Should a hedge fund ever use public relations it is normally to stay out of the press as secrecy and a low profile are prized in that industry. However, at least one group of hedge funds actually embraces publicity to enhance its trading strategies.
Muddy Waters Research, a US-based hedge fund, has been making a living from finding badly run Chinese companies listed in the US or Canada and then following a period of thorough due diligence shorts their shares - that is sell them with a view to buying them back at a lower price or not at all if the company goes bust.
The dreaded research report
Typically, the fund will produce an in-depth report on the company it is shorting highlighting its deficiencies such as its business model, dubious management or simply out-rightly exposing lies and malpractice. This makes the fall in the share price a self-fulfilling prophecy. As the fund says on its website, western investors are unprepared for fishing in the 'muddy waters' of China-based stocks. Chinese companies have been able to avoid considerable scrutiny when listing in the US and Canada by reversing into listed shells and this has opened up the possibility of over-valuing assets and committing fraud.
China-based Canada listed forestry group, Sino-forest, is among its most high profile cases and MWR sent its shares plunging 70% on exposing alleged malpractice. Basically China's business practices are often opaque making it hard to distinguish genuinely well run companies from those that are flaky. Even the legendary British investor Anthony Bolton who heads up the Fidelity China Special Situations investment trust has been caught out by this problem, such as with China Integrated Energy.
Hiding in the shade
Other hedge funds are following a similar model such as Citron Research and GeoInvesting and often target micro-caps as knowledge about them is usually more sketchy and scrutiny is less intense. According to Carson Block who founded MWR this allows some companies to be creative in their accounting in a way that can mislead shareholders.
If done with integrity, and Block talks of being intellectually honest when conducting research to ensure conclusions are supported by facts, these funds are providing a public service by routing out the rotten apples. The fear among some observers is that less honest funds might use these tactics of to manipulate share prices, a practice which is illegal - so having solid facts is important for this type of trading strategy.
But the fact that these funds exist is a warning to small companies to maintain best management practices and to be honest and transparent with their shareholders. These funds not only benefit from the media's lurid fascination with corporate scandals, but also from social media where bad news can travel like wild fire with devastating consequences for a listed company. MWR for instance has nearly 7,000 followers on Twitter, many of whom will re-tweet any tasty bits of news to their followers.
A trading model for bad times?
These funds are in a way tailored to an environment of poor economic growth and sluggish stock market performance when malpractice and frauds most often come to the surface. In terms of lime light hugging hedge funds they are a variation on shareholder activists who make a living shaking up or throwing out the managements of under-performing companies and do so in a very public fashion to lift the share price. Their breed though tends to thrive during long bull markets and economic optimism.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.