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Beware of Muddy Waters' Elephant Gun

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David rocking Goliath's world. The 1980 U.S. Olympic ice hockey team stunning the Soviet Union. Little Mac knocking out Mike Tyson.

In the annals of underdog victories, is short-side research firm Muddy Waters about to get an entry?

It's being reported today that John Paulson's Paulson & Co. hedge fund has dumped its entire stake in Sino-Forest (TSX: TRE), a Chinese forestry company that was the latest target of Muddy Waters. In a statement, Paulson said: "Due to the uncertainty over Sino-Forest's public disclosures and financial statements, we have sold our stock and await the results of the independent committee's investigation."

This isn't the first time that a big-name investor has been caught in the crosshairs of a Muddy Waters takedown. Back in February, the firm released research on China MediaExpress (OTC: CCME), saying in no uncertain terms that the company was "engaging in a massive 'pump and dump' scheme." C.V. Starr, the investment vehicle of former AIG chief Hank Greenberg, was a major holder of China MediaExpress shares. Though the company hasn't admitted wrongdoing, shares have been delisted from the Nasdaq and have lost more than 90% of their value since January.

Orient Paper, RINO International, and Duoyuan Global Water (NYSE: DGW  ) have also been among Muddy Waters' targets. Only Orient Paper has thus far managed to fend off the attacks to some extent. The company just announced that a four-month investigation found no evidence of Muddy Waters' claims against it -- though it remains to be seen how much that will help the ailing stock. Meanwhile, RINO has been delisted and trades for less than $1, while Duoyuan's stock has been halted since April.

The China MediaExpress hit put Muddy Waters in the spotlight, and if Sino-Forest is unable to clear its name, this latest volley could add even more market-moving power to the research firm. For the 12 months ending in March, Sino-Forest reported nearly $2 billion in revenue. The Wall Street Journal suggested that Paulson's paper losses on the stock were in the $500 million range.

For investors on the long side of the small-cap China trade, there is now more reason than ever to fear the Muddy Waters cannon being trained on their stock. While it remains to be seen whether the Orient Paper findings will ding Muddy Waters' credibility at all, it's a virtual guarantee that any stock that the short seller writes about will lose a considerable amount almost immediately.

And it doesn't seem as if there is any shortage of targets out there. Harbin Electric (Nasdaq: HRBN  ) has been in a tug-of-war with short-seller Citron Research as it tries to convince investors of the veracity of a buyout offer from its chairman, while last week China-Biotics (Nasdaq: CHBT  ) became yet another Chinese stock whose shares have been halted.

Of course, if you just can't quit China, then you can at least get a view from the ground. Click here to sign up for free dispatches from the Motley Fool Global Gains team as it treks through China looking for the best investments it has to offer.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (5) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2011, at 4:03 PM, Gonzhouse wrote:

    Until someone proves these RTOs are legitimate, their track record says they're not. Good luck Harbin, you are going to need it (in massive quantity).

  • Report this Comment On June 22, 2011, at 8:24 AM, wgushue wrote:

    Is Sino-Forest The Biggest Theft In History Or Could It Possibly Be The Hedge Fund Companies?

    The Ontario Securities commission is investigating Sino-Forest and it will take a few months. Why is the media making such a sensational story out of this when the truth has yet to come out?

    Sending out a strong sell to financial websites on allegations without a proper investigation by the securities is reckless and has wiped out many families life savings not to mention the fallout from other avenues i.e., employees of the forest industry & yes Sino Forest. I find you a greedy & vindictive company/person. Even if Sino Forest is at fault, the fact that you would bet money the company goes to $0.00 is even more ruthless & shows a person with no empathy. Sure you can laugh all the way to the bank but in the end who's money are you taking or do you really care as long as you get the money?

    Thanks Wayne


  • Report this Comment On June 23, 2011, at 11:37 PM, TMFAleph1 wrote:

    Nice article, Matt. I have nothing against short sellers; in fact, I think they are useful market participants. However, Muddy Waters looks like a firm of dubious integrity to me. Have any of the claims he has made against any of the companies been verified? As far as qualitfy and thoroughness of research goes, I would pick Paulson & Co. over Muddy Waters any day of the week.

    One thing, though: It's no longer a paper loss once Paulson sold the shares.

  • Report this Comment On June 23, 2011, at 11:45 PM, ETFsRule wrote:

    Ya, Paulson sold his shares pretty quick. He didn't even try to put up a fight against MW... it seems like a clear admission that he didn't really do any due diligence on this Sino-Forest company before he invested.

  • Report this Comment On October 24, 2013, at 4:10 PM, kernelbranndt wrote:

    Can anything be done about Muddy Waters? It seems to me that unsubstantiated allegations can hurt a lot of small investors.

    It also seems to me that the SEC should be investigating Muddy Waters. What about it fools?

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