Carson Block said he had no idea what he was unleashing when he sent out his first report - on a Chinese micro-cap company called Orient Paper.
Photo: Muddy Waters
Muddy Waters founder Carson Block
The founder of Muddy Waters Research emailed it out to 25 friends and around 50 folks in the investment industry – not all of whom he was sure remembered him.
“It was really a test case,” Block told CNBC. “I didn’t have any business plan for Muddy Waters at the time, and no expectation that the market would be interested in this.”
Block issued the report on June 28, 2010, stating that the stock was a “strong sell.” He and fellow researcher Sean Regan were confident it “is a fraud.”
The company had misappropriated “most to all” of the $31.5 million it had raised, overstated revenue by 40 times in 2009 and was “the factory equivalent of a Potemkin village,” the report said.
What happened next shocked Block. The stock, trading above $8 in America just before the report, cratered within 48 hours and is still trading at around $4.
Block said he had bought less than $5,000 of put options against the company, netting him small change.
Winston Yen, the CFO of Orient Paper , told CNBC: "We certainly believe the Muddy Waters report on Orient Paper is totally false, (but) we have to be very careful in picking the right type of thing to do against Muddy Waters."
Block said he was not worried about lawsuits from companies he has targeted, since Muddy Waters was “careful.” He added that he has not been sued by anyone so far.
After Orient Paper, Muddy Waters became renowned as a short seller, spilling the beans on several Chinese stocks listed in North America. It has tapped a vein of skepticism over Chinese small-caps, which often accessed American capital markets through back-door reverse mergers.
Most recently, the company took on Sino-Forest , the Canadian-listed forestry company, which has seen its stock collapse more than 80 percent.
John Paulson’s hedge fund, Paulson & Co., held 34.7 million shares in Sino-Forest but dumped them all at an estimated loss of $720 million.
“We haven’t had the final tap out yet, but I expect that will be coming,” Block said, likening it to the end of a wrestling match.
A restless entrepreneur who has rarely stayed in a job longer than a year, Block, by his own admission has always had a problem with authority. The New York City native grew up in Summit, N.J. where he scraped by, graduating with a 1.4 grade-point average in his senior year.
“I ranked either first or second in my senior year in terms of parties that I hosted,” Block, now 35, recalled. “The police became a regular presence outside my father’s place,” worried about underage drinking.
But high school did give him the germ that’s led to such a high profile. He first got interested in Asia when he spent a month in the summer of 1991 in Toyama, Japan, in a home-stay split between two families.
“We were in a part of Japan where people had never seen Caucasians – it was a far cry in many respects from Tokyo,” he said. The immersion in such a different culture at 15 “made me more flexible when I was somewhat older so that I was able to move to a completely different culture like China.”
Block went on to study business, concentrating in finance, at the University of Southern California, where he also studied Chinese and spent a month in Beijing. He thought its domestic A-share markets might be fit for a business he could develop down the line, by encouraging Chinese savers to shift cash to stocks.
He went on to graduate in law from the Chicago-Kent College of Law, the law school of the Illinois Institute of Technology. He never intended to practice, he said, but was interested in learning how he could act as a better “in-house counsel” to investment firms.
As a young lawyer he moved to Shanghai to work for the law firm Jones Day. He stayed there from the fall of 2005 until the end of 2006, leaving to write a book that he co-authored with Robert Collins, “Doing Business in China for Dummies.”
But the idea of Muddy Waters took root when his father - who runs a research company based in Los Angeles that writes research on small caps - became interested in U.S.-listed Chinese stocks. He asked his son to visit the Orient Paper plant in Baoding City, Hebei, at the start of 2010.
In January 2010, Orient Paper failed its due diligence “with flying colors,” Block said. “The machinery was basically scrap equipment that probably belonged to a state-owned enterprise.”
His father, Bill Block, whose company W.A.B. Capital writes reports in return for shares and warrants, decided not to touch Orient Paper. But his son Carson started wondering if he should write a negative report of his own. It took six months for the first Muddy Waters report to come out because Block was unsure what to do with the information.
He was convinced Orient Paper would fail its next accounting audit. When it passed the audit without issue, he decided to write the report to demonstrate how he could scrutinize Chinese companies, and see if anybody was interested.
They were. Block had hit a nerve targeting a Chinese micro-cap, according to Bob Dodds, the managing director of DRP Capital, which consults companies on mergers and acquisitions in China.
“There was a bubble that was ready to be burst,” Dodds said. “The timing of it clicked,” with too many Chinese companies having gone public through reverse mergers, using the approach to cut fees and skirt listing standards.
But while the time was right, what has surprised investment professionals is that how quickly Muddy Waters caught on and developed a reputation. Many in the Hong Kong hedge fund community said they do not know Block at all. But the markets have been paying attention. “He’s got an incredible amount of attention from investors, and an incredible amount of influence,” Dodds said.
Taking on Sino-Forest may have been the making of the company, Dodds said, because it was a bigger target than many of the other reverse-merger companies, and it had big-name backers like Paulson. At the start of June, Muddy Waters put out a report claiming that the forestry company had overstated its timber holdings. The report caused a vertiginous decline in its shares.
But not all Block’s targets have come off that badly. Muddy Waters published an open letter on its Web site on June 28 to the chairman of chip designer Spreadtrum Communications , questioning the company’s sales trends and turnover in directors.
The shares of Spreadtrum tanked initially, but have rebounded almost as fast, and the company has received the backing of analysts. Quinn Bolton, an analyst at Needham, for instance, reiterated a buy call on the stock, saying Muddy Waters was taking advantage of its success with other targets.
Diana Jovin, Spreadtrum’s vice president of corporate strategy and investor relations, told CNBC, “Our investors have quite a bit of confidence in the company, and the analysts who cover us also believe in the fundamentals of the company.”
Another Chinese company, Hong Kong-listed China Yurunsaw its shares lose one-third of their value on a rumor that Muddy Waters would put out a report on the meat producer. The company was already dealing with negative press in the local media, but found it hard to fight research that it hadn’t seen.
“That is the power of the rumor,” Bunny Lee, who has been fielding investor relations calls for the company said. “The Muddy Waters reports are very powerful on Chinese companies.”
"Within the fraud-committing circles in China, the U.S. markets were a laughing stock. They thought of Americans as dupes willing to snap up any piece of garbage brought out of China."
Block is also troubled by the incident. All Muddy Waters research is released on its Web site and sent to thousands of subscribers who have now signed up. “I had never even heard of China Yurun,” he said. “Somebody obviously used our name. And that’s something that is very bothersome to me.”
A fake release was also issued on business press release site Briefingwire.com on June 21 that claimed the Securities and Exchange Commission had charged Muddy Waters with fraud. The SEC confirmed it was a hoax, and Muddy Waters said it might resort to litigation if it can tie the press release to a company it targeted.
Block, who now splits his time between the West Coast and Hong Kong, left Shanghai near the end of 2010 for lifestyle reasons and because it would be easier to run Muddy Waters overseas. He said he doesn’t have a fixed team working with him but uses consultants on a project basis.
“I’m quite proud of the impact we’ve had — within a year it’s been a complete sea change,” he said. “My understanding was that within the fraud-committing circles in China, the U.S. markets were a laughing stock. They thought of Americans as dupes willing to snap up any piece of garbage brought out of China. Now it’s the complete opposite.”
He continues to look for fraud cases, and said he was now looking for companies on which he could go long. “If I found a company I really liked, we’d probably make more money on that than all the companies we’ve shorted so far,” he said.