The Value Perspective Podcast – with Carson Block

28/06/2022

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

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Juan Torres Rodriguez (JTR):

Hi, everyone. On The Value Perspective podcast today, we will discuss the contentious topic of short-selling – an investment or trading strategy that speculates on the decline in the price of a stock or other security. It is a risky strategy and can be viewed as exploitive but, to challenge that idea, today we are talking to Carson Block, the founder of Muddy Water Research, who takes an activist approach to short-selling and has exposed fraudulent accounting practices in publicly traded companies. Juan and Carson discuss the probabilistic thinking and psychological frameworks needed when being a contrarian thinker as well as the inter-industry collaborations used to expose unethical financial practices. A couple of definitions before we kick off – firstly, ‘capital structure arbitrage’ refers to a strategy used by companies where they take advantage of the existing market mispricing across all securities to make profits. This strategy involves buying a company’s undervalued securities and selling the same company’s overvalued securities – the main objective being to make use of the pricing inefficiency to make a profit when a company uses its capital structure. Carson will also reference the AMF in France. I will not attempt the French pronunciation but it translates as the Financial Markets Authority and is the stockmarket regulator in France. Enjoy ...

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https://www.schroders.com/en/uk/the-value-perspective/podcasts/podcast/

Chapter headings for Carson Block on The Value Perspective Podcast

Please click on the link below to jump straight to a chapter

* Carson Block, welcome ...

* How is an ‘activist’ short-seller different?

* What traits make a successful activist short-seller?

* Analyst, entrepreneur, lawyer

* The pressures of being a contrarian

* Decision-trees and pre-mortems

* Facing down big personalities

* Book recommendations and one big mistake

Carson Block, welcome ...

JTR: Carson Block – welcome to The Value Perspective podcast. It is a pleasure to have you here. How are you?

CB: Doing well. It is summertime so I am relaxing a little bit – but doing well.

JTR: Where do we find you today?

CB: I am in Austin, Texas. I have lived here for a little less than a year after I moved the firm from San Francisco to Austin.

JTR: Was that because of Covid-19?

CB: Well, Covid-19 had an impact. We were supposed to relocate to New York City as of summer 2020 – and that was a decision that we made in 2018. But – I guess in November of 2020 – we really had to make that call and had to figure out whether we were ultimately going to go to New York or not. And I just couldn’t –especially with young kids – in good conscience move to New York City when it was unknown or unknowable how long Covid would be with us and whether there would be lockdowns.

By the same token, though, we really needed to get out of California. I was personally living in a fire zone – so we wanted to stop spending all of our time in a house that was in the wildfire zone – but the other thing was just that California has just gone off the deep end culturally. And, during Covid, I did get an opportunity to cogitate a decent bit on the importance and purpose of local and state governance and just became convinced that the government of California has gone so far off the cliff that really it is just hostile to its citizenry.

So, yes, we wanted to get out of there and had not really ever spent time in Austin and so we kind of threw a dart – but we made it here and we have really enjoyed it. I mean, we really like the culture here in Austin. It is not hard-right by any means – it is probably left-of-centre politically – and people are very friendly and it has been a great place for our kids. The kids are thriving and those of us who made the move here I think are generally very happy with it.

JTR: I jumped right in and asked about your location without giving you the opportunity to introduce yourself . For those who do not know you or Muddy Waters Research, could you give a brief intro?

CB: Sure – and sorry! You got everything about my location and nothing about me or my firm. On Muddy Waters, I started the first incarnation of this business in 2010 and it is basically an activist short-selling model. So we look for companies that are, if not frauds from a technical or legal perspective, are at least intellectually fraudulent – and we short those. We short the stocks, or sometimes the bonds, and go public with our analyses or our reports that explain what is really going on at these companies. So I think of it as a form of investigative financial journalism, but married to a non-traditional revenue model. And in 2016, we began managing outside capital so the non-traditional revenue model portion is actually now a fully SEC-registered private fund manager. So that is our business.

How is an ‘activist’ short-seller different?

JTR: You describe what you do as ‘activist short-selling’ so, for those of a less financially technical disposition, what is the difference between that and normal short-selling?

CB: In theory, if the universe of good short ideas was, say, 100 ideas, then the universe of good activist short ideas might be 10 to 15. The vast majority of short-selling is done by long-biased managers and it is used to hedge out market risk or hedge out beta. So they might go long an automaker they like while trying to hedge out beta by being short some automakers they do not like. But then you also have long-short managers, or you used to have more short-biased managers, that will go directionally short a company – I think this company’s profits are going to fall off a cliff, blah, blah, blah, therefore, I am short that company.

Now the vast majority of short-selling is based on fundamental theses – or what we describe as a melting ice cube – the short-seller thinks the business is going to deteriorate faster than the market thinks and that is why they put on a position. That is traditional short-selling and what would constitute 85% to 90% of actionable or reasonable short theses.

Now that other 10% to 15%: you can call it ‘fraud-shorting’ although, with a lot of the companies I would put in this category, from a legal perspective, it would be very hard to prove they are frauds. It is, basically, intellectually fraudulent financials or presentations of TAMs [total addressable market] or the states of business – but maybe, from a legal perspective, they have their boxes ticked and nobody is ever going to try to bring a case against them. So that would be stock promotions, as well,  and stock manipulations – but that is also a form of fraud.

Basically, though, it is those companies that are significantly manipulating the information they give to the market – and those are really tough to short, if nobody is going to tell the world about it. It used to be that, pre-financial crisis, there was a somewhat robust investigative journalism profession in finance but, before the rise of activist short-sellers, such as ourselves, I would say a significant portion of active short-sellers – not activist – would avoid this class of stock just because the promoters or the fraudsters can keep the illusion going for a long time, if nobody tells the world about it.

Still, for the firms that used to do fraud-shorting, the idea was you take your short position and then you go and find a journalist who is looking for something really interesting to dig into and you give them the story. They do their work and, hopefully, they end up publishing an article exposing the company. But that model has become non-viable, really, because newsrooms have been cut, experienced reporters have been laid off and the human attention span has shrunk – so there isn’t the appetite for that kind of long-form, deep-dive, investigative journalism anymore, especially in finance.

So, as the traditional media has receded from the space, that left an opening for people such as ourselves who said, we can actually bring more sophisticated analyses to bear than traditional media did – because, you know, I have a former auditor who works with me, we take a team approach here and we engage lawyers and investigators. We throw a lot of resources at this so we can do much better research and reporting than traditional media has done.

Now, we do blend the news with our commentary and our opinion because, a lot of times, you need to interpret these facts. So a typical report structure will be fact, fact, fact, opinion, fact fact fact, opinion or conclusion. So that is a little bit different from traditional media – but, then, the way we pay for this business is by basically putting on risk and hopefully making money.

And when we do what we do – if we do it well – we get sued and we get attention from hostile regulators who are set upon us by companies that lobby the government and are at the same cocktail parties with government officials and regulatory officials. But that is basically the nature of this beast of activist short-selling. So we have stepped into a breach that, at this point, is almost entirely unpopulated by traditional media and we out wrongdoing in unethical, immoral, if not outright illegal practices. And we pay for it by trading the companies we are reporting on.

JTR: I am going to ask how much you believe your behavioural psychology has been impacted in moving from doing the research and making that public for someone else to trade to actually trading and taking on the risk yourself. Before I do, though, I want to pick up on your point about there being so few reporters these days working on exposing cases of fraud. I remember reporter Bethany McLean helped expose Enron, despite the fact there had been some short-selling – and, actually, wasn’t it a short-seller who told her to look into Enron because things were not adding up?

CB: Yes – Jim Chanos of Kynikos Associates was Bethany’s original source for Enron. They had discovered a number of anomalies at Enron – and that is one of the things with complex situations like that. It is really hard from the outside, as an investor, because we also have to make sure we do not come into contact with material non-public information. So it is very difficult for us, if we are going to be trading the stocks, to really understand, at times, the scale of problems within a public company. We can detect, a lot of times, if there is fraud or if there is real misrepresentation but the scale of it can be really hard to understand from the outside.

A great example of that was NMC HEALTH PLC  Healthcare, which we reported on in December 2019. We knew it was a fraud. We knew there was some debt the company was not actually reporting – basically debt it was illegally keeping off-balance sheet – but, as of its most recent financial report, the June 2019 report, it had disclosed about $2.5bn of debt. So we knew that there was more – I thought it was maybe up to $500m more in debt that they were illegally keeping off the balance sheet ... turns out the real number of undisclosed debt was $4bn and that the actual debt of this company was not $2.5bn but $6.5bn!

So that is an example – and that is similar to what happened with Kynikos, Enron and Bethany McLean, they saw indications there were things that were seriously off. And, once Bethany started reporting on it – and some journalists from the Wall Street Journal began a series of reports as well, where I think short-sellers were their primary source – then the company unwound relatively quickly. But it had been a massive company by the standards of the time in terms of market capitalisation.

JTR: One critique one hears of activist short-sellers is you take a position – you are already invested – and  you release your report. But how is that different from 20 years ago and Jim Chanos telling Bethany McLean to make it public that Enron had very aggressive accounting?

CB: Well, for one thing, Jim Chanos could never tell Bethany McLean to make it public, right? I mean, he is competing for her attention with lots of other people who have stories – both positive and negative – that they are pitching reporters all the time. And the other problem you get in that traditional model of short-seller/media relationship is that the reporter has limited time – and, now, the amount of time that reporters are given to turn stories today is far less than what they used to get. Back then, they were given more licence to dig deeply and they did not have to constantly pump out stories to get these ‘clickbait’ headlines – trying to draw people’s eyeballs for, like, 13 seconds. So the nature of journalism has made it much more difficult for journalists to work with sources, such as ourselves or such a short-sellers.

But the thing is, even if you are dealing with one of the rare journalists who has licence from his or her employer to do long-form journalism and to investigate, they do not have the sophistication to understand complex accounting – that is number one. Number two, they do not have the resources to do fieldwork, most of the time. Muddy Waters started by exposing Chinese frauds that were listed in the US so, if we had gone to a US-based media outlet instead and said, hey, we have found this company is a fraud – we need to send people to their factories in remote parts of China, talk to security guards there, set up video cameras to count trucks, things like that – those are resources journalists will almost never have.

So that is the kind of work that activists short-sellers would do. And that is the kind of work traditional short-sellers who do fraud-shorting work would do – but, again, the journalist is not going to be able to do that kind of work. So, ultimately, what the journalist is going to be able to publish or be willing to publish is going to be a very watered-down version of the problems that exist at an egregious company. And, again, that is for lacking the understanding and sophistication we can bring to bear to analyse the situations; not having the resources we have to do the work; and, nowadays, not having the time.And PS – long-form investigative journalism, especially in finance, is a loss-leader. So traditional media outlets only countenance it to the extent it helps them with ‘halos’ and hoping they win some awards out of it – they do not make money directly on that type of reporting anymore.

So, even if you felt like, gee, this is a more pure form of exposing the dirty laundry of our public markets – all right, great. It is just, you know, the economics are not there and, in the world we live in, it is kind of activist short-sellers or nothing. I mean, that is effectively what it is. I hear from critics all the time – I have been doing this 12 years – and it is, oh, you should not be shorting it. Well, I don’t know, man – there is no other business model that pays for this kind of reporting. That is the reality. This is the only one I have found – in 12 years spent cogitating on this.

And, when I say I have thought about whether there are other ways to pay for this type of reporting, it is driven by the fact that even though, in theory, when we get sued by one of these companies, we should be similarly situated – especially in the US, where you have the First Amendment – to any traditional media defendant. But that is theory. And practice is, judges are generally sceptical – well, you are short-sellers – and so it is always a higher bar for us to get rid of a case than it would be for the Wall Street Journal, say, or Bloomberg. They can do it more easily than we can.

So I have thought, over the years, gee, is there another way to have a viable business doing this – one which would not have, I guess, this bias in the public and in the judiciary against it, so we could at least deal with the litigation in a more expedient manner? And the answer is no – I can come up with nothing that will pay for it. I mean, maybe I could raise a bunch of money from investors for a new media company that I do not really believe is going to be viable or make money – at least if we do this long-form journalism. But I do not feel like blowing up a bunch of investors either – I want to run a business that actually has an economic rationale to it. So that is why I am here with you, right now, as a quote-unquote ‘activist short-seller’.

What traits make a successful activist short-seller?

JTR: That is really interesting. Now, this is a podcast where we explore human behaviour and how some biases have an impact on the way people make decisions – good or bad – while dealing with life’s uncertainty and it can be very taxing, psychologically, always taking the contrarian view, especially in an ecosystem like the market. Indeed, we have heard some of your colleagues say short-selling is all about the psychology of the actors involved so I wanted to ask you what sort of personality and behavioural traits do you believe an activist short-seller needs to be successful?

CB: OK – and I will apply this to traditional or non-activist as well as activist short-sellers – my observation of us as a group is that many of us are socially awkward. You know – every summer prior to Covid, one of the traditional short-selling funds in the US had a big event that was just fantastic and short-sellers would come, even from Europe. And, just being in that crowd, most of these people would have probably been somewhat marginalised in high school, at the very least.

And so I think, having kind of been rejected by the mainstream – or, I should say, maybe having never been accepted by the mainstream – throughout most of our lives has, by necessity really, given us the ability to think very critically about the mainstream and, therefore, consensus. In my case, I think I come off generally as less socially awkward than most short-sellers but I grew up in a wealthy community, just outside of New York City – a lot of people's fathers worked on Wall Street or as bankers, country-club memberships and so on. But my parents got divorced when I was six, which was a demerit, basically, in a town where everybody was trying to pretend they had these very intact, happy families. And one of my parents also descended into alcoholism, which became known and that was something I got ripped on quite a bit for, growing up.

So I was never quite in the mainstream. Even in high school, when I had kind of reverse-engineered how to be popular – basically, have access to alcohol, access to girls, a good car and throw lots of parties at my father’s place, because he didn’t really have a problem with that – even then, I wasn’t really on the inside. So, being on the outside looking in at the pretty people who, like I said, had very strong ties to Wall Street, I began to see through the façade – these ‘intact’ families, where parents were alcoholics, mothers were on maximum dosages of antidepressants and families were levered to the hilt and needing their kids to get scholarships, even though they had a vacation home and country-club membership.

So seeing through that facade was a survival skill, right? Because if you are being shunned by the mainstream, effectively and you don’t want to feel like you’re a loser, you need to feel like the mainstream are losers. So you develop that critical eye. I think the things I am saying here apply broadly to short-sellers as a group, in some form or another, but what happened to me is I began to loathe hypocrisy – because that is what I saw around me, right? The people who were constantly putting themselves on this pedestal vis-à-vis me, because of the divorce and the alcoholic parent and so on? Your parents are just better at covering this stuff up and you are better at covering this up and, look, man, at least I have been transparent here – you have not.

So that really gave me an intense dislike for hypocrites and hypocrisy that still exists today. Just to give you an example, I recently was having a discussion with another father in Austin – our kids are on the same baseball team and he is an evangelical Christian. Anyway, he is white and married to a black woman so he does have a lot of sensitivity to racial issues – unlike, I think, a lot of your typical white evangelicals. Still, we were talking about Bill Cosby versus Dr Dre and he was saying, look, net-net, Bill Cosby was largely a positive influence – the way he role-modelled behaviour for black Americans, especially young men, being an active father, not being into violence and swearing and degrading women and this and that, this was net-positive. And I am like, bro, he was a serial rapist.

And he is like, well, the thing is, there were 16 women whose lives he destroyed, or something like that, but far more people whom he influenced positively. And he said, on the other hand, look at Dr Dre who, you know, beat his girlfriends early on and was around a murder and even rapped about it – it was the last NWA song they ever dropped. And I was just, like, I don’t know – for me, the opposite is true. Dre never hid what he was, right? It was in the lyrics. But Bill Cosby – that is the most insidious type of behaviour on the planet because he was a monster and he hid it.

So that is where I come from and I think I am shaped by that experience growing up where, out of necessity, I had to see through the facades. And that is effectively what we do as activist short-sellers – especially when, with Muddy Waters, we generally fish in a larger market-cap pond than most activist short-sellers do. So we will criticise companies and we will expose companies and managements that are banked by prestigious investment banks and have prestigious law firms representing them.

And that is what gets me out of bed in the morning – it is to say, you know what? I know the deal here, OK? There are thousands of investors out there who do not – who think that you at the investment bank actually do something called due-diligence. I know – and you know – you don’t do it. You just want to pump out financial products and you have pumped out a really bad one here and your equity research analysts are beholden effectively to the management of the companies they cover and the general public doesn’t want to see that. So I am going to go at you, man – I am going to expose what is going on.

When you get to the activist short-seller, I think that is basically the psychology that drives those of us who have been in this a long time and have had staying power. At the end of the day, it is just that intense dislike of hypocrisy and the facade that these guys are doing the right thing and that they are good citizens and good corporate citizens. And we just want to expose that.

Analyst, entrepreneur, lawyer

JTR: You did not mention it at the beginning of our conversation but am I right in thinking you majored in business as an undergraduate but then you specialised in law?

CB: Right. I actually grew up in finance. My father also worked on Wall Street but he was in more of a micro-cap segment, rather than the Goldman Sachs segment. So I grew up helping him type his reports and edit them and going into work literally on Wall Street in the summers. I think the first summer I did that was after eighth grade – so I was probably 13 or 14 when I started. And so I always wanted to be an investor. I went to university and got a business degree with a concentration in finance.

When I graduated in 1998, I had this idea of setting up an equity research firm in China, focusing on Chinese A-shares. In 1998, there was no foreign equity research on A-shares so I figured, hey, better early than late. So I went to China right after graduation and took about six or seven months to realise I was probably a decade or more too early because there were just no investable companies listed the mainland exchanges at that time – it was deliberate policy to not allow good companies to list.

So I went back to the US. I did i-banking for about nine months – with CIBC World Markets, which for a moment in time was trying to be a bulge-bracket – but really did not like the politics of the big bank. And then my father had moved out to LA so we teamed up and did long-oriented equity research together on micro-cap companies. This was 1999 through to 2002 and it turns out we had gotten lied to by a lot of managements and used by them because our clients were fund managers.

So we would take the managements on non-deal roadshows and our institutional clients would buy the stocks up – but it turns out the managements were dumping, in many cases, and back then their stock sales were not public for 45 days after the sale. So we were totally being used, confronted a couple of these managements, they lied to us and one of the companies ended up being adjudicated a fraud. I mean, that was this crazy story where I set up a meeting with one of my institutional clients – a portfolio manager in LA – and my father and the CFO of this company called Rent-Way, which went on to be acquired by Rent-A-Center in 2006.

The CFO’s name was Jeff Conway and, at the meeting, he looked my client in the eye, pointed at my father Bill and said, in the 17 quarters Bill has been following us, we have never missed one of his earnings estimates – that is how good a handle we have on the numbers. I mean, he said that with such conviction. But the next week, when he was supposed to meet my father in New York, he did not show up and the stock did not open. And then there was an announcement – uh-oh, accounting fraud. Conway pleaded guilty – ultimately – went to prison, found Jesus and got out a little early for his Jesus points.

It was just this embittering experience I had where I am like, we are getting lied to in Microcapland – let’s look up the chain. Oh, that is Enron, WorldCom, Tyco, HealthSouth ... who in the markets is not lying and cheating? That was my question. So, as of 2002, I was greatly disillusioned about investing because it is what I had wanted to do for years – like, ever since I accepted I would not be a professional baseball player, I wanted to be a professional investor – but I just felt like this was a really disadvantaged position to be in.

So I decided, OK, I am going to go to law school, which is a graduate degree in the US – it is a three-year degree – and I will, by virtue of going to law school, hopefully get tools that will help me be a better investor and protect myself against financial predators. That was my orientation when I went into law school and I liked law school far better than I had anticipated. I ended up practising for a little bit – I had an offer from Kirkland & Ellis in the US, I had an offer from Jones Day in Shanghai and look, if I had wanted to be a lawyer, the right thing to do would have been to take the US offer.

But since, for me, it was about being an investor or an entrepreneur, I took the offer in Shanghai and I was with Jones Day for about nine months. I left and started the first self-storage business in mainland China – and got just smoked almost every single day of having that business! But through that, in China, I learned to ‘see the Matrix’ – and, also during that time, I co-authored Doing Business in China for Dummies so I absorbed experiences from a lot of other foreign entrepreneurs in China. And it just taught me so much about illusion versus reality and how almost anything can be faked.

At the very end of 2009, my father got interested in these Chinese companies – these micro-caps that had gone public in the US via reverse-merger. He was super-excited about them because they all had these great growth stories and, you know, me I was cynical. I mean, I did not think that the numbers were fake – I basically thought, look, the chairmen from these companies are going to be stealing money out of the companies, but that will be reflected in numbers. Question is – is it an acceptable amount of money they are stealing? And if it has thus far been acceptable, will it remain acceptable or are they basically just trying to get a massive payday and screw investors?

That was kind of how I went into this and, based on that orientation, I thought my father was barking up the wrong tree – but he wanted me to help him. So I did and I looked at this first company, called Orient Paper and, again, it was audited, right? So why wouldn’t the numbers be real? Well, I would soon thereafter learn – and I am not being facetious – an auditor’s remit is not to look for fraud. Their remit is to ensure or to give assurance that the correct accounting standards have been applied and that they have been applied correctly.

So if you have a management that is handing auditors a bunch of fake contracts and fake invoices and fake bank statements, that is all you need to commit fraud, basically. The auditors are not trying to figure out whether the documents are fake – they take them at face value. So that is how Orient Paper had just reported $103m in revenue in 2009 while the real revenue was about $2.5m to $3m – I mean, it was like 96% or 97%, fake. And that is what we found in China. So we exposed Orient Paper and the report went viral – we did not expect that.

We realised this was a systemic issue with Chinese companies listing in the US – that they were pretty much all committing fraud – and it became a race against other activist short-sellers as it suddenly became a profession. There had been a couple of guys doing activist short-selling but it was just kind of funky micro-cap stuff. Now, all of a sudden, it was getting real attention and, because of China, institutional investors were long things that were total frauds. So we sprinted to expose those over the next two years and finally came up for air and thought about, like, what is the cause?

How do you get these empty boxes – these abject frauds from China – listed in the US, audited, IPOs with Goldman Sachs and so on? And I just connected the dots – you know, the conflicts of interest, the laziness, the ineptitude, the plausible deniability ... that is how it happened with the China frauds. And I said, that is the same thing that really enabled all this stuff in the first iteration of my career as well.

So that is the state of the financial markets – a lot of people who are overcompensated for basically looking good but not actually doing any real value-add and just being lazy. And, unfortunately, investors on the other side of these trades sometimes – actually, a lot of times – when we say some of the company is highly problematic, will shoot back, well, Goldman Sachs or Deloitte or whoever would never risk its reputation. But they do it all the time – they get incinerated publicly all the time – and, because you guys do not remember, they have realised it doesn't matter and they can do it again and again and again.

And so they do it again and again and again. So, when I connected those dots, I was, like, anywhere there is liquidity and stock to borrow, there are going to be people in the markets doing things they should not be doing. You know, the dumb guys go and they rob convenience stores; the smart guys go to the financial markets. So we went global, starting in 2012, looking for dysfunction, really, in any market that makes sense for us, from a trading perspective. And that is how I got here.

JTR: Does that combination of having been an entrepreneur, having spent some time in finance and also the legal angle help you see the world from a different perspective?

CB: Well, I think it helps me. It makes me much more sophisticated and it definitely is what I need to run this business in the way I do run this – because I know enough accounting to be able to work closely with my partner, who is a former auditor and understands the issues, and help figure out where to prod. I know enough about real business – and, believe me, if all you have done your whole quote-unquote ‘business career’ is sit in front of spreadsheets, you are actually really missing out on how businesses work. I learned so much through my, effectively, failed real-world business attempt – I learned so much about what makes businesses, the people that go into them and how the policies and leadership and so on shape these things and the cultures.

So, yes, these three ‘toolboxes’ have been integral. Now I would say also, the legal toolbox is very important because, when I look at when short activists screw up – like, when short activists put out reports I think are in some way wrong? I mean, I think usually they are directionally correct. I have not seen too many where I felt, man, you have totally got it wrong – like, this is not a messed up company. But there are portions of those reports that I think can be really off-base and what I think gets the short activists in those instances – it is not malicious. It is ‘unknown unknowns’.

And, because of my three toolboxes – but especially the legal toolbox and particularly because I did it in China, so I had to learn the US legal system and then the legal system in China, which is a great shifting of perspectives – it really helps me to make our ‘unknown unknowns’ ‘known unknowns’, and then go and try to get the answers and figure out whether it is really a problem or not.

I sit on top of a large team and, in some ways, I am a general contractor, right? Like, I am basically directing and synthesising the work of subject-matter experts beneath me, or people who are focusing on portions of a research project that play to their strengths. And then it comes to me and I bring it together. For me, then, I think of my job at least as much as risk management or playing defence as it is playing offence. That is, I think, the mentality you need to have as an activist short-seller because your mistakes are so much more amplified than the mistakes of somebody who says something on the long side about a company – so much more.

And, look, if I could add toolboxes, I would be more quantitatively adept. I wish I understood, like, high math and option math much better than I do. But the legal, the practical, real-world business and, obviously, the finance, I think, are really the building blocks for somebody to sit in my chair and hopefully do a good job.

The pressures of being a contrarian

JTR: Being a contrarian demands a lot of self-confidence to endure periods where the market fails to recognise or understand what you see that others have missed. Plus, as you said at the start, it exposes you to the anger of many of the different actors involved in any specific situation. So how do you protect yourself psychologically during such times – especially if the market is going against you?

CB: Well, almost the entire time I have done this, the market has gone against us! I mean, at least overall, having started this in 2010. But, in the early days, I lived and died a little bit each day, based on how a given stock was moving, right? Like, we were out there and these things get really personal at times – or they used to get really personal. I always had thick skin – you need that to do this business – and my skin has gotten thicker. But I would say, by the same token, the period during Covid has changed me and my approach to business somewhat.

Covid was kind of liberating in some ways because I generally used to do my TV appearances in a suit – often a tie – but that is not who I am. Right now, I am sitting in a T-shirt and jeans talking to you and that is what I wear every day, if it is not a T-shirt and shorts basically. Occasionally, it is a polo shirt. So when Covid hit, to me, it was the height of silliness to have all these people appearing on financial TV in suits and ties while their wives are in the other room with leashes and muzzles around their kids like, praying they will not burst in on daddy’s CNBC appearance. So I just took this approach of, like, let’s not even go through this pretence, man. We are all sitting at home in some version of a closet or what have you so I basically dropped the last vestiges of a TV version of me.

And I also did the same thing on social media. People used to advise me – look, do not get into debates with these individual, unhinged investors on Twitter. Do not punch down. But at times – and especially during Covid times, when the markets ripped and there was just this flood of people touchdown-dancing every day that one of the things we had been short went up and calling me a fraud and calling for me to go to prison; and me knowing the whole time the subject company is basically fake in many respects, if not an outright fraud – I wanted to point out I have seen this movie before, because I have been around markets most of my 46 years on this planet and these people were confusing luck for skill. And, like I said, it was liberating.

So I do sometimes engage in those slugfests out there on social media and, look, I might be highly sarcastic but I don’t think I tear into anybody and get really personal and call them names. But, at the end of the day, you have to have thick skin and you have to be able to find ways to let all the negativity roll off you. I mean, this is a much harder business than people think it is from the outside. I had a partner, who was an old college friend of mine, who had been at Pimco. In fact, he was a rock star at Pimco – running a capital structure arbitrage book inside one of the company’s hedge funds.

We have known each other since college and he thought he had a good sense of what my business was like. Then he joined and, day one, it was like, hey, man, just to let you know – we just got hit with a request from the SEC, on behalf of the AMF in France so we are under AMF investigation. Oh, and we just got hit with this lawsuit here by this company that we shorted a few weeks ago. So, genuinely, by the end of his tenure here – despite all of the conversations he had had with me, all of my explanations to him about what makes this business hard and my venting to him and really encouraging him to think long and hard before deciding to leave Pimco to join us – even then, this guy was still shocked by how difficult and just emotionally taxing this business is.

So I do not think any of us who do this business – or do this business for a while – are going to be thought of as the most well-adjusted people out there. But that is what you need, right? You need people like us, who just feel like there is something that drives us, there is some maladjustment there and, you know, sometimes we can call upon a deep reservoir of anger to fight through all of the stuff thrown at us by the companies and also the central bankers, who have been pushing up the markets for more than decade.

Decision-trees and pre-mortems

JTR: That is really interesting – and, yes, you do need a lot of thick skin to go against a very large crowd. Probabilistic thinking is something we like to explore on this podcast and while, for some people, it comes naturally, for most, it is a challenge. As part of your process, do you think in terms of probabilities before coming out publicly with your research, when you are trying to anticipate the likelihood of different outcomes taking place? We had hedge fund manager turned author Dominic Mielle on this podcast earlier this year and she said, when she was at Canyon Capital buying distressed debt, she was a big fan of decision-tree analysis. Is that something you and your team consider?

CB: Well – yes and no. We do not sit there and try to model out outcomes and assign probabilities to them. I mean, when you think about short activism, the way it is successful is we bring a bunch of problems to the market’s attention that the market was generally unaware of. I mean, even though a lot of times, to us, these things are hiding in plain sight but whatever – we bring these problems to the market’s attention.

Now, if there is a strong reaction on day one, this is critical to the long-term success of a short-activist campaign. When I started doing this in 2010, coming out of the financial crisis, investors on the long side were still remunerated for being good assessors of risk – but I feel like the turning point or the tipping point was in 2013, when the mentality of trying to assess risk and care about risk on the long side just became basically anachronistic. Those investors de facto became labelled ‘value investors’ and they underperformed while everybody who basically said ‘I don’t care about risk. I only care about stories’, they were the ones who benefited from the bull market.

So, especially against that backdrop – where successful long-side investors have been deconditioned from caring about risk – it is critical that, day one, we have a real reaction on the stock price. Because, if you do not have that, then the investors are not going to ask the questions of the managements and then everybody can pretend that this did not happen.

Because one thing you have to understand about long-holders vis-à-vis short activists is the long-holders want us to be wrong – they want us to fail initially. But if there is enough of an initial reaction, where they have lost money, then they are forced to care. And if they are forced to care and they start asking questions of the company, that is when – usually, if the campaign will be successful – all this pressure is put on the company and things start to break on the inside.

Decisions are made not to be so aggressive or, if it is a fraud, they realise they have to just tank the numbers because they cannot continue with the fraud. Directors resign, the CFO might resign, there could be an investigation, the auditor pays somewhat closer attention – these are the things that will get you a win over the long term as a short activist, but it is really dependent, in most cases, on day one. Like, does the market seem to care? Or are people being forced to care?

For us, then, the hard thing is not finding companies we think are problematic – the hard part is finding companies where we think the problems are so significant they can overcome investor apathy. Really, that is what I am saying – from financial crisis onward, at least to Q4 of 2021, the markets were just an apathy building and reinforcing mechanism.

So we have to think, like, this probably will matter or this probably won’t matter – and that is hard. I mean, we get that wrong all the time – you know, where we took a pass on something because we did not think investors would care. And then you see another short activist do it and – oh wow, actually, investors did care! Or else it is something we do think investors probably will care about and sometimes we get that wrong. So we do have to think about probabilities.

Then there is also the technical aspect – and this was especially acute during COVID – of what is the probability we get squeezed? Like, what is the probability that it closes up massively on day one? I mean, that is a crazy thing we see happen – especially during Covid. But, even before Covid, we would see this phenomenon where – because of algos, HFTs [high-frequency traders], bad decisions –  we or other short activists made vis-à-vis floats and how much the floats were already short and so on. And also if it leaks that we are going to be publishing on XYZ, that can create this phenomenon too.

But you will see these charts where there is a short activist’s report and, even when we say this company is a complete fraud, we have seen the stock just go down sharply for a few minutes and then just rebound and soar – like go through the ceiling. And it is, like, you know there is no person on the planet who found out about our report – in which we are calling the company a total fraud and saying, you know, 99% of its revenues do not actually exist – you know there is no person who read that and thought, well, I was on the fence about going long the stock but now I actually think it is a better company than I thought and I am going to buy it!

No, it is technical reasons that cause those movements. So we have to judge probabilities of those technical bounces, right in our face, and especially relate that to what I was saying a moment ago, about needing a good day one to create pressure on the company. And this also gets to the media, right? Like, if the stock closes down 10%, the headline is, you know, ‘Investors alarmed by concerns raised by Muddy Waters’ – something like that. If the stock is flat, then it is ‘Investors brush aside concerns raised by ...’ – and if it goes up, you know, it is like ‘Investors ebullient in the face of concerns raised by ...’! There is no regard, of course, to what actually drove the movements.

It is weird. We live in this strange time where technology has massively changed the nature of our markets but we still tend to think of them as fundamentally-driven. I mean, here in the US especially, we have had some academics ... I can think of one academic, in particular, who has been pretty toxic because he has allowed himself to be used as a tool by these companies to make the case that activist short-sellers are manipulating stocks. But, when I read his work or the work of other academics, they speak about things in terms that, again, are so anachronistic – it is, well, if the activist short-seller thinks the stock is overvalued, then they will place a shorting the stock and publish a report but then they will cover when they think it is no longer overvalued.

Like, that is not how stuff works, OK? The market agreed to stock was overvalued? No. When you are looking at the markets and the prices of securities and your only construct is a fundamental construct, you are wrong – you are missing so much of what drives markets these days. It is flows into passive. It is how much of the float is really going to trade – so is owned by active managers and not by ‘hodlers’ long-term buy-and-holders] or people who are trying to get into control positions or board seats. That is the disconnect.

So we live in this time when media and investors, especially, do not understand the impacts technology has on markets. I would say regulators have no clue either. And so, even if they are not really driven by fundamentals, or trading related to fundamentals, the results of campaigns – at least in the short term – are always linked back to the strength of the thesis or the activist report,. And it is increasingly random.

In terms of thinking about probabilities, then, we have to accept that, since 2010, the outcomes – especially in the short term, but therefore somewhat in the long term – have increasingly become random in activist short-selling, including for top-tier players. That said, playing probabilities is still, I think, a great strategy – if you can deal with all of the headaches, all of the blowback, handle all of the money you are going to spend on legal and the time it is going to take and blah, blah, blah. And if it gets you out of bed in the morning, to basically expose hypocrisy, then it is still a good strategy.

JTR: Another way to ask that question is by reference to the ‘pre-mortem’, the decision-making tool invented by Gary Klein, where ahead of taking a decision you ask each member of your team individually to look five years down the road and list everything that could end up going wrong – for example, the regulator taking the side of the company or not doing due-diligence on the price or maybe even a well-known investor taking the other side of the trade, which I guess has happened in the past?

CB: One thing that is key to understand about active short-selling is that, for us and I think for most activist short-sellers, it is basically backward-looking. So we are not trying to come up with earnings models – again, this is not traditional short-selling, which is model-dependent, it is activist short-selling. We are asking three questions about the past – has the company accurately disclosed key information or has it told a lie of commission? Has the company disclosed all adverse material information or has it told a lie of omission? Does the market interpret the information correctly?

And, if we can answer ‘no’ to at least one of those questions, there might be something to do. So, from the perspective of what could go wrong with our thesis, we are not saying, OK, we think earnings are going to be down 35% next year. So there is no point in sitting there and saying, well, what might make our projections wrong?

In terms of what can cause issues for us ... Steinhoff is a company that blew up several years ago. It was a big fraud, initially they home-listed it in Germany and then in South Africa. The key people there were South African. We knew Steinhoff was a fraud and we considered very strongly publishing on Steinhoff – but here is the problem. I had recently read Bill Browder’s Red Notice so I knew Russia constantly sends out these red notices to Interpol for him so he always has to make sure before he travels to a foreign country that they will ignore that Interpol red notice from Russia.

I said, OK, this is South Africa – we do not know much about this country but it doesn’t seem like it has a strong rule of law. These guys are very wealthy South Africans and the company is now home-listed in South Africa. Even if a US court would not recognise the decision of a South African court, or the South African regulator – so, you know, having to go through the hoops in the US to show there was no due process equivalent in South Africa – even putting that to the side, I am thinking, god, what if they put out a red notice?

So we do have to think about what can really go wrong with some of these situations. We did not do anything on Steinhoff and, of course, it blew up a few months later with, ironically, the auditor being the one to pull the plug – whereas we usually assume auditors are not going to pull plugs and will fight to avoid having fraud accusations ratified. I mean, if we are playing probabilities, that is the way it goes – but sometimes the auditor is backed into a corner and has no choice but to find the fraud, following the exposure, and then pull the plug.

So, in certain situations, we do think about worst-case scenarios and, yes, I have found myself a number of times over the years saying, well, there is a price for everything. If we are in a foreign jurisdiction that we think could be hostile to us as short-sellers, we are not going to do that for a small potential P&L – you know, we will do it for a P&L we think could be significant. So not only, in those situations, are we thinking about possibilities, as opposed to probabilities, we are also putting dollar weightings on what they are worth as problems, if they come to fruition.

Facing down big personalities

JTR: Warren Buffett famously said one reason he did not do much shorting himself was that while, for him, it was just one more position in the overall portfolio, for the management of the business being shorted, it was everything so they were willing to fight him and defend their situation to the end – to the point where it became exhausting. How do you think about this and how much does the process change when you are dealing with a company with a big personality behind it? I do not want to make the question about Elon Musk even if that is who comes to mind – at least in my head – but, either way, in many famous short-selling cases, there is very often a big investor on the long side of the trade.

CB: That is a really good question and there is a decent amount to unpack there. If we are dealing with a company that has committed crimes, the way the management will look at it – almost always, when they run their upside-downside analysis – is, there is no downside to denying this as hard as we can and fighting and going back at the short activist with everything we can. There is no downside to it. I mean, it is not like, at the end of the day, they get off lighter if they just say at that point, ha, ha, you got us, OK, fine. That is not the way the world works, right? So they are backed into the corner – and they hit you with everything they can hit you with, to try to get out of the corner. So that is the guys who are committing crimes well over the line.

Another bucket is the intellectually fraudulent, financially engineered, aggressive accounting types, whose financials can be very meaningless or more misleading than actual frauds or more misrepresentative of economic reality – but they have had the auditor sign off. And the auditors have had their lawyer sign off. And the company’s lawyers have signed off their disclosures in the notes that nobody can understand – deliberately – but that basically should exculpate everybody from liability.

Now, those guys are not necessarily going to fight – you know, they are not necessarily going to hit you with everything they can, unless, say, they have a lot of stock pledged or they were really thinking about moving up to the next tier in wealth and status. Then they will fight hard but, a lot of times ... I mean, day one, in terms of management and directors, I think everybody has a bad reaction to basically being called unethical and being shown to be misleading their investors. But I also think a number of them do ultimately look in the mirror and say, OK, maybe we should be less aggressive here; or some people might leave because they have been uncomfortable with the culture or the the focus on producing paper profits and value-destructive growth. So those guys are not necessarily going to come back with guns and flamethrowers blazing.

Now, in between, there is another situation – and you alluded to this – the big personality. Here, maybe the company has not actually crossed the line but you get these cults that are sometimes built around CEOs or, if it is not a full-blown cult, maybe the guy has just been on the cover of ‘Business Genius’ magazine or whatever and they develop these fragile egos where they have doubts about themselves – and I can speak to this from experience.

In June of 2010, I was basically sitting in a sub-economic, self-storage warehouse in Shanghai, China – and, by July of 2011, I was named by Bloomberg as one of the 50 most influential in global finance, with the likes of Ben Bernanke and Christine Lagarde and Jamie Dimon. And then I am getting asked to opine on everything in finance and economics and I was offering it up – you know, well, I think the proper rate on the 10-year should be this and corporate spreads need to be that. Like, I was so far out of my lane but people were eating out of my hand when I did that.

And I knew I was a faker, right, at least when it came to those things! That did give me some sensitivity about this and, for me, the decision was ultimately just to climb down from the tree and accept, look, man, I do something very narrow, I think I do it very well and I am happy with that. I do not need to be ‘market genius to the masses’ here. But, for a lot of CEOs, who find themselves in a similar situation where they are suddenly put on these pedestals – and, look, they know they are human, not superhuman, and they know their companies have issues – I think many of them will fight really hard to cover those issues up once problems arise. And that is what can take them into, you know, highly aggressive, misleading accounting, value-destructive transactions that produce growth, or even across the line into fraud.

I have seen this pathology and, having talked to Bethany McLean about this in detail, I know she felt that was part of the pathology at Enron, with Ken Lay and Jeff Skilling and Andy Fastow – they did not want to disappoint. They loved their auras and statuses and, if anything, when problems cropped up in the business, it just incentivised them to be more aggressive and to try to paper over these problems. And the problems of course, got bigger – because it is almost a law of the universe that, left unaddressed or papered over, any problem gets bigger, not smaller. So that is a special case there.

Those guys with really fragile egos – even if they have not committed fraud – they are often incentivised to come back really hard at you. A good example of two of these buckets would be Jean-Charles Naouri of Group Casino, who just got raided by the AMF. We issued our report on Casino and its holding company Rallye and the true debt and the bad economics that were being covered up through financial engineering in December 2015. That was our first report.

And Naouri is just tremendously indebted so, as Casino stock fell, that put the entire holding structure at risk – and all the companies above him have since filed for ‘sauveguarde’, which is the French form of bankruptcy. But he also had this ego, right? I mean, he is a genius, literally, but that bred arrogance – you know, that, just because he was a genius, he could take on all this debt. He borrowed money at low rates, invested it in high-yielding countries like Brazil and other places in Latin America and, when those countries went into the toilet in 2011, 2012, 2013, that is what really started to weaken the empire.

But he was just too proud to let people see that as well and so, as I said, the holding companies – I think there are four of them – have all filed for ‘sauveguarde’. That happened in 2019. He has kept the plates spinning but he got raided by the AMF too – that has been reported in the news. So Naouri has fought really, really, really, really, really hard. We have been out of Casino for years but that is an example of a guy in both buckets two and three, who will come back at you with everything he has got.

JTR: Very interesting, thank you. Carson, we are coming to the end of our session and we always ask our guests for two things – a book recommendation and an example of a bad outcome that was the result of bad process, not bad luck.

CB: Sure. So book recommendations. Look, my people ask me all the time – you know, should I read, say, Financial Shenanigans by Howard Schilit or GordonNorgrove’s book on accounting, if I want to be a good short-seller or at least understand what you guys do? But I prefer the financial crisis books – so my favourite book is on the collapse of AIG, Fatal Risk, by Roddy Boyd. I like [Greg Farrell’s] Crash of the Titans about Merrill Lynch and I would also throw in [Roger Lowenstein’s] When Genius Failed – the book about Long-Term Capital Management’s collapse – but, I mean, all of them are really valuable.

And the reason I put these books at the top of my recommended reading list for people who want to understand what we do is so you can see just how the personalities and personal pathologies of just a relatively small number of people can bring these enormous organisations to their knees – by creating the conditions directly themselves or sowing dysfunction within them. I mean, Crash of the Titans tells how Stan O’Neal became chairman and CEO of Merrill Lynch and totally changed the culture, surrounded himself with his cronies and yes-men, basically demoted the people who handled risk management – guys who were telling him, hey, we have all these really crazy credit exposures to subprime in our book – marginalising those guys by creating a wall of sycophants around them.

Books like that are really instructive as to just how human businesses are, at the end of the day, and how all of the foibles people have can be amplified massively when you talking about a company. And I think that is counterintuitive because a lot of people look at a company and think, well, you have all these cogs in the machine and they are just spinning and doing their thing. Yes ... but under the right conditions with the wrong people, it can become catastrophic, with just a few personalities at the top of the business. So that is why I like those – and it also just shows the self-interest and short-termism top people often have in their decision-making, and the propensity to just dig a hole and dig it deeper and deeper, while telling yourself everything is going to be OK. That is what people really should focus on if they want to understand what we do.

In terms of process that was wrong in retrospect – people do ask me, well, have you been wrong? And I say, no, we have never been wrong – but we have had situations where we haven’t made money! Now, that sounds arrogant but, again, we are dealing with history, right? We are not trying to figure out the future. It is not that, say, our earnings estimate was off, it is just that we dealt with the past – like, this did happen, this did not happen. So, if you do your work well, it is hard to be really wrong about that.

But where we have had problems is with front-running [trading a share or other asset based on inside knowledge of a future transaction that is likely to affect its price]. Front-running has been a big problem for our business over the years as that can create technical conditions that just cause a stock to rip, the moment a report is issued – and we have already discussed all the problems that creates. So that has been something I have had to deal with forever – just trying to eliminate people from our orbit who could compromise the confidentiality of what we are doing.

I would say also, though, if you look at one of our worst shorts ever – American Tower [AMT] in 2013 – two things went on there. Number one, we were front-run massively and it was an internal problem and AMT is what tipped me off to that. Number two, the market has to care. Over the years, the way we generally are successful is we take a company the market already perceives as having problems and we show that actually, no, it is a really problematic company – so taking a mediocre company and saying it is highly flawed.

We make the most money and have the biggest impact, when it is a company the market thinks is great – Sino-Forest, say, or Burford, which at least was priced that way – and you show it is actually a highly flawed, highly problematic company. But those are rare, taking a ‘10’ on a scale of one to 10 – 10 being great – and showing it is a two or a three is pretty rare, versus taking a five or six and showing it is a one or a two. Now, AMT was thought of as a nine or 10 and we showed it as a five or six – and that was just a mistake. The market does not care when you are saying, here is a company priced for perfection but it is really a mediocre company and should be priced as such. So that was one of the failures on American Tower.

But I would say our most acute process failure came out of Sino-Forest, which was two years earlier, where we produced an almost 90-page report – I mean, the company had been public for 16 years and there were just so many smoking guns of fraud and we threw most of them into the report. And that mattered to people – they were like, oh my god, this is like an 80-plus-page compendium of fraud. And, with American Tower, we were still in this ‘kitchen-sinking’ approach and we had found specific issues that, I believe, are highly material.

The thing is, though, we also kitchen-sinked it by putting in a fundamental thesis like, hey, everybody thinks the cellphone tower is unassailable and the best business model around – however, there are threats to its long-term growth from data offloading through wifii and small cells. And we just lost credibility with that because what we do is specialise – for example, when traditional sell-side analysts try to argue with our research where, say, we pull local filings and show these undisclosed related party transactions that are likely fraudulent. The sell-side analyst calls up management and says, hey, is this true? No, it is not true. Now, the sell-side analyst is normally making models about the future and trying to understand the industry dynamics – so, when they cross over into our lane and reject the work we have done, you know, they shouldn’t be doing that. They are out over their skis.

We are out over our skis, when we start doing things that are fundamental – like on American Tower. This was a large-cap company – it was $30bn at the time – so the A-teams at Fidelity and T Rowe Price were the analysts on this and they already understood the technical threats and they had strongly-held views – right or wrong – about how the tower industry would develop.

So when we started telling them, hey, maybe you are overly optimistic about this, we just lost credibility with them and I think they the automatically discounted substantially everything else we said. Like, when we said, hey, it looks like this one transaction in Brazil involved about $250m of fraud and theft, I think they said, you know what? They are probably as sloppy about that as they were about their assessment of the tower model. So who cares? We do not need to listen to this.

So that was a big process mistake we learned – don’t kitchen-sink these things, especially in more recent years, when attention spans just do not exist anymore, at least among humans! And don’t get fundamental – don’t get out of our lane and hope the fundamental guys respect us in return. I mean, they don’t but, you know, at least we should not get out of our lanes.

JTR: Carson Block, thank you very much for coming on The Value Perspective podcast.

CB: Great. Thank you. Enjoyed it.

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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