I recently read this book “The Most Dangerous Trade: How Short Sellers Uncover Fraud, Keep Markets Honest, and Make and Lose Billions” written by Richard Teitelbaum where he profiles 10 high-profile short-sellers including Bill Ackman, Jim Chanos and David Einhorn among others. In particular, the chapter on Carson Block of Muddy Waters Research caught my attention. Carson Block of Muddy Waters Research is best known for his firm’s short-seller reports on Chinese companies. Carson Block embarked on this journey as an activist short-seller with a visit to NYSE-listed Orient Paper (NYSEMKT: ONP ) in January 2010, at the request of his father William Block who operated an investment research firm called WAB Capital which was compensated by listed companies for publishing research reports. During the visit, Carson Block spotted a couple of red flags, including the inconsistency between the actual raw materials (20-foot pile of used paper which was used as feedstock) sighted and its accounting value on the company’s books, the condition of the fixed assets (“the rolling machinery was antiquated”), and the fact that management was apparently unable to answer questions relating to operational metrics during the meeting. He published a negative report on Orient Paper and distributed it via email in June 2010; the stock is currently trading at a fraction of its share price prior to the report. In the next few years, Carson Block started Muddy Waters Research and went on to publish more reports on companies such as Sino-Forest and Rino International. On Muddy Waters Research’s website, the firm highlights its track record , where it claims its nine “Strong Sell” Reports have led to four de-listings, four resignations of auditors/CFO/board members and more than six formal investigations by regulators into covered companies. Lessons From Muddy Waters In September 2014, Carson Block of Muddy Waters Research gave a presentation to accounting students at Baruch College, the presentation slides are available for download here . Carson Block highlighted a couple of red flags that investors should take note of: High Days Sales Outstanding Few tangible assets on balance sheet Highly acquisitive / high capex Outsized gross margins inconsistent with the value-add they are providing to customers Unique in reliance on intermediary counterparties Often (successfully) entering new businesses High revenue or expense concentrations with counterparties Unexplained cash in the Variable Interest Entity Business models that don’t make sense Opaque business model Tax preferences / rates that don’t hold up Obfuscating answers on conference calls Changing Key Performance Indicators Initiatives disappearing without mention Heavy insider selling Losing customers as evidenced by changing names of top 10 customers Significant customer and/or supplier is a related party Inventory turnover inconsistent with industry peers I will elaborate on some of these red flags in greater detail below with actual case studies. Highly acquisitive In 2011, it was reported that Olympus ( OTCPK:OCPNY ), a Japanese manufacturer of cameras and other electronics, utilized acquisition payments and associated fees to hide the fact that it had made severe losses on its investments. The writing was on the wall, for those who bothered to do due diligence, as the company was a serial acquirer buying companies at inflated valuations, only to write down some of these acquisitions in a short period of time. Furthermore, most of these acquired companies were in industries unrelated to Olympus’ core business and were loss-making. Outsized Gross Margins Longtop Financial, a software company with banks and other financial institutions in China as its clients, was the subject of a negative report by Citron Research in April 2011. One of the red flags highlighted by Citron Research was that Longtop reported outsized gross margins of 69% in FY2010, compared with gross margins between 15% and 50% for its peers. According to Citron Research, management’s explanation for the higher gross margin was that “they have more standardized software sales then peers and standardized software has very high gross margins of around 90%. The company claims that these solutions and modules can be deployed to new customers with fewer man-hours and expenses.” In May 2011, Longtop’s auditor resigned; and the company’s shares were suspended from trading in August 2011 by NYSE. Opaque Business Model Charlie Munger has this particular quote which I like a lot: Where you have complexity, by nature you can have fraud and mistakes. You’ll have more of that than in a company that shovels sand from a river and sells it. This will always be true of financial companies, including ones run by governments. If you want accurate numbers from financial companies, you’re in the wrong world. Certain industries and businesses are inherently more complex and opaque, making it difficult for investors and even auditors to understand and do decent work on them. It is telling that several vegetable farming/processing companies in China have been the target of short-sellers at any one point in time or another; see the reports published here and here . On e key risk factor with investing in companies operating in the Chinese agricultural industry is that both sales (to distributors) and purchases (from farmers) are usually transacted in cash without supporting documents such as receipts. Inventory turnover inconsistent with industry peers China Biotics, a manufacturer and distributor of probiotics products, reported inventory turnover ratios of 33 and 29 times in FY2009 and FY2010 respectively, while a March 2011 report published by China Economic Review mentioned that “During our visit to Shanghai Shining Biotechnology’s facility, we saw no evidence of inventory leaving the premises or clients coming for inquiries.” In June 2011, both the auditor and CFO of China Biotics resigned. Closing Thoughts I am a long-only investor and I do not engage in any short-selling. Munger’s quote below echoes my view: It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then watch it go from X to 3X and watch the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that? Nevertheless, investing in value traps, particularly those that are or will be the target of short-sellers, is the single easiest way to lose money with stocks. Therefore, investors should actively learn from short-sellers and draw on their knowledge and experience to minimize the possibility of total capital impairment with any single one of their positions. As a special bonus for my subscribers, they will get access to a list of close to 100 Asian and U.S. stocks with large positive accruals (divergence between earnings and cash flow) and high Beneish M-Scores (these two are good indicators of fraud risks) in a separate bonus watchlist article. For readers interested in further exploring this topic, I have also previously written two articles on value traps, namely “How To Avoid Potential Value Traps With Net-Nets And Other Deep Value Stocks” and “Drawing Inspiration From Short-Sellers In Avoiding Potential Value Traps” published here and here respectively. Note: I flag potential value traps with corporate governance issues, financial statement manipulation risks and other red flags as part of my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service. My subscribers get access to the list of value traps for both deep value & wide moat stocks, in addition to monthly top ideas, potential investment candidate profiles and potential investment candidate watchlists. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.