market folly

We're posting up notes from the 2014 Value Investing Congress in New York. Next up is Carson Block of Muddy Waters Research who talked about short selling/fraud and presented a new short idea: 500.com (WBAI). His presentation was called "Avoiding Blue Pill Investing."


Carson Block's Value Investing Congress Presentation

• Obvious reference to The Matrix – some investors tend to “take the blue pill” during bullish times or  in other words, willfully ignore negative signs. Carson says if you have taken the blue pill, you need   to be prepared to unwind quickly when the inevitable mean reversion rears its head

Many things tilt the playing field against investors:

Management
o Often short-term focused. To remedy, check the proxy and remember the absolute dollar  value of comp. If a CEO can earn $30mm in 3 years, that's short term any way you slice it.  
o CEOs tend to be charismatic, and the more successful a CEO is, the less willing he/she is to   being held accountable 
o Solution: management is better seen, not heard. Reading transcripts is better than listening   to calls.  
o Compare transcripts chronologically, looking for disappearing initiatives and changes in   language. Are questions systematically evaded? If so, which ones? Are questions often the   same each quarter? If so, ask yourself if sell side seems too close to management to ask the   hard questions 
o Insider selling is also very significant. 10b-5 plans are smart because they give management   cover/deniable plausibility. They can also lock in value of their shares without actually selling

Board of Directors
o Often have a symbiotic relationship with CEOs 
o Insulated from negligence liability by BJR, insulated from other liability by D&O insurance 
o Many directors view directorships as perquisites, not responsibilities.  
o Independent investigations often “shambolic”

Lawyers
o Never forget that lawyers represent the interest of their clients, or the people who hire and  pay them 
o Prestigious law firms are a surprisingly effective fig leaf and are great at writing   indecipherable prose. If you ever find yourself reading a passage in a filing and, halfway   through, realize that you didn’t understand anything, that is probably on purpose 
o Attorney-client privilege hides acts of corporate wrongdoing and  
o "Fraud lawyers are eternal" - John Hempton

Auditors
o Auditors are completely misunderstood by the investing community. Like lawyers, they  represent the interest of their clients (the people who pay them) 
o Auditing is a profession that rewards failure. Why? Whenever a company is found to   potentially have serious fraud, the accounting issues lock the auditor to its accounting firm   “for life” 
o Reason: Say you're an accounting firm and a partner had a blowup. You can’t throw   them out because you immediately worry about other clients that they've audited. The   accounting firm has imperfect information, doesn’t know when they'll get sued and for   what. Therefore they want to keep these bad actors around to exculpate the firm from   liability 
o Audit is also a profession that fights accountability. The PCOB is trying to keep auditors’   names from being disclosed on publicly filed documents 
o Audits aren't designed to detect fraud. Instead they presume that documents not forged   and that management is telling the truth 
o The most important function of the auditor is cash confirmation at year/quarter. A lot of this   is gruntwork that is done by juniors. As investors we have no idea how thorough the cash  confirmation was and it tends to be more cursory. This isn't just a China problem either

Banks
o The bank’s imperative is to sell financial product. Analysts aren’t rewarded for skepticism.  Like audit work, junior bankers tend to do the key due diligence tasks

Market Research Firms
o Can actually be a great source for short ideas. The SEC should investigate 
o S1 filings often cite market research that is fabricated. Companies pay for it, provide the   data, and feed the research house people that they should talk for their “research” 
o Research houses are provide people to talk to. No disclaimer.  
o Tianhe short idea – Carson says they aren’t in it, but Anonymous Analytics made a good   point that the research firm that the company used completely fabricated the data

Thoughts on Chinese companies:
• China is to stock fraud as Silicon Valley is to tech 
• Country is run as a kleptocracy... should we be surprised that companies are as well?  
• Investors have become complacent once again about the risks 
• No fraudster from China has ever been meaningfully punished for defrauding North American   investors. Carson doesn't blame the Chinese for this because US and Chinese courts don't recognize   judgments against each other. The US simply has no jurisdiction  
• VIEs: owner of listcos don't even own the operating company. Look at tax rates for proof

Recent Lessons Learned From Shorts: RAX, BLNX.LN, X Group (Eike Batista's fallen empire)
• RAX: Investors were lost in the word 'cloud' when RAX was at its core a plain old internet host with  no magic to the business. Larry Ellison ranted on the stupidity of the market’s obsession with the   cloud in 2009, saying that the cloud is just a computer. RAX CEO was also selling an image of being a   technologist (went as far as to wear Google Glass to speaking panels... looked ridiculous) 
• BLNX.LN: Harvard Professor Ben Edelman is a bit of an “internet sheriff” and good to follow. He   published a report on Blinkx, alleging that they were defrauding customers. Muddy Waters dug   deeper and saw evidence of the same 
• X Group: Batista was obsessed with passing Carlos Slim to be wealthiest person in the world. Carson   saw him speak in 2011 and said he was very nationalistic and claimed that his group of companies   was what Brazil deserves. Q&A was also a joke. One questioner went as far as to ask what he would  do if he were president


New Short: 500.com (WBAI)

• Sells online sports lotto tickets with a $1.2bn market cap and 37x P/E 
• Market expects that WBAI will be explicitly authorized to sell sport lotto tickets but that will only   open up to more competition 
• 500.com is selling on behalf of provincial lotteries. 500.com gets 10-11% fees which are far in excess   of the 5-6% that others are getting in the industry 
• When the new regulatory regime is implemented, fees will come down to 4% 
• Chinese Ministry of Finance also prohibits cross-border sales of these tickets and it seems like seems   like 500.com is selling cross-border, particularly in Jianxi province 
• If that’s not enough, 500.com has been playing the lottery themselves and actually won $2mm from   playing the lottery in 2013 (50% of pretax income)
• Major red flag – employee bank accounts are used to collect winnings. 500.com claims that you  have to be a natural person to get paid and this is why they set it up this way. Carson thinks this   makes it extremely easy to commit fraud 
• Another flag – discrepancy between claimed mobile downloads and downloads as indicated on 3rd  party sites


Be sure to check out the rest of the Value Investing Congress presentations here.