Carson Block on short-selling and what investors should watch out for when going long

Matthew Partridge: Please could you start by explaining how activist short sellers like you differ from traditional short sellers?

Carson Block: Traditional short selling is generally more focused on fundamental problems, where you, as the short seller, think that you understand the company better than the market does; that it’s deteriorating faster than perceived; and you’re playing what we call a “melting ice cube”. As activist short sellers, we tend to focus on shorting companies where there is usually an element of wrongdoing or misrepresentation by management, if not outright lying or fraud. This means we generally focus on a much smaller universe of stocks, and we’re vocal about our short positions.

We have to be provably correct at the time we speak about our theses. Indeed, from a traditional short sellers’ perspective, our type of companies are the worst to bet against because when you have managers working to push the stock up and deceive investors, they can generally keep going unless and until somebody tells the market what is going on.

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Matthew Partridge: Over the past few years, several prominent short sellers have either retired or faced prosecution. Is shorting shares more difficult than it used to be?

Carson Block: Well, what happened in the US with Andrew Left of Citron Research (he is being prosecuted for alleged market manipulation, which he denies) was definitely a shock to me. European regulators, especially those in continental Europe, have a track record of getting up in arms about short reports (research from short sellers attacking a company). However, it was worrying to see the US authorities start to lose the plot and begin thinking that activist short sellers could be the problem. I’m still trying to unravel what caused that.

I’ve brought two lawsuits under the Freedom of Information Act (FOIA), one against the US Securities and Exchange Commission (SEC) and the other against the Department of Justice (DOJ). The DOJ is refusing to produce anything, so we’re fighting them. But the root of the problem seems to be an article by Joshua Mitts, professor of law at Columbia Law School. The SEC’s FOIA production shows that he has been highly influential in convincing regulators that there is a widespread problem with activist short sellers.

However, I’ve publicly critiqued his work as being easily debunked. In any case, activist short sellers were thoroughly examined, which was a huge distraction for me and my business for over a year, though in the end, they decided not to take any action against us. In addition, companies are much more likely to sue than previously, which is something that you have to price into your business model.

Matthew Partridge: What red flags do you look for when deciding which companies to investigate?

Carson Block: There are many things, some of which are a little difficult to explain, but one key indicator for us is highly promotional language by management. So let’s say there is a trend that is in the zeitgeist, such as AI. A company that suddenly tries to sell itself as an AI specialist, and drops AI into every presentation would be highly suspicious. We also like to read transcripts of conference calls and if you can’t understand what the CEO or CFO is actually saying, then that is another sign of potential danger.

You would be surprised how often the analysts who ask the questions on the calls have no idea what the management is actually saying. So they’ll ask a question with management, giving a bunch of buzzwords in response. It’s much easier to catch this sort of evasion from a transcript than from an audio recording, so we’ll typically print off three or four years worth of transcripts, and see how management’s language has evolved. If there are sudden changes in topics, language or key performance indicators (KPI), then that could also be suspicious.

Matthew Partridge: Is there anything that ordinary investors on the long side should watch out for before buying into an individual company?

Carson Block: Well, when you see significant insider selling, that is worrying, especially in cases when these executives hold large numbers of shares. In the 1980s, there was a big move to give executives big share awards in order to align their interests with those of shareholders. The problem is that this encouraged some to run companies in a very short-term manner, focusing on short-term growth at the expense of the firms’ long-term health – for instance by taking on debt, or cutting research and development to the bone. So, when executives who have accumulated large shareholdings start selling their shares, even if it’s only a relatively small part of their holdings, you should think twice.

Consider also whether the company is trying to play around with their debt or equity. Those on the border between investment grade credit and junk status may engage in tricks such as using reverse factoring (supply-chain finance) to disguise debt as an account payable. Firms focused on growth may suddenly experience outsized growth in one or more areas, which is why you have to ask yourself whether it is sustainable.

Matthew Partridge: In which sectors are these frauds occurring now?

Carson Block: It’s important to underline that only around a quarter of the companies that we short are outright frauds, meaning the firm’s conduct is likely to meet the legal standard of intentional material factual misstatements. More commonly, our shorts exhibit a large amount of hype that is highly misleading but not legally fraudulent. This grey zone is the biggest problem for investors and markets.

However, while this tends to occur most often in sectors such as technology or biotechnology (where the belief is that great fortunes can be made by investors who get in early), we don’t start out by focusing on particular sectors.

That said, at one stage we shorted quite a few companies in the green-technology sector, as there are a lot of subsidies in that area. We felt that a lot of solar-tech companies were abusing tax incentives in the US, if not committing outright tax fraud.

More broadly, when you’re looking at an industry or sector that depends at least in part on government subsidies, you will find that what determines the winners and losers in these spaces, unfortunately, is not the best products, the best service, the best value. It’s a case of securing the most subsidies in the shortest amount of time, and that can be inimical to service and quality.

Matthew Partridge: You’ve said that investors should “date the Chinese market rather than marry it” – in other words, take short term tactical positions, as opposed to viewing it as a long-term investment opportunity.

Carson Block: Yes, the market seems highly risky and unpredictable. The Chinese government alone is a major risk factor. You have the risk that president Xi Jinping could decide to invade Taiwan. But then you also have the risk that has manifested itself before, of Xi Jinping disliking an industry and deciding to shut it down. He kneecapped the for-profit education sector, the ride-hailing app Didi Chuxing Technology Company, and Ant Financial right before its flotation.

However, when you take into account the political risk of an unpredictable and hostile US government, things get even worse. No one really knows what’s going to happen with tariffs. They could suddenly rise to 3,000% tomorrow, or go down to 10%. Throw in the fact that there’s no way to punish Chinese executives for defrauding US investors, as shown by the case of Luckin Coffee, where the chairman Lu Zhengyao got away with a fine for falsifying figures, along with the general lack of transparency, and the market is just teeming with risk.

So, if you’re feeling lucky, and you want a short-term punt, fine, but generally I’d say to anyone considering investing long-term in China: don’t you have anything better to put your money in?

Matthew Partridge: How do you think Donald Trump’s second term will pan out for the US market?

Carson Block: If I had a 16-sided dice, I might have a chance of rolling the accurate answer on that one. The one thing that you can say is that Trump’s never binary. It’s not a case of he’ll do A or B, or maybe A, B and C. In truth, he might think about A, B or C, but decide to do G, and trying to predict Trump turns out to be a really bad idea. I also have a very hard time predicting moves in US tech stocks in general because they can be driven by flows of cash rather than fundamentals. Index funds just keep buying the stocks regardless of how ridiculous the valuation is. They are not going to sell that stock until they suffer outflows and have to sell it.

In this environment, you will get ridiculous valuations in these companies that just keep attracting inflows of money. Palantir’s director Alex Moore admitted that his company relisted on Nasdaq so that he could get inflows from exchange-traded funds related to the Nasdaq 100. Overall, once you get to valuations that are untethered from economic reality, like many US tech shares, I don’t want to try to call the direction.

Matthew Partridge: You’ve recently started long-side investing in the mining sector, as well as Vietnam and India. Why those particular areas?

Carson Block: Given that we’re managing funds focused on those areas, it makes sense. Generally, we thrive anywhere where there are significant information asymmetries, and since the turn of the century, there haven’t been a lot of bright graduates who’ve wanted to go into the mining industry, so you can add a lot of value if you can distinguish between good companies and worthless ones. In terms of Vietnam and India, we realised in April 2020 that we were going to see the biggest geopolitical realignment since 1945, and those two countries would be the biggest winners from it.

While Vietnam has a very similar political and business system to that of China, China has been complacent and acts as if foreign investors need it more than it needs need foreign money. By contrast, Vietnam is never going to have the scale of China, and so it will have to treat foreign capital much better than China does.

In the case of India, while it totally skipped over export manufacturing and went right to exports of services, it now boasts very strong domestic consumption, driven by a growing, young population. It could become a real power in export manufacturing. But even if it doesn’t, we think that the growth in domestic consumption is going to power the economy and asset prices for quite some time.

Carson Block is the founder and CEO of Muddy Waters Research, an investment firm specialising in activist short selling. Carson is also the author of Doing Business in China For Dummies, with Robert Collins.

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