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 (Nasdaq: FMCN  ) . Obviously, there are those who would rather see Block keep quiet and fade away, rather than have him continue to release damaging reports.

Reap the Wild Wind
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 The Wall 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.

The High and the Mighty
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.

True Grit
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 (NYSE: YUM  ) , with 43% of total revenue from China; Las Vegas Sands (NYSE: LVS  ) , with about 50% of total revenue from Macau; and NVIDIA (Nasdaq: NVDA  ) , with 24% of total revenue from China.

Or, if you want broader reach in emerging markets, check out our free report put together by our analysts with one great emerging market ETF, and two other winning ETFs: "3 ETFs Set to Soar During the Recovery." It's free!

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 services have recommended buying shares of NVIDIA and Yum! Brands, as well as writing puts in NVIDIA. 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. The Motley Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (14)

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 December 23, 2011, at 11:40 AM, Pkylie wrote:

    Well done, Carson Block. Now are you about to out Sheldon Adelson's Las Vegas Sands too?

    The biggest profiteer from money laundering including the biggest drug trafficker in Mexico, Zhenli Ye Gon .

  • Report this Comment On December 23, 2011, at 11:52 AM, JF125780 wrote:

    Thanks Dan for a very informative read and if I may add another great company to your list.

    Let's add Wynn and maybe MGM.

    Danny Kowkabany

  • Report this Comment On December 23, 2011, at 1:42 PM, fjfjfjjfjjfj wrote:

    I had read most of Carson's reports. 90% of the content are speculation based on 10% facts. It does not stand up to reality check. The most successful success of his career was CCME and sino. According to my research, both of them have basic structural problem, trying to circumvent the Chinese law of restricting foreign ownership of specific industry, none of which was mentioned on CB's report. He does not understand business in China and with all this year spent in China, he does not even speak the language. He targets Chineses companies with spectacular growth or turn-around stories. His famous last word was "If it is too good to be true, probably it isn't." I regard him as a tabloid writer at best, and maniuplator at worst." Undoubtly, he has a lot of fund behind him to generate the impact he has on the market. I had a habit of doing my own research and follow him to make money. I went long after his attack on sprd and so far had cashed in $13.00+/sh and had rebuilt my profolio on the downturn. I cashed out on fmcn with $3.00+ /sh profit and in the green after rebuilding my profolio in $19.00+. He is lucky so far with fmcn. The stock could already have been in $30.00+ if the market wasn't worrying about the economic condition in general. "WHO IS GOING TO PROTECT US FROM FRAUD ON WALL STREET." Do you remember ENRO, TYPCO, WORLDCOM, BREX, NORTHTELE, BANKING INDUSTRIES, GM, Chrysler". The last thing you need is the help from CB. He is your worst enemy. A lot of followers of him shorting fmcn and sprd after the attack are in deep trouble. As he said " TRUST ME AT YOUR OWN RISK."

  • Report this Comment On December 23, 2011, at 3:51 PM, fjfjfjjfjjfj wrote:

    A report titled "Is 'Independent' Verification in China Better than Toilet Paper" is covered by an extra-ordinary long disclaimer saying that the report can only be used in California and covered under a specific California Law. It should have been said "ALL OF HIS REPORTS WORTH LESS THAN TOILET PAPER". He also said that on CNBC that he does not understand FMCN's business and does not trust anything from the management unless they explain to him in detail how they conduct their business. He claimed most of the Chinese companies listed on NA are questionable. He is the only one that is trustworthy. There are as many Chinese companies taken private by LBO with spectacular premium as the companies delisted ie HRBN taken private with 50% premium. Pick your fight. I am building a profolio on ONP. The machine that CB said that did not existed, have been installed. December/2011 will have their first production going out to customers. I am betting that if is true, a LBO of $13.00/sh in 2012-2013 will be a possiblity. Remember, "Trust CB at your own risk." What he succeed so far is cast doubt on a lot of Chinese stocks. It means they are under-valued. LBO and relisted in Hong Kong will be becoming like a torrence.

  • Report this Comment On December 24, 2011, at 12:52 AM, LMedico wrote:

    The High and the Mighty is, indeed, a John Wayne movie. However, it is not a western / cowboy flick.

    In it, John Wayne plays an airline captain and pilot of a plane that suffers engine malfunction over the pacific ocean as it flies from Hawaii to California. It is a very entertaining and well done movie. It just isn't a western like the other movies you used.

  • Report this Comment On December 24, 2011, at 11:57 AM, Pkylie wrote:

    CB outed Lehman Bros, Bear Stearns, wall st. CDS, MF Global, Euro sovereign debt too.

    Give him credit. The man is a genius.

    He also picked Palin to win the White House .

  • Report this Comment On December 25, 2011, at 8:55 PM, lennysims wrote:

    just stay out of china or bet against most of them

  • Report this Comment On December 25, 2011, at 9:58 PM, Schwaggz wrote:

    CBEH was also a "suspected" fraud. Shares dropped fast after people realized they were publishing numbers out of tune with the rest of the biodiesel industry.

  • Report this Comment On December 26, 2011, at 5:09 PM, easystreet70 wrote:

    i suppose even the devil himself is not all bad...

    spreadtrum (sprd) is usually left out of reports like this....block attempted to destroy this company several months ago; and succeeded in trashing the stock price temporarily (thereby enriching himself & destroying others people's portfolios). his allegations were flimsy at best, and he quickly retreated...after rewarding himself via the endeavor.

    imo, block has wreaked more devastation than the alledged fraudulent companies ever would have...and profited handsomely from it. he's quite the activist, eh?

  • Report this Comment On December 26, 2011, at 5:58 PM, Ragingmoose wrote:

    Wath about SINA ? Are there any reliable business Far East ?

  • Report this Comment On December 26, 2011, at 5:58 PM, buffalonate wrote:

    If you are a longterm investor in these companies why would you car if this guy attacks the company you own? If you really believe in the company it would just be a great buying opportunity. In the long-run if the company is legit the stock will reflect it.

  • Report this Comment On December 26, 2011, at 6:19 PM, Ax7777 wrote:

    Read the financial statements before you invest. Most of the statements I have read from Chinese companies are obvious frauds and signed by accounting firms I have never heard of. From what I have seen, this guy has nailed it - why would anyone recommend investing in a Chinese stock?

  • Report this Comment On December 27, 2011, at 4:06 AM, mountain8 wrote:

    To make money??? I am.

  • Report this Comment On December 27, 2011, at 9:04 AM, eeibbay wrote:

    Carson Block has made a fortune by pursuing attacks on companies based purely on guesswork and innuendo. People who have spent time doing DD on these companies then get flattened in the stampede to the exits by the sheep who sell first and ask questions later. In the long term, the share prices may recover but the diligent investors have already lost. Carson block may keep his whereabouts secret because of death threats but it is more likely to avoid the constant litigation against him. He plays on peoples fears and profits from lies. That this article even attempts to to assign some usefulness to this leech on society does the MF no credit at all

  • Report this Comment On December 27, 2011, at 1:50 PM, EdGrey wrote:

    Since the SEC doesn't bother to watch even many of the biggest frauds from US companies, people like Block, and people much less reliable, will fill the gap.

    The SEC's current policy not only protects huge banks that should be broken up and prosecuted, it also fails to protect smaller, honest businesses when they become victims of huge unfounded shorts based on disinformation.

  • Report this Comment On January 05, 2012, at 8:42 PM, TmyM wrote:

    @mountain8,

    As a fellow person of Chinese heritage, I know better than to trust anything financial or otherwise coming out of China.

    There is a disconnect between the western mind and the eastern one and that has to do with the concept of right and wrong. This is the same lack of morals that mixes poisonous melamine into baby and pet food to increase the nutrition count.

    Life does not have the same value over there, but money does.

  • Report this Comment On January 11, 2012, at 6:04 PM, mmmm101 wrote:

    TmyM,

    You may be of Chinese heritage, but the white washing is very apparent. How dare you make such a statement! What, only Chinese people have committed fraud in the history of the world? People of all ethnicity commit fraud and worse. To single out one race is... RACIST! Open your eyes, open your mind. The mind is like a parachute, it only works if it opens.

    Ever hear of Saddam Hussein, Hosni Mubarak, GeorgeW. Bush, Dick Cheney, Lehman Bros and the U.S. banking system, and the list goes on and on, you inane, silly sot!!!

    The African-Americans use the term "Uncle Tom". You are the "Uncle Woo", get a clue!

  • Report this Comment On March 07, 2012, at 8:22 PM, jcchango wrote:

    PRICEANGELS COMPLETE FRAUD

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