I have become a big fan of Muddy Waters Research. Muddy Waters is a micro company that focuses on debunking Chinese stocks, mostly for fraud. Muddy Waters is the brainchild of Carson Block, who describes himself as “an entrepreneur who’s practiced law and pioneered an industry in China. Our team members are likewise veterans of China’s business trenches who similarly understand how business is really conducted in China. Through their successes and struggles, they’ve developed the knowledge and contacts to navigate China’s muddy waters.” Muddy Waters has been first to reveal a number of Chinese publicly traded companies pretty much had no clothes.

Muddy Waters recently came out with an article full of good advice, entitled, “The Six Rules of China Due Diligence,” with the following six tips:

  • Approach the company as a potential customer does. “You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.” In other words, look to see how the Chinese company with whom you are interested is treated by other Chinese companies.
  • Take all company-provided introductions with a grain of salt. “When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt….In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree.
  • Try to construct your own fraud scenario.  “At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It’s good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.” I absolutely love this advice and I urge everyone to follow it.
  • Forget about the paper. Focus on the operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times – a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.” I completely agree with the advice to put the Chinese company’s operations under a microscope, but I completely disagree with the advice to ignore the paper, as I discuss more fully below. I advocate puttting the paper under a microscope as well.
  • Always speak with competitors. “Competitors with real businesses can usually tell you one of two things about a fraudulent competitor – either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.” This is excellent advice, but one should also take the views of competitors with at least a bit of salt.
  • Do not delegate. “A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attuned to the dichotomy between the investment funds at stake and the income/wealth of the people on whom you rely for judgment.” Very true. At least half the time when my firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

The seventh rule (my added rule) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in the document. In my career, I have caught the following, all of which threw up massive red flags:

  •  Company claimed to have a multi-million dollar account at a non-existent bank;
  •  Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;
  •  Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;
  •  Company claimed to be bringing in twice as much product as physically possible on a particular ship;
  •  Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;
  •  Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

I could go on and on….

What do you think? What measures do you like for checking the bona fides of Chinese companies?

  • Andeli

    I am not sure Mr Block is doing this because he wants to make the world a better or less corrupt place. It seems like someone thinks he is short selling some of the stocks of the firms he takes a look at.
    For more see
    A lot a people lost a lot of money on this

  • Sino Man

    What I don’t get is the lawyer asking his readers what they think about the issue. Surely there should be some guidance from lawyers on this rather than Muddy Waters – named after a blues guitarist – doesn’t seem very credible.

  • Twofish

    Andeli: I am not sure Mr. Block is doing this because he wants to make the world a better or less corrupt place.
    I’m sure that he isn’t. Mr. Block is doing this because he wants to promote his consulting business. There’s nothing necessarily wrong with that. He is offering samples of his research with the hope that he’ll make money in the end with his research reports.
    Which brings us to an important rule of business. People are trying to make money. Always remember that the person that you are doing business with is trying to make money, and they aren’t doing what they are doing out of altruism. After all, you are trying to make money also.
    The question that you always have to ask yourself is *how* the person you are talking is planning to make money, and how you fit into the picture. If it’s not obvious to you exactly how the person that you are talking to is trying to take advantage of you, then there is something wrong. If they are offering stuff to you really free or really cheap, you have to understand what the pay-off is going to be, and if you can’t figure out how the other person plans to make money, don’t do the deal.
    The other question that you have to ask yourself, is what keeps the person at the other end from making *more* money if there is a knife in your back.
    As far as why Dan Harris is asking people what they think is that he doesn’t know. China is big and complicated. Business is big and complicated. People only see one part, and it’s interesting to see what other people are seeing.

  • Lo Kok Kee

    Hi Dan,
    As a very very small shareholder of CCME, a Nasdaq listed company whose reputation has been muddied by Muddy Waters recently, I have a suggestion for your firm: Launch an investigation into CCME for alleged irregularities, as a few other law firms have already initiated. I can be your lead plaintiff in this case. If indeed, the company is a fraud, you win one for the shareholders, on the other hand, if CCME is legit, then you can turn around and sue Muddy Waters on behalf of the shareholders who suffered losses on their shareholdings during the bear raid. This is what I call a win-win situation, haha.

  • Tim

    @TwoFish – finally a voice of reason. I was surprised by the utter lack of logic behind most of the vitriol being thrown Carson’s way for offering up some rather chilling analysis. As condescending as your explanation is, sadly many folks need a refresher of what they should have learned in the sandbox.

  • Andeli

    Dear Tim and Twofish,
    Believing in the free market and an individual right to make money based on ones own skills does not, as the both of you seem to think, sanction intent to defraud other people of their money. Which is what, among others, Lo Kek Kee may seem to think has happend in the case of the CCME report.
    Still the “its your own problem if you trust other people and it a jungle out there” 1980s mentality is by all accounts not as popular as it was before 2007. The poor souls (all of us) that where set to pay for the bad bets made by banks from 2001 to 2007 are not as strong believers in the “anyone for himself” or the “stupid finish last” mentality that you both hail so much. I always like rules and law more then brute force or petty scams, but we all have different views on the world I guess.
    Condescending comments is not uncommon in this fora, but still condescending is never far from 趾高气扬.

  • Tim

    You’ve read far more into both mine and TwoFish’s post then was said. Take a deep breath and read again.
    There is little evidence or reasoning happening in the link you posted or other related posts but there is an over abundance of unsubstantiated accusations and name calling. Carson conducted an analysis on a Chinese company and found them to be overstating their positions.
    TwoFish’s point: Carson is attempting to make a gain out of his findings and so are ‘you’. Hell, just in case you didn’t know that before you downloaded his report he states it before you can even delve into his analysis.
    TwoFish’s comment is condescending as he should not have to point out that the onus is on you, the investor, to choose how to use this information. Something that many of the posters on the forum you linked to have clearly forgotten as they attempt to find a scapegoat for their poor investment decisions. ‘It couldn’t be my financial statement analysis savvy! Let’s track this guy down and take pictures of the agent he used to incorporate his HK holding company! Then, let’s call him names and ask leading questions about his background to prove that his analysis is an attempt to defraud investors, but at no point shall we accept responsibility for our bad decisions.

  • Kari Juntunen

    Dear Dan,
    no denying that Carson Block gives good general advice although Philip Fisher & Co originated most of it years ago, Carson basically added word China. But you might want to check a bit deeper into his actions regarding Oriental Paper (ONP) and now CCME. SeekingAlpha’s melee grounds is a good start. Prepare to be amused.
    While we are on the subject of China fraud, what is your experience with the reliability of
    1. General credit reports on Chinese small cap companies
    2. China SAIC filings by those small cap companies

  • Muddy Waters is not named after a guitarist, but is the English rendering of a proverb that is more or less the equivalent of the English saying “fishing in troubled waters” (the character for “muddy” and “confused/troubled” are interchangeable in the Chinese saying).
    I’d be a little careful with Mr. Block. His company takes positions so the research is not impartial. Further, the reports read as though they’ve been put together by a sophomore, not a professor of law, Mr. Block’s other hat. MW is taking huge legal risks, surprising for a company founded by a lawyer, in using the word “fraud” liberally and bluntly in the context of Sino-Forest. No professional investment firm would allow that kind of claim to go out of the door. Finally, Mr. Block is a brazen braggadaccio, constantly harping on about how much smarter and more experienced in China he is than any competitor. you can be sure that he is making enemies rapidly and will be taken down a peg or two before long. There are thousands of competent foreign speakers of Chinese, many of them bilingual, unlike Mr. Block, who deal with Chinese in business daily. He’s already in a crowded marketplace.

  • Frank

    I like your blog, but you guys didn’t do your due diligence on Muddy Waters. Are you sure you are “big fans” of the “micro company”?
    What exactly did he pioneer? Carson is just a tool who got paid by some hedgies to be a talking head in connection with some short selling. I have no problem with this per se, just don’t confuse what he does with quality due diligence.
    Since you are fans of the company…maybe you can write a bit about the depth and breadth of the team, who the key people are, where they are based, their qualifications and what type of dd they do.