Short selling
THE SHORT
STORY
Short sellers – investors who gamble that a stock will plunge
once the company’s true worth is known – exposed the bulk
of accounting scandals at Chinese companies listed in
North America. Kevin Voigt talks to one prominent short seller
about how accounting figures into his decisions
Illustrations by Crystal Fung
36
August 2011
T
he blaze of scandals lit across Chinese
companies listed on overseas stock
markets was set neither by companies
themselves nor regulators, but by the
kind of global investors often cast as
villains or heroes in the capital markets: short sellers.
And after setting markets alight in Toronto and New
York, short sellers like John Hempton of Bronte Capital
Management in Sydney are hunting in Hong Kong for
fresh tinder. Short selling in Hong Kong spiked to an
eight-month high in June, according to New York-based
Data Explorers.
The rise was sparked in part, analysts say, on hedging
against a slowing Chinese economy, but also driven by
the June short seller attack on Sino Forest – a Hong Kong
headquartered and Toronto-listed forestry company –
by investment research firm Muddy Waters, knocking
US$3 billion off its value in two days.
Short sellers make money by betting that a company’s
share price will fall. And the tools short sellers use
to mark their targets come straight out of analysing
company accounting and audits, Hempton says.
“Let’s take Longtop, for example,” says Hempton,
referring to the Chinese financial software company that
was found in March to have cooked its books. “Longtop
is a company which had a US$1 billion market cap,
which had Deloitte as an auditor, which had Goldman
Sachs as an IPO [underwriter] and had almost every
major investment bank on Wall Street recommending
the stock as a buy.”
Financial fraud echoes through company statements.
The trick – as Hempton describes it – is listening for false
notes: “The company, as it turned out, had faked its cash
balances. The reason it had faked its cash balances is that
it had faked its earnings. So if you have fake earnings,
you wind up with fake assets; the fake assets usually
manifest themselves as fake cash.”
Sniffing for bogus accounting
“When I started looking at Chinese companies, I
was looking at small cap Chinese companies listed
in America, and their accounts were faked in almost
amateurish ways,” Hempton says.
Last year, Hempton was sifting through Chinese
companies listed on North American exchanges, on the
prowl for companies he believed were overvalued to bet
against. He happened upon Gulf Resources, a Chinese
maker of bromine, listed on the Nasdaq in New York.
As he does for all companies he’s looking to short
– making money by betting that the share price of
a stock should be much lower – he pulled out Gulf
Resources’ financial records and cross-compared them
with equivalent companies. A look at Gulf Resources’
balance sheet from its 2009 annual report stopped him
cold, he says.
“The American equivalent was a company, which is
now private, called Great Lakes Chemical,” Hempton
tells A Plus. The company, which was last publicly
listed six years ago, recorded an inventory of US$324
million and sales of US$1.6 billion on its 2004 annual
report – meaning it turned over its inventory five times
that year.
But Gulf Resources recorded US$110 million in
sales with US$650,000 in inventories. “In other words,
August 2011
37
Short selling
they turned their inventory stock over 170 times per
year?” Hempton asks rhetorically. “That just didn’t
make sense.”
For the record, the market has been ambivalent about
Gulf Resources. The company’s stock price has doubled
from 2009 to 2011, noted the influential website Seeking
Alpha in a February article entitled “Gulf Resources: A
Compelling Opportunity in the Bromine Market.” Then
it tanked from its high of US$11.17 a share in November
and fell as low as US$2.30 – in July it was in the US$3
range. Many traders are now advocating Gulf Resources
as a buy.
“I could be wrong of course,” Hempton wrote in April
on his Bronte Capital blog. “Gulf Resources may indeed
be able to turn its inventory over 34 times faster than
the best American operator. They may. An otherwise
obscure Chinese company might be that good and the
short might be stupid.
“But as a short seller that is a bet that I was willing to
take without any further due diligence,” he concluded.
White knights or pariahs?
Short sellers like Hempton are painted as rumour-mongers whose allegations become self-fulfilling prophecies
as market players herd towards their accusations, true
or not. Richard Fuld, the last CEO of Lehman Brothers,
blamed – in often colourful language – short sellers for
the bank’s downfall. Indeed, short selling was banned
in both the United States and the United Kingdom at the
height of the credit crisis in 2008.
The target of Muddy Waters’ first report in June
2010, Orient Paper, was thought to have overstated its
equipment purchases and the number of customers it
said it had seemed too few to buy the inventory levels the
company reported. Orient Paper hired an independent
auditor to investigate and the subsequent report in
November found no evidence of fraud. Still, Orient
Paper’s stock value has yet to recover.
“Some people are sometimes critical of speculators
but I think it’s important to know that speculators
serve a very important function in capital markets
because if they can make money by finding accounting
irregularities, well that’s great,” says Gary Biddle, chair
of the accounting department of the University of Hong
Kong. “Ultimately that gives everybody an incentive to
have better accounting and that serves all investors.
And if they profit from it, well that’s fine – that’s
their service fee for increasing the transparency and
efficiency of capital markets.”
Biddle says lax accounting firms are already facing
consequences. “One of them is that the U.S. Securities
and Exchange Commission and regulatory officials
in Canada are investigating these listings and, in
particular, holding the North American auditors, who
are licensed or certified to practise by these regulators,
to account.”
“That’s sort of the fundamental
difference here. Nobody has been
prosecuted and it looks like nobody
will. And as long as nobody is
prosecuted, conducting fraud against
western investors will continue.”
38
August 2011
However, the pickings aren’t as easy as on the Toronto
and New York exchanges, Hempton says. “There have
been a few notable frauds in Hong Kong and I know a few
more. But they are the exception rather than the rule.
The fraud risk in Hong Kong is higher than the fraud risk
on an American exchange for American companies. But
it’s not total.
“I suspect there will turn out to be a lot of fraud in
Hong Kong but there will also be a lot of good stocks
mixed in with the frauds and I wouldn’t want to short
everything,” says Hempton. “You’d be throwing the baby
out with the bathwater.”
Long-short ratio (Hong Kong equity)
13
250,000
11
200,000
Institutional long value
(inventory)
9
7
5
150,000
Long-short ratio
(Hong Kong equity)
3
100,000
Short sale value
(loans)
Value (USD millions)
The way Hempton sees it, any mainland company that
lists outside of China is questionable – largely because
there is little recourse for foreign investors if things
go afoul. “The problem has become you can’t actually
enforce laws across the border,” he says.
Hempton uses Longtop as an example. “In that case
– which was the second-biggest fraud yet exposed and
was the biggest [in which the company] actually put out
releases that admitted it was a fraud – no one has been
prosecuted, and there is no hope for western investors
to recover money because they would have to get hold
of the Cayman Islands company that owned the variable
interest entity in China.”
Hempton suggests the reverse-merger company
debacle in North America is a result, in part, of Chinese
executives willfully duping foreign investors. “The
lesson here is, gweilos are fair game,” he says, noting that
the risks would be much greater if a corporate fraud was
committed in China.
“If you did this to a countryman, you would run
the risk of a show trial,” he says. “That’s sort of the
fundamental difference here. Nobody has been
prosecuted and it looks like nobody will. And as long as
nobody is prosecuted, conducting fraud against western
investors will continue.”
Now short sellers like Hempton are looking to pluck
overvalued mainland companies listed in Hong Kong.
Long-short ratio
Next target: Hong Kong
50,000
1
Jun
Aug Oct
2010
Dec
Feb
Apr
2011
Jun
Source: Data Explorers
August 2011
39