Reuters Insider - Short-seller Block: Markets overvalued, even after sell-off

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17/10/2014 09:38

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 Source:             Thomson Reuters                                   
                                                                       
 Description:        Short-seller Carson Block, who gained prominence  
                     for denouncing alleged fraud at Chinese companies 
                     via his firm Muddy Waters, discusses the markets  
                     and his latest investment calls                   
 
 
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Transcript (May be auto-generated)

 Short-seller Carson Block has made a name for himself, denouncing alleged fraud 
at Chinese companies. He joins me now with his take on the markets and some 
recent investment moves. So nice to see you here on the East Coast. Well, it's 
good to be back, thank you. Let's start with the markets because that's where 
everyone's attention really is. What do you make of what's really been an 
amazing couple of days in terms of volatility? What do you think is going on? 
Okay, well- look, I am not a market prognosticator. I'm not a macro investor- 
But you're an observer clearly. Sure, and I've felt for some time that both the 
equity and the credit markets were mispricing risk. I thought that the equity 
markets' valuations were stretched, frothy in some areas. So, look, this is- 
this could be finally a realization of that state of affairs, I mean, or maybe 
it's just a wobble on the way to going higher. I really don't- I don't- I 
couldn't be directional one way or the other on where the market is going from 
here. But ultimately, yeah, valuations will come down because they have not been
sustainable, and I think are still not sustainable. 

That's what I was going to ask you if they've come down enough or are there 
still pockets of overvaluation in the stock market? Sure, I mean, there 
definitely a- I mean, there's been- there's been some correction here but I 
think we're still not at levels- I mean, we're in an environment where it's very
difficult to understand markets because they're- they've been manipulated so 
much by central banks. So really, how can you value a business when the markets 
are- when you have so much central bank interference? I don't have the answer to
that. I kind of look at it from the perspective of do I think valuation on 
company X makes sense? And even with the stocks having come off, there are very 
few companies that I think would fall into the category of, well, now it makes 
sense. And tech is one area in particular you think is a little frothy. Yeah, I 
mean, tech tends to get frothy in a real bull market. I mean, within tech, you'd
really look at SAS as having- Define that. -software as a service. Well, it's 
interesting that you'd ask about defining it because there are companies that 
we've look at that are kind of masquerading a SAS companies because that's what 
got hot. But we don't think really are SAS companies. So but you know basically 
that would be the Cloud. That's what SAS companies are- companies that rely on 
the Cloud so- Are you taking the short positions in any of them currently? We've
got some tactical positions in some. We've been in and out. It's tough to short 
SAS right now because there's- we're- the market, the way it's been since the 
middle of 2013 is that you've had some of the worst quality names perform the 
best. And that's the problem with shorting in SAS. I mean, there isn't- 
everything is very frothy so it's kind of hard to pick a hedge there. And if 
you're shorting SAS, you have to be worried that these things really run on you.
So the only answer is: be tactical about it and keep your concentrations pretty 
low. One company you did take a short position is 500.com. Now that is a case of
being overvalued, you've mentioned. Is it anything beyond that? So we- I've made
some comments last month in a private forum about 500.com and I have talked 
about how we have managed short position in that. I think this is certainly- 
there are two issues with 500.com, which 500.com, it's a company based in China-
all of its business is generated in China. 

It sells online these sports lottery tickets, which is the way that you would 
wager on sporting events in China. And you have a fundamental issue there which 
is that right now it's operating what's kind of a legal grey area. Now, more 
regulation is coming and 500.com will probably get one of the early licenses. 
But think that that regulation and the licensing will actually create 
competitive pressures that are going to drive down market substantially, 
especially as the lottery business gets more centralized in China as opposed to 
be operated by provincial operators. So there's a fundamental concern with that 
company over the medium to long term. There are certainly some strange things 
about this company as well. So one of my favorite is that when they have a 
customer who buys a lottery ticket online, the company actually sends employees 
to the provincial lottery administers office. They buy the ticket in person and 
then if that ticket is a winning ticket, they send employees back to that 
lottery office. The proceeds are wired into a personal bank account belonging to
one of the employees and then wired to the company and then wired to the winner.
Now, when you look at all of the issues that have had with fraud and China- and 
I'm not saying the 500.com is a fraud but this set up is so easy to commit fraud
with it that it really is a company that should trade at a much lower multiple 
than it does presently. And that's- Because of a fraud risk? Yeah, because of 
the fraud risk- there are other issues there that were- there were some 
accounting yellow and red flags as well. But it's- there's a price for 
everything and I just- our view is that the price of 500.com stock does not come
anywhere close to reflecting the risks of, not only the fundamental issues, but 
the risks of wrongdoing that could be there. How prevalent is fraud among some 
of these Chinese companies now say a year or two ago? Is there progress being 
made or are you finding potentially more opportunities than ever before? Well, 
so there are- my view is that the fraud problem still exists and exists in 
serious scale, and here's why? There has not been any management of a China 
company that defrauded US investors that has been materially punished ever for 
defrauding US investors. The reality is - and I think even the people who are 
bulls on China can admit this - that there was a huge problem fraudulent 
companies from China listed in the US. Again, not one management has ever been 
materially punished. Worst case scenario for them, some of them have had to 
repay pennies on the Dollar to the SEC, probably so that they can continue to 
come to the US and visit their kids who are likely getting their MBA somewhere. 
That's one issue. Another issue is that the Chinese government has actually 
acted to protect the frauds. So the Ministry of State Security, the public 
security bureau, have imprisoned people who are doing due diligence on 
companies. That is not an environment- I mean they're going to complete opposite
way in terms of they're not fostering transparency, they're basically creating 
opacity. So you have, nobody's been materially punished, the macro environment 
and the government is supporting an environment in which companies can defraud 
foreign investors. And then finally, you've heard a lot of people from China 
Inc. be very outspoken in criticizing US short sellers. Well, here's the thing: 
I have never ever come across somebody from China Inc. who has been outspoken in
criticizing managements that have committed fraud. There have been a number of 
confirmed frauds and you know what, if I were a CEO of a legitimate Chinese 
company, those will be the people that I would be calling out in public as 
opposed to short-sellers. So when you take this combination of factors, it's an 
environment in which it would be incredible if there weren't a significant 
amount of fraud taking place. But at the same time, does it make companies that 
now list in the US like an Alibaba better vetted? In other words, there has been
attention or am I just deceiving myself upon trying to find a positive spin on 
it? Because Alibaba clearly got the most attention of any recent IPO or 
Chinese-based company with its- and investors obviously didn't shy away from it 
has come down, but certainly nobody was worried about investing in Alibaba. Well
at the end of the day, one has to really think about how due diligence is done 
by investment banks and how audits are performed. Let's look at the investment 
bank angle first. Due diligence usually consist of a junior banker, somebody 
who's maybe one to three years out of school, on the phone with a potentially 
fraudulent supplier or customer of the company just going down a list of 
questions. And you know, the thing is, if they get an answer that makes the hair
on the back of his or her neck stand up, because of the youth- I mean, I've 
talked to some bankers who have been in these situations in the past, they often
chalk it up to, hey, this must be my problem that I don't understand this 
answer. You're not going to race to your boss and say, "I really didn't get the 
response to this question." So due diligence is a checklist-driven exercise in 
many cases. That's the reality of how these IPOs are vetted by the banks. In 
terms of the audits, audits- this is to me one of the great misperceptions of 
investors. Audits are not designed to detect fraud. They're designed to detect 
accidental misstatements. And there was a report that came out I think about six
months ago that really hammered this home, had to do with corporate fraud that 
was ultimately discovered. So public and private companies developed markets but
included Europe. Audits only discovered fraud, I believe, it was 4% of the time.
Accidental discovery was more than double that. 

It's a little scary. Yeah. Auditors are not out there trying to catch frauds. So
it's really a buyer beware in your views? If you're seeing anything coming from 
outside the US listed here or in China in particular? Well, especially China 
because, as I said, the environment there, it's just so conducive to fraud. I 
mean, it's a completely asymmetrical trade. If you are Chinese, you have a 
company, what is your downside in creating false accounts and trying to go 
public in the US? There is no downside for you. If you pull it off, you'll get 
tens, hundreds of millions of Dollars. If you fail- 

But you don't have any concerns with Alibaba? Because you've said that if it 
wanted to defraud investors, it absolutely could. You were quoted saying that. 
But I just want to clarify, you don't have a concern that that has happened? My 
issue with Alibaba is the opacity. Opacity never ever works in investors' 
favors. Alibaba could have disclosed a lot more in this whole concept of "we 
view all of these different business lines as a single business unit, therefore 
we're not going to report them separately." And that's ridiculous. I mean, does 
Alibaba have a real competitive threat that it's concerned about if it broke 
down even basic metrics for its business? No. That argument doesn't fly either. 
I don't know why Alibaba is as opaque as it is but that's something that should 
concern investors. I think the fact that investors line up around the block for 
this IPO basically is a sign of the times and that there is a lot of froth in 
the market. So why not short it then? Just on the fact that there's not enough 
disclosure that would help you make a valid decision on whether it's a good 
investment even from a business perspective? 

Well the thing is, right now, there are a lot of good shorts out there because 
there are a lot of companies that it's clear are bad companies that have real 
market caps. Such as? Well, unfortunately we play it- We're not going to hear 
just yet. We play it close to the vest until we don't. But you did raise a point
that there are these big companies that you think there could fraud committed. 
So when you disclose your next big idea or two, is it going to be a big market 
cap company? We're talking a company worth billions potentially? I mean, I think
there's a good chance that our next idea will have a market cap north of $1 
billion. We will definitely be watching for that. You're thinking at fourth 
quarter, you're going to put that idea, right? 

Or sometime soon. Yeah. I'm expecting us to do one to two- start one to two 
activist campaigns in Q4 on the short side. So you are not a China bull and 
you're concerned about asset bubbles in China and artificial inflation of 
various things in China. Do you take a position with a big macro short on China?
No, I mean there's- I think that in- look, if you talk to macro investors, 
they're- they could have vastly a different way of looking at this but I think 
that if you want to play China from a short position on a macro basis, you 
probably want to look at these kind of tail risk type traits that don't cost a 
lot. So maybe a "put" spread on the offshore RMB, the CNH. Maybe even "puts" on 
the Hong Kong Dollar because they're very cheap and if there is a hard unwind in
China, I can see scenarios in which it pressures the peg, the Hong Kong to US 
Dollar but that's, you have to get the timing right and you have to figure out a
way to keep the carry cost of those trades low but that's kind of how I think 
about trying to play it from a macro perspective. And what about on the fixed 
income side? In terms of debt? China specifically or in general? Yeah, yeah. So 
the China high-yield market has just baffled me for a long time because it 
really, from a credit risk perspective, it's so significant because I believe 
there is not even one instance of recovery against a bankrupt Chinese debtor by 
an offshore bond holder. If there are any recoveries, they're few and far 
between. And I think the instance of Suntech's bankruptcy is pretty instructive 
and that is, you had a lot of bondholders offshore but there was a lot of debt 
that was owed to the local banks. So when the creditor committee was 
constituted, there was not one representative from offshore lenders on that 
committee. So structurally because of the FX controls, there's just such a 
massive- in the legal system, there's just such a massive barrier to getting any
recovery. So investing in China high-yield is really a play on them being able 
to refi and just roll the debt by issuing new bonds. And I don't think that 
that's too far away from how one would define a Ponzi scheme. So yeah, I can't 
be too sanguine about China's high-yield market offshore. But the likelihood of 
a bubble actually bursting, you think might be not something we potentially see 
right away, correct? If there's this need to keep feeding the beast, then maybe 
it's a worry that is overblown? Well, I don't think it's overblown in the sense 
that somebody, an investor looking to invest in China, what I would say to that 
person is that China is right now in a massive asset and credit bubble. Now, is 
that going to end tomorrow? I don't know. So, if you take a view where you're 
long China at this point in time, fine. Just be aware that there is this risk 
that there is this massive potential downside risks. So, stay nimble. I think 
private equity investments at this point in time would be a really bad idea in 
Mainland for that reason. But yeah, be cognizant that this really could unwind 
hard and usually, these unwinds happen, they can happen pretty quickly. So areas
that also might be a little dicey- property developers, one would think? Sure. 

Property developers, construction, the supply chain for the construction of real
estate industries. Those are I mean, among the ones that can be hardest hit. The
banks are sitting on a bunch of bad loans but those are state-owned banks so I 
don't think that there's a real trade there. And their prices kind of discount 
that already. But yeah, I mean that's- and then also, if you want to think about
things from a macro perspective, then you think about fraud shorting China as 
well. So, in every bubble that we've seen, you do get frauds. People who come 
out of the woodwork and look to capitalize on the euphoria. And so with China, I
mean, there were for various reasons, as I have said, there are a lot of frauds 
anyway but in a horrid landing for China, it's inconceivable to me that these 
frauds that are listed in the US are going to fare well. Now, look, they have 
defied logic to-date at least in the past year and changed so it can be a 
dangerous short. So I wouldn't put everything on shorting suspected China frauds
but that's another way to look at it from a macro perspective. Should US 
regulators be doing more in terms of some of these listing requirements for 
companies? It's really hard for them, to be honest. I mean, there is- So, US and
Chinese courts do not recognize each others' judgments so you have that barrier 
to cooperation between the two countries regardless. Language barrier is not 
insignificant. I mean, for the SEC to investigate a Chinese company, to get all 
these documents in Chinese, I mean, just the translation work alone is 
substantial. And to be fair to the SEC, again, the best that they have ever been
able to do is get pennies on the Dollar with these China frauds. 

So, how long do you really want to slam your head into the wall if that's your 
payoff? So it's hard the way that the legal system here works. In Hong Kong, 
Hong Kong has a system that actually does have particular requirements for 
issuers from Mainland China in terms of the listings and materials that they 
have to provide. The US doesn't work that way. We're pretty much, we try to 
create this level playing field. In actuality, I think we've done something 
that's- and this is really an act of congress that makes us more vulnerable and 
that is, and if you look at these Chinese companies, most of them file- instead 
of filing a 10-K, they file what's known as a 20-F. That's because they are 
"foreign private issuers." So as FPIs, the disclosure requirements for them are 
even lower than they are for companies that are 10-K filers. So we're giving 
them an easier time of it than we are domestic US companies. And I think that's 
really being taken advantage of in a big way. Carson Block. We're going to end 
it there. Thank you so much for your time. Thank you. I'm Rhonda Schaffler, this
is Reuters