocks of Chinese listed companies become extremely volatile after the investigative reporting of one firm.


    One of the old adages of legendary Fidelity investor Peter Lynch is to invest in what you know. This theory includes buying Proctor & Gamble because you use Tide and McDonalds because you can’t stay away from their fries. Recent stock valuations certainly reflect that institutional and individual investors have embraced this theory. Companies that people embrace, such as McDonalds, Chipotle, Apple, Priceline &, attain Price/Earnings ratios well above the average. This is partly because consumers don’t only show their approval of products by purchasing a company’s product or service; they have come to purchase stock as well. Investors feel comfortable investing in a product or service that they have used or are currently using. That leads us to U.S. listed Chinese companies.


    In a best case scenario, before the average individual invests, they look at a company’s financial statements, see what the company generally does, check out its valuation and make a decision. Institutional investors might look more closely and hone in on gritty financial metrics and the market for a specific product or service a company is selling. Unless investors are willing to fly to China and conduct on the ground surveillance, it is unlikely that they will be able to feel secure that their investment in a China listed company is anything other than a high risk. For this reason, when an entity such as Muddy Waters issues a negative report, using the company’s own numbers against it,  sell off and panic ensues in the stock. Whether or not the allegations are true or are already priced into shares is largely neglected. The losses that investors can bare as a result of reports such as this can be significant.


    Here are a few suggestions to those investors that are interested in investing in Chinese companies. First, do as much investigative work as possible on the company’s financials. Foreign companies are required to file when there is a significant event, as well as a form 20-F at the end of the year (equivalent to 10-K in U.S.). Through these statements, you should be able to ascertain financial metrics such as DSO’s (accounts receivable collectability) and free cash flow (how well the company converts earnings into cash). Additionally, the 20-F will inform you whether or not the Auditor has approved the validity of the reported financial statements as well as how strong the company’s audit committee is. Second, see how much equity management has in the company and what the insider activity has been. Typically, management teams that are confident in their companies will purchase shares on a severe decline. Additionally, in today’s world of transparency, it is hard to believe that an executive that owns a significant portion of company stock would risk their shares going down for the short term benefit that fraud might produce. Finally, don’t put your life savings into a China stock. This will ensure that if a negative report or development does come out on your stock, you will not lose too much sleep over it. 

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Stocks: FMCN, SPRD, CCME, ONP
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