Tag Archives: financial

Lessons From Muddy Waters Research And Other Short-Sellers In Avoiding Potential Value Traps

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.

ETF Product Development: Innovation Versus Over-Engineering

ETF Product Development: Innovation Versus Over-Engineering Source: Wiki Commons ETF Product Development: When Innovation Turns into Over Engineering This quarter’s volatility has produced some early victims, notably some high profile hedge funds and quantitative market-neutral based strategies . As a former quantitative equity portfolio manager, I lived through the infamous August 2007 Quantitative Meltdown , where highly levered strategies using a combination of value and momentum were forced to liquidate all at once causing significant losses tied to what had been historically strong performing strategies. With this quarter’s sharp underperformance of similar strategies, the concern floating out amongst trading desks is whether we’re seeing another forced unwind of such strategies, particularly ones focused on price momentum, which had been one of the better performing strategies in recent periods. In discussions with a handful of capital market desks, I don’t get the sense that there is as much leverage employed today as there was in 2007, but one never knows until the counter-trend unwind exhausts itself. In some ways, the August 2007 Quant Meltdown served as an early warning signal of the fragility of capital markets resulting in the Great Financial Crisis of 2008. Much has been written about this period (and more recently in film, such as The Big Short ), but I highly recommend reading a Demon of Our Own Design written by Richard Bookstaber, who formerly headed firm-wide risk management at Salomon Brothers. In a nutshell, Bookstaber maintains that a system designed with ‘complexity’ and ‘interdependence and tight coupling’ is prone to normal accidents, whether nuclear power plants or leveraged financial vehicles tied to the performance of subprime mortgage-backed derivatives. It’s a cautionary tale particularly for Wall Street whose lifeblood is tied to increasing innovation that can quickly mutate into over-engineering. Complexity when combined with leverage leaves the financial markets more prone to liquidity-driven accidents and contagious selling of unrelated market segments. Correlations spike to one where diversification no longer matters as long as the investment program is only invested in safe assets. ETF Innovation: Know What You’re Buying Becoming Increasingly More Difficult This quarter’s market-neutral meltdown partly inspired this blog post, but it was primarily due to an analysis of a recently-introduced multi-strategy ETF designed to provide U.S. equity market exposure but with lower volatility and greater risk-adjusted returns. First, ‘smart’ beta (factor) investing is not ‘smart’ at all but just a reformulation of the Dimensional Fund Advisors’ (DFA) strategy of investing in areas of the market which have afforded higher risk premia over the long run. ‘Small cap’ and ‘value’ factors outperform over the market because they come with higher risks which investors are compensated for over the long run – these factors are no ‘smarter’ than a traditional market-cap based approach such as the S&P 500. Corey Hoffstein from Newfound Research published a recent piece on ETF.com in which he makes this astute observation about smart beta investing: “It is important to point out that for the long-term premiums to exist in these factors, they must be volatile over time. The excess return generated by one investor is at the detriment of another. If the returns were not time-varying, they would be viewed as “free.” In that case, there would be significant money inflow into the style, driving up prices and valuations and driving down forward expected returns until the premium converged to zero. Quite simply, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain . [Underline Emphasis Added by 3D]” Smart beta investing is not a free lunch but one with real risks involved, such that the largest harvests of risk premia occur when weaker investors are bailing out at just the wrong time. Now ETF product innovation is a good thing as it has afforded investors access to market segments and themes only available to institutional investors. ETF product innovation has captured the systematic elements of many actively-managed strategies and has helped expanded the list of options to DFA like-minded investors who no longer wish to be constrained to the Fama/French 3-factor world. But new entrants to ETF sponsorship along with more participation from institutional investors has resulted in a new cycle of product innovation characterized by increased complexity. ‘Dynamic’ management of market exposures represents the latest innovation. Rather than providing a static exposure to, say, currency hedging, the ETF sponsor implements a rules-based dynamic hedging scheme designed to generate superior risk-adjusted performance over a static hedged or fully unhedged equivalent. The chase for ‘dynamic’ management introduces a new layer of complexity into the underlying exposure an ETF is designed to achieve. This brings us back to an analysis of a recently-launched ETF whose objective is to generate superior risk-adjusted returns over traditional asset classes through a combination of long and short positions where the short exposure is dynamically managed. Consider the components: ‘Long’ position weightings are based on a multi-factor approach combining value and growth metrics. The long weighting is further adjusted for its volatility characteristics (lower volatility stocks receive an incrementally higher weighting). The short exposure is designed to hedge out equity market risk. It is implemented using short S&P equity futures. These same value and growth metrics are used to determine the hedge ratio where the ETF can be 0%, 50%, or 100% hedged to market risk. Some variants of this approach provided by other ETF sponsors use a separate top-down business cycle indicator to determine the hedge ratio or base the hedge ratio on momentum-driven technical analysis. Now consider the complexity embedded in this approach as well as the interlocking dependencies making it more vulnerable to the type of accidents of the kind found in Bookstaber’s narrative. The ETF investor must ask, “What exposure am I ultimately buying with this ETF?” It is not a straightforward answer because the exposure is contingent on how this ETF is positioned given the latest market conditions. In addition, multiple things have to go right in order for this ETF to achieve its objective. The choice of factors must be correct. How the factors are mixed and weighted must be correct. The hedge ratio must be correct (market timing is an historically dubious exercise). But what ultimately is this ETF trying to achieve? It’s trying to achieve that elusive equity market free lunch – high capital market returns associated with equity investing but without as much risk. But that sort of objective flies in the face of capital markets pricing theories and would be expected to achieve the opposite, namely lower risk-adjusted returns when you factor in the ETF’s complexities and underlying fees. Many aspects of this strategy would have to perform consistently well in order for the ETF to achieve its objective, whereas, the failure of just one aspect can result in underperformance or an accident (especially if it were combined with leverage). When it comes to strategic beta or complex ETFs, it is imperative to know what you’re buying and why you’re buying it. Ask yourself, “What is this ETF designed to achieve and how does it fit within your asset allocation?” If simpler solutions are available to achieve a similar objective, then opt for simple over complexity. Product innovation is welcomed to a growing marketplace, but it a balance must be struck between innovation and system complexity. That is the elegance of design. 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. Additional disclosure: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of February 22, 2016 and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com.