Who Will Save Us From Chinese Fraud?

"They tell me everything isn't black and white... well I say, why the hell not?"
-- John Wayne

In recent years, Chinese companies have ridden into Western stock exchanges with no apparent fear of defrauding investors. The investor's traditional warden, the SEC, can only reach so far into China before violating Chinese laws against sharing certain documents with foreign regulators. With the SEC losing the fight to protect investors, who will protect you against fraud?

Carson Block, The Quiet Man
Welcome a new sheriff to town. Carson Block leads his posse at Muddy Waters Research, a firm that's been shorting and reporting on Chinese companies with accounting irregularities, and presumably making a nice profit. Critics of Block's profitable vigilantism cry for him to withdraw his financial interest and question his ethics, but others see him as insightful investor to follow.

Block is the only full-time employee of Muddy Waters, which he started in 2010. His background includes a self-storage business in China, a book titled Doing Business in China for Dummies, and a law degree from Chicago-Kent College of Law. He keeps quiet on his whereabouts because of death threats, and his website was hacked over Thanksgiving following a report released on Focus Media (NAS: FMCN) . Obviously, there are those who would rather see Block keep quiet and fade away, rather than have him continue to release damaging reports.

Block first issued a report on June 28, 2010, alleging that Orient Paper was a fraud. The closing price that day was $8.33 per share. Today, Orient Paper trades for less than half that at $3.12 per share. Through a visit to Orient's factory, scouring public records, and talking to suppliers and customers, the Muddy Waters report included these conclusions:

  • Orient's actual 2008 revenue was only 3.7% of what it reported in its 10-K.

  • Two of Orient's top 10 customers in 2008 were too small to purchase the amount of paper Orient claims that they purchased.

  • Orient allotted more than $27 million for the purchase of a machine that claimed levels of output higher than any existing machine available, at triple the price of any existing machine.

Orient refuted the results of this report, and an independent audit sided with Orient on a number of issues -- but also recommended further study on Orient's capacity, inventory value, and purchases from a supplier with connections to Orient's chairman. And, casting the first shadow on Block's ethics, according to TheWall Street Journal, Orient stated that Block offered to release a positive report on the company in exchange for money or equity. Nevertheless, shorting this after Block pulled the trigger would have netted investors over a 60% return.

Since Block's first success with Orient Paper, he has taken aim at RINO, Duoyuan Global Water,China MediaExpress, and Sino-Forest. Since then, RINO and China MediaExpress have lost largely all of their value, while trading in Duoyuan and Sino-Forest has been halted for months.

With Block's reputation for accuracy, the market punishes any stock seen lingering in his sights. This also means he is likely to benefit in the short term after releasing negative information even if his reports are proven false. This power to short and distort could easily be abused, even by those without Block's history of accuracy.

Most recently, Block released a sell report on Focus Media -- once trading around $25 per share, diving down to $15 per share on Block's report, now trading around $20 per share. Block is now warring with the company over the accuracy of an independent review on Focus Media's LCD screen advertising network, just recently releasing a report titled "Is 'Independent' Verification in China Better than Toilet Paper?". This report criticizes CTR Market Research for its seemingly numerous conflicts of interest, demonstrated by its failure to accurately report the size of China MediaExpress' LCD screen network.

The report also touches on Block's larger role as a reformer, rather than simply making money through shorting and releasing reports to bolster his gains. He states, with a little shorting-and-distorting irony, that corruption and conflicts of interest in the private sector "are too significant in China for investors to put any faith in market research." Even with Block's debatable ethics, each company that he reveals using questionable accounting lessens the chance of investors choosing a loser -- and pressures other companies to maintain ethical behavior.

Is Block your hero?
Shorting stocks holds an unlimited downside as the price has no ceiling, and a limited upside because the lowest the price can drop is $0 per share. It is also difficult to verify Block's claims without personally visiting China. For these reasons, Block's largest benefit for a long-term investor is probably the pressure he puts on companies for truthful numbers.

If you fear owning Block's next target in the Wild West of Chinese companies, but still want exposure to China, look for well-established domestic companies with a large share of business in China. This includes Yum! Brands (NYS: YUM) , with 43% of total revenue from China; Las Vegas Sands (NYS: LVS) , with about 50% of total revenue from Macau; and NVIDIA (NAS: NVDA) , with 24% of total revenue from China.

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At the time thisarticle was published Fool contributor Dan Newman believes this town is big enough for the both of us. He also does not own any shares of the companies mentioned above. The Motley Fool owns shares of Yum! Brands.Motley Fool newsletter serviceshave recommended buying shares of NVIDIA and Yum! Brands, as well as writing puts in NVIDIA. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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