Carson Block, director of research and founding partner of Muddy Waters Research LLC, speaks during an interview in New York, October 16, 2014.Brendan McDermid/Reuters
When Carson Block, founder of San Francisco-based Muddy Waters Research, published a report in June, 2011, alleging Sino-Forest Corp. was a fraud, seven analysts rated it a buy and hedge-fund legend John Paulson held a major stake.
Within a year, Sino-Forest was bankrupt.
Since then, Mr. Block has analyzed and sold short many other stocks. Several bets paid off, providing testament to his knack for uncovering questionable corporate activities overlooked by others.
The hedge fund he founded in 2016, Muddy Waters Capital Global Opportunities Fund Ltd., has since inception earned an annualized return of roughly 19 per cent, after fees, according to Institutional Investor.
Muddy Waters, which has assets of about US$256-million, accomplished these returns by targeting mainly corporate fraud and malfeasance. Mr. Block has found that approach usually works out better than shorting companies with high valuations or poor fundamentals during a raging bull market.
But despite believing that corporate fraud and malfeasance in Canada “is right up there with other countries,” he’s been staying clear of bets against Canadian firms over the past few years.
His last short position in Canada was Manulife Financial Corp., initiated in late 2018. He argued that a lawsuit the insurer faced concerning high interest payouts tied to insurance policies could have put it at risk of significant financial damage. The case was dismissed a year later by a Canadian court.
Most of his current short campaigns (detailed on his website muddywatersresearch.com) involve U.S.- or U.K.-listed stocks that largely aren’t familiar to Canadians.
In an interview with The Globe and Mail, Mr. Block said he believes Canada’s uneven approach to securities regulation means, too often, unethical corporate behaviour goes unpunished.
“One reason is the decentralized regulatory system that spreads resources over so many provinces, which I believe dilutes surveillance and enforcement,” he said.
“In my experience, the Ontario Securities Commission gets it,” Mr. Block adds. “But the agencies in other provinces don’t appear too interested – the relationship between the regulators and regulated seems a bit clubby in those regions, in my opinion.”
In most provinces, short sellers face an uphill battle, and “it’s not usually worth the brain damage,” Mr. Block finds. That is unfortunate because by discouraging short sellers, there could be even less incentive for the “bad apples” to be honest with investors, he says.
Mr. Block also thinks Canada is a difficult environment because of “the strong corporate lobby.” One manifestation is the number of lawyers that have carved out niches as “paid shills for companies dealing with short sellers,” as he puts it.
The lobby has also actively petitioned for curbs on short selling – even though most academic studies support the practice. Experts say it is a countervailing force against the preponderance of bullish messages and sentiment in the market, and thus helps improve its functions of providing liquidity, price discovery and the allocation of capital.
Already these basic functions are in a bad state, not only in Canada but around the world. “Stock prices now often move without reference to company fundamentals because the flow of money is increasingly guided by other imperatives,” Mr. Block asserts. “The markets are broken.”
One of the primary causes of distortion is the prevalence of passive investing – which simply directs capital to whatever stocks are in the index, in proportion to their market capitalization. So whenever a stock goes up, the passive fund needs to direct more of its inflows into the stock, prompting further price increases regardless of the fundamentals.
This kind of dynamic is a big factor behind the unrelenting rise in the shares of companies such as Tesla Inc., Mr. Block argues. It also likely has played a role in short squeezes, he says, like the one that occurred in January in GameStop Corp. (about a quarter of its available shares were owned by passive investors).
Another big contributor to market distortion is extremely loose monetary policies and low interest rates. This not only leads to more leverage and buying stocks on margin, but pushes balanced funds to rebalance toward stocks – as well as driving pension and endowment funds to seek higher yields in equities.
As bull markets age, more and more questionable listings make it onto the market. Recently there’s been a rush of Chinese companies with questionable accounting, blank-cheque SPACs and uneconomic IPOs. A great deal of capital is being drawn into dead ends, Mr. Block says.
All these factors have made his job more difficult to generate returns, he argues. Short sellers have a profit motive, of course. But a positive side benefit is the counterbalance to brokerages issuing mostly buy recommendations, auditors signing off on overly positive financial statements and regulators who may have capitulated to industry pressures.
It’s not easy to be a short seller and go against the bullish ethos. It can arouse fierce opposition and create a great deal of stress.
Take Mr. Block’s experience.
Almost daily, he receives online messages containing verbal abuse and threats of bodily harm – even the occasional death threat. Furthermore, companies hire private investigators, and even hack his computer, to gather information on him.
Mr. Block says 2018 was an especially stressful year, and he nearly quit. He was dealing with a lawsuit from one company and under investigation by two market regulators in Europe. If the latter investigations had not gone in his favour, he could have been arrested and imprisoned.
When asked how many times he has been sued, he says: “Just about every time I issue a research report, a threat of a lawsuit is implied or made. In five instances, lawsuits were actually filed. One just ended after three years and half a million dollars.”
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