Are complex companies easy targets for short-sellers? It’s certainly looking that way based on a couple of recent cases, where investors who profit from falling share prices have poked holes in seemingly bulletproof companies that can be painfully difficult to defend.
Case one: Muddy Waters Research, led by Carson Block, alleged in early February that Fairfax Financial Holdings Ltd. had overstated its balance sheet by US$4.5-billion with “abusive accounting” and “value destructive” transactions.
Even long-term, loyal investors of the insurance company may have been stumbling for an immediate response, given the stock’s swift one-day decline. The share price plunged nearly 12 per cent on Feb. 8, which is a huge move for a company valued at $35-billion.
Case two: Dalrymple Finance, led by Keith Dalrymple, alleged in October that Brookfield Infrastructure Partners LP, one of the publicly traded divisions of parent Brookfield Corp., employed “aggressive accounting” and used “inflated cashflows and asset values” to mask an unsustainable dividend.
Although Brookfield Infrastructure’s share price was already being weighed down by higher interest rates in the months preceding the report, the U.S.-listed version of the stock slumped another 12.6 per cent over the week that followed the report’s release.
No doubt, investors were left wondering if it presented a risk that they hadn’t previously considered. Full disclosure: I’m one of these head-scratchers.
Short-sellers bet against stocks for any number of reasons, including concerns about valuation, competitive pressures and strategic direction.
Since they make their money when stocks fall, they have a strong interest in releasing information and opinions about companies that can help their cause, often in the form of lengthy reports crammed with charts and financial data.
They are frequently right. In some cases, their reports outline shenanigans that can sink a company.
In 2011, Mr. Block accused Sino-Forest Corp., a Canadian forestry company that had been valued at more than $6-billion, of exaggerating its Chinese assets. By 2012, the share price had collapsed and the Ontario Securities Commission filed fraud allegations against the company and six of its top executives.
This level of success can establish a short-seller’s reputation. That helps explain why Fairfax’s share price fell sharply when Mr. Block released his February report, even though Fairfax said in a statement that it “disagrees with the allegations and insinuations” and some analysts rushed to its defence.
But here’s where things get interesting. Fairfax’s share price fully recovered from the severe selloff within a week of Mr. Block’s report and is now about 8 per cent above its pre-selloff level. Similarly, Brookfield Infrastructure Partners is roughly back to its level before the appearance of the Dalrymple report.
This whipsawing doesn’t prove that the short-sellers were wrong. It does, however, suggest that the initial allegations may have touched a nerve with investors who cannot immediately assess the validity of a short-seller’s case.
The reason is that Fairfax and Brookfield Infrastructure are not simple companies to understand, given that they value various global assets using assumptions that can be opaque.
Brookfield Infrastructure has additional complexities related to the web of other Brookfield entities in which it resides. Anything involving the Brookfield group of companies – which includes not only the parent but also the private equity arm, the asset management division and the renewable energy spinoff – can add cross-ownership issues and intercompany transactions to the mix.
“It’s extremely complex. It may be the most complex organization, in aggregate, in the country,” Anthony Scilipoti, chief executive officer at Veritas Investment Research, said in a December interview.
That comes from the head of an independent Toronto-based equity research firm that approaches stocks using forensic accounting.
Complexity is not necessarily a bad thing – well, most of the time.
Brookfield Infrastructure, though well off its high in 2022, is up 105 per cent over the past decade (not including dividends). The gains reflect interest in the company’s global mix of stable utilities, transportation assets and data operations.
Long-term investors have been well-served by Fairfax as well. Its share price has risen 212 per cent over the past decade, as its investment assets and insurance operations have expanded. That is well above the 48-per-cent return for the S&P/TSX Composite Index over the same period.
In both cases, though, investors appear to be easily rattled by views that challenge the bullish case.
The take-aways here may be unsatisfying. The first is that some complex companies have targets on them, which means that investors will have to accept that there may be uncomfortable periods of turmoil.
The second is that selling into a downturn can be a bad move. Short-sellers can create mayhem, but they can also set up attractive buying opportunities.
David Berman