Critics of short-selling erupt at every instance of plunging share prices, and the current crisis among US-listed Chinese companies is no exception. Critics say investors should assume these companies are innocent until proven guilty (in a court of law). Short-sellers are fear mongers, they say, and their unproven allegations do harm to companies and investors. Short-sellers acting in concert could cause a full-blown market panic.
These people usually propose all kinds of limitations on short-selling. One popular recommendation is to limit short-selling to only the largest, most liquid stocks.
This is a bad idea, and particularly bad in the current instance. Banning shorting of small- and medium-sized developing companies destroys the economic incentive for short-sellers to expose weak business plans, accounting irregularities and fraud while companies are still in an early stage.
In the case of Chinese reverse takeovers (RTOs), such exposure was clearly overdue, and the ordinary precautions of auditing and due diligence were either skipped or, in many cases, woefully inadequate. Banning short-selling and options trading eliminates the quantitative risk signals those activities naturally provide – namely, high share-borrowing costs and high put option premiums.
Woe the RTO
Critics of short-selling are also wrong to believe greater authority and government regulation can be more effective than short-sellers at catching or preventing large-scale fraud. The track record of the US Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority, the Public Company Accounting Oversight Board and the Federal Reserve in the US shows that regulators almost never take action until after the crisis has unfolded (as they did in the case of American subprime mortgages) or when the problem company is already too big to fail (as in the case of General Motors or the American Insurance Group).
Bigger budgets and greater power for regulators are unnecessary if short-sellers are allowed to perform their natural role in the markets. Short-sellers do not cost taxpayers one cent – indeed, the best ones earn a nice profit from their efforts.
First of all, understand that short-sellers had no economic incentive to research fraud in China until the US-listed shares achieved enough liquidity. Rarely do companies with a market capitalization of less than US$100 million draw the attention of short-sellers. The opportunity is just not profitable, even if the company in question is a total fraud. But in 2009 and 2010 many Chinese companies achieved listings on major US exchanges, and consequently exposed themselves to the scrutiny of the shorts.
In the past 12 months, short-sellers have uncovered widespread evidence of fraud at many of these companies.
For example, on April 28 I reported that four months of video surveillance of Sino Clean Energy (SCEI) show little or no production of coal water slurry fuel at each of its three plants, calling into question whether it has even one-tenth of the US$33.7 million in sales it reported achieving in the first quarter of 2011. SCEI’s chairman then tried to disprove the video surveillance by posting copies of his own security camera videos that appeared to show production activity at the company’s main facility in Tongchuan, Shanxi province.
However, I subsequently showed from official weather records and photographs that the chairman installed his security camera after the fact and that his production videos were staged sometime after the period in question. SCEI stock fell from over US$7 per share in February to close at US$2.10 on May 8, following my most recent report.
The most effective short-sellers are well-connected Chinese speakers with investment and trading experience in China. Few people have the skills and connections to do this alone. Effectively researching US-listed Chinese companies requires a strong network of local investigators paired with analysts who can compile and write the reports.
To make the best profit, researchers typically sell the reports to hedge funds. The fund(s) then short the stock, nearly always causing the price to decline as their position builds up selling pressure.
Traders who follow chart and options trading patterns often detect that something is amiss and join in on the shorting. Large purchases of “put” options are a sure sign that short-sellers are close to sharing their research with the public.
In the case of SCEI, the stock fell from US$7 to US$4 before the first short-seller published a negative report. Several more negative reports followed and, over the ensuing two months, those who shorted the stock at US$7 achieved a nearly 70% gross return on their investments. However, it’s worth noting that shorters’ net return is often greatly diminished by share borrowing costs as well as the premiums paid to purchase put options, both of which can run as high as 10% per month.
Considering the large profits short-sellers can make when share prices fall, investors should be careful to review short reports thoroughly and wary to believe them. Some short-sellers such as Andrew Left of Citron Research, Carson Block of Muddy Waters and myself have built up substantial track records exposing fraud in many Chinese US-listed companies.
I think our track records give us a certain degree of credibility. Nevertheless, I encourage investors to always review the facts independently and make their own educated decisions. I, for one, do not give investment advice. Instead, I simply try to share the facts as I see them.
Shooting stock in a barrel
Thus far, the opportunities for short-sellers have been plentiful. Given a universe of hundreds of US-listed Chinese companies, the shorts have so far wisely targeted the most obvious frauds. They have found more cases of fraud than anyone expected.
The result has led to pressure on all but the “blue chip” IPOs in the sector. Hundreds of stocks that were never attacked by short-sellers have fallen in sympathy.
Bullish investors in the sector responded by pushing companies to upgrade to Big Four auditors. However, even a Big Four auditor upgrade does not always convince short-sellers that a company is legitimate. Ch
ina Integrated Energy upgraded its auditor to KPMG in December and its 2010 financials and internal controls passed muster. However, after I released six months of video surveillance showing that China Integrated Energy produces no meaningful volume of biodiesel at its two plants, KPMG resigned and withdrew its audit and internal controls opinion.
In the wake of such profitable victories, short-sellers are of course even more motivated to expose fraud in this sector. Considering the shorts have only so far picked the low-hanging fruit, I believe the risks remain high for quite some time.
On the other hand, I am pleased to see long investors now demanding higher standards of due diligence, particularly when focused on company operations. Shorts rarely target companies that maintain high operational excellence.
As investors reallocate funds to these companies, the bulls will run again. Looking back, we should recognize that shorts made a profit separating chaff from wheat, and we should defend this unique and beneficial feature of US markets.