How A Famous, Polarizing Wall Street Short-Seller Sniffs Out Corporate Frauds: 'What We Look For Is Behavioral'

Short-seller Muddy Waters Research founder Carson Block in a bare-it-all interview aired on Monday discussed his foray into the world of investing and how his firm sees through fraudulent corporate practices and actions.

In The Blood: Block was initiated into investing by his equity analyst dad at a very young age and when the youngster realized that he wasn’t going to be a basketball player, he decided Wall Street would be his ultimate playground, he said in the “Investopedia Express with Caleb Silver” podcast.

After a stint in investment banking, he began working for his father, covering U.S.-centric micro-cap equities from 1999 through 2002.

Disillusionment And Sabbatical: They were astute enough to avoid stocks that were frothy during the Internet bubble. But one of the companies Block’s dad followed for over four years, namely Rentaway was adjudicated as fraud.

This fraud, Carson said, happened at larger corporations too, with companies such as Worldcom, Enron, HealthSouth and Adelphia blowing up on accounting scandals.

"And it was a very disillusioning time for me because I realized that as much as I wanted to be an investor, I just hated being dependent on people who have these short-term incentives to investors to pump their stock prices so they can unload stock,” the investor said.

That was when Block decided to leave the market for a stint at law school to better equip himself. He worked as a lawyer in China and founded the first self-storage business in mainland China.

See Also: Best Penny Stocks

The Return: As destiny would have it, he was forced a return to investing. His dad led him back this time around too, as he wanted Block to evaluate one of the Chinese companies listed in the U.S. via reverse merger. Ornian Paper, the company he was asked to do due diligence, was found to be a total fraud.

He then put together a report and sent it out to people whom he was in touch with about a decade ago. His disclosure took the stock down about 55% and recognition followed.

Block realized then this rottenness seen in the corporate world – a function of mediocrity in the industry and laziness and overcompensation, was prevalent across geographies.

Making Money: Muddy Waters, founded in 2010, initially operated with internal capital, taking a short position in stock ahead of the firm’s publications of short reports. Since 2015, the firm has been managing outside capital.

On behalf of these funds, the firm takes short positions and publishes reports.

CRE Short Bet: Block noted that his short bets on the commercial real estate sector started with Blackstone Mortgage Trust. He also said Muddy Waters wasn’t generally thematic and some of the bets become thematic in hindsight.

“Now, occasionally, we’ll look in the rearview mirror and say, oh, yeah, it turns out that within this period of time, we did a bunch of shorts in this space. And, hmm, okay, I guess there was a theme there,” he said.

Zeroing In On Shorts: Block said his firm does not run screens to look for metrics that seem out of place, as these return a lot of false negatives and false positives. “There’s so much context that you really need to understand to figure out whether a metric being out of line is significant,” he said.

“But a lot of what we do is really, what we look for is behavioral. So we’re really interested when companies are involved in related party transactions. We’re interested when companies that are seemingly profitable are undertaking financing, especially debt financing.”

Being highly promotional or latching on to the latest trend could also be red flags, he said, adding that right now it would be AI.

“Several years ago, that was cloud or SaaS. So when you see those catchphrases or words suddenly appear in filings and speech of the CEOs, that’s something that does get our attention,” Block said.

The short-seller said his firm would also look for the “me toos” in a given space. If there were a bunch of IPOs in a given space just because the space is hot, the first one or two companies were probably okay, he said. “But number three, four, five companies to go public, that’s when you start getting the guys who are thinking, ‘okay, I see all this money flowing into this area, so let me put some lipstick on some pigs and we’ll use the buzz phrase and let’s go public.’ And that’s also what gets our attention,” he added.

Block said he would also follow individuals who have been involved in stock blowups. “Once you’re in crap stock land, nobody respectable is going to hire you,” he said. “If somebody hires a person who’s been involved in a stock disaster, you’d really have to question the judgment,” he added.

He mentioned “AI,” “level three fair value gains,” and “related parties” as three catchphrases that raise red flags. “A good way to look for that is to compare the present filings to a year ago and see whether there was just a global find and replace. What did they take out in order to drop that in?” he said.

“And if the incidence rate has gone up significantly, it might be on to something.”

A company that’s generating a lot of level three fair value gains is often a red flag, Block said. Level 3 fair value, according to SEC, includes unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the related assets or liabilities. 

On related parties, Block said, “If we see a pattern, a number of these related party transactions disclosed, it’s always a red flag, even if it seems small dollar because it’s never a good look.”

The SPDR S&P 500 ETF Trust SPY, an exchange-traded fund tracking the broader S&P 500 Index, ended Monday’s session 1.58% to $501.98, according to Benzinga Pro data.

Read Next: Muddy Waters Shorts Fairfax Financial Holdings: ‘Not The Berkshire Hathaway Of Canada’

Photo by Overearth on Shutterstock.