Investors who two days ago had never heard of short-seller Carson Block or his investment firm, Muddy Waters Research, are now trying desperately to figure out just how much weight to give his allegations against Sino-Forest Corp. as the stock plunges.
Shares of Sino-Forest, a Toronto-listed company that invests in Chinese timberland, have plummeted 71 per cent since the report from Muddy Waters was made public Thursday, calling Sino-Forest a "fraud." In response, Sino-Forest said Friday that its public disclosure is accurate and investors should "take extreme caution in responding to the Muddy Waters report."
The report is striking not just for its big accusations, but for how at-odds it is with the mainstream take on Sino-Forest. In Canada, the company for the most part had been perceived as a fast-growing analysts' darling. The stock is on the "buy" list of analysts at big firms such as RBC Dominion Securities and in the portfolios of star mutual fund managers such as Rohit Sehgal at Goodman & Co. Mr. Sehgal has said that if he had a $100,000 windfall, he would consider putting some of the money in Sino-Forest.
"There are two competing public statements right now," Mr. Sehgal said in the wake of the report. "We are keeping a close eye on the matter."
Mr. Block appeared on the investing world's radar in just the past year with a series of audacious accusations against a string of companies, of which Sino-Forest is the latest. Muddy Waters has initiated coverage on five companies with Chinese roots in the past year, calling every one a "strong sell" and throwing around accusations of fraud, cooked books and forgery.
In the case of water-treatment equipment maker RINO International, Mr. Block may have been on to something. RINO said in the wake of a Muddy Waters report that in fact its audited financial reports for two years should not be relied upon.
Muddy Waters appears to be the latest in a string of startups for Mr. Block, who trained as a lawyer in the U.S. and practised in Shanghai. He then tried his hand at entrepreneurial ventures in China ranging from co-authoring the book Doing Business in China for Dummies to starting a mini-storage company in Shanghai. The website for Love Box Self Storage features a guarantee from Mr. Block that "you'll get self storage with no BS."
Muddy Waters presents itself as equal parts investor and crusader against malfeasance, saying in the case of Sino-Forest that "were Muddy Waters not to have come along, it is likely that this fraud could have continued for a few more years and billions of dollars more."
Mr. Block told Barron's that Muddy Waters grew out of his experiences in China.
"After law school in 2005, I went to China because I figured it would offer me more entrepreneurial opportunities. I chose Shanghai because I thought the post-legal opportunities would be better. I came across a stock that was a substantial fraud. It happened to be a reverse merger, and that is how the whole Muddy Waters saga started," he said in the interview, which Barron's published in March.
As for the name Muddy Waters, it has nothing to do with the blues (though investors in Sino-Forest may well have them). According to the firm's website, the name comes from a Chinese proverb that says "muddy waters make it easy to catch fish," a reference to the difficulty of analyzing Chinese businesses, according to the firm's website.
Mr. Block looks for the "element of too good to be true," he told CNBC in April. "Even though it's China and it's a fast growing economy, pigs do not fly in China."
Beyond Mr. Block, it's hard to tell what resources Muddy Waters has to do all its sleuthing. The firm didn't respond to a request for an interview. The website doesn't list an address or give any information on who, besides Mr. Block, works there.
Publicly, he has been cagey about who is on the team, or how big it is. His rationale: that researchers could be in danger if people knew who were they are.
"I have a lot of people I work with in China, though not on every project," he told Barron's. "We are attempting to prevent managements from making tens of millions of dollars in illegal profits. And that's not the kind of money that people usually have a sense a humour about. Protecting [researchers]is top priority, because they are more exposed in many ways than I am."
Mr. Block has a theory about why analysts in North America may miss trouble at Chinese companies. He argued on CNBC that analysts don't go to China to see what the companies are doing, and whether the operations are as big as the numbers the companies report.
"I think a lot of analysts are failing to do this basic work, or they are showing up at Potemkin factories and are easily fooled," he told CNBC.
Analyst Paul Quinn of RBC Dominion Securities described in a note to investors Friday how he came to the conclusion that the stock was a buy. "We have relied on information supplied by the company, outside consultants such as Poyry, the company's auditors Ernst & Young LLP, and others to formulate our current Outperform investment rating."
With a file from reporter Tim Kiladze