Carson Block discusses short selling and the warning signs for long-term investors

Kaylie Pferten speaks with renowned short seller Carson Block about his area of expertise and where to go long

Kaylie Pferten: Would you kindly begin by outlining the ways in which activist short sellers, such as yourself, are distinct from conventional short sellers?

Carson Block: Conventional short selling tends to concentrate more on core issues, where you, as the short seller, believe you know the company better than the market does, that it is failing more quickly than it is thought to be, and that you are playing a "melting ice cube." As activist short sellers, we usually target companies where management has engaged in some form of misconduct or misrepresentation, if not outright deception or fraud. We were open about our short positions, indicating that we typically concentrate on a much smaller universe of stocks.

When discussing our theses, we must be demonstrably correct. Indeed, our companies are the worst to bet against from the standpoint of a traditional short seller because, in most cases, managers who are trying to manipulate investors and drive up the stock can continue to operate until the market is informed of the situation.

Kaylie Pferten: A number of well-known short sellers have either retired or been charged in the last several years. Is it harder to short shares now than it was in the past?

Carson Block: I must admit that I was taken aback by the events involving Andrew Left of Citron Research in the United States. He is facing charges of market manipulation, which he disputes. European regulators, particularly those in continental Europe, have a history of becoming alarmed by short reports, which are studies conducted by short sellers that criticize a business. Nonetheless, it was concerning to observe that US authorities were beginning to lose their train of thought and speculate that activist short sellers might be the issue. I'm still investigating what went wrong.

The US Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) are the targets of two lawsuits I filed under the Freedom of Information Act (FOIA). We are battling the DOJ since they are not producing anything. However, an article written by Joshua Mitts, a Columbia Law School professor, appears to be the source of the issue. He has had a significant impact on persuading authorities that activist short sellers are a pervasive issue, according to the SEC's FOIA production.

I have, however, openly criticized his work for being easily refutable. Even though they ultimately chose not to take any action against us, activist short sellers were closely investigated, which caused me and my company a great deal of distraction for more than a year. Furthermore, businesses are now far more likely to be sued than they were in the past, which is something you need to factor into your business plan.

Kaylie Pferten: When choosing which businesses to look into, what warning signs do you look for?

Carson Block: There are a lot of factors, some of which are a little hard to explain, but for us, one important sign is the management's use of extremely promotional language. Assume, for example, that AI is a trend that is prevalent in the zeitgeist. One would be extremely suspicious of a business that abruptly attempts to position itself as an AI expert and incorporates AI into every presentation. We also enjoy reading conference call transcripts, so if you are unable to understand what the CEO or CFO is saying, that is another indication that something might be wrong.

Surprisingly, the analysts who ask the questions during the calls frequently don't understand what the management is saying. They will then pose a question to management and respond with a litany of catchphrases. We usually print off three or four years' worth of transcripts to observe how management's language has changed because it's much simpler to detect this kind of evasion from a transcript than from an audio recording. It may also be suspicious if there are abrupt changes in the language, subjects, or key performance indicators (KPI).

Kaylie Pferten: Before investing in a specific company, are there any things that regular long-term investors should be aware of?

Carson Block: Well, it's concerning when there is a lot of insider selling, particularly when the executives in question own a lot of shares. A significant effort was made in the 1980s to align executives' interests with shareholders' by awarding them large shares. The issue is that this pushed some people to manage businesses in a very short-term way, emphasizing growth in the short term at the expense of the company's long-term health, such as by taking on debt or drastically reducing research and development. Therefore, you should reconsider when executives who have amassed substantial shareholdings begin to sell their holdings, even if it's just a small portion of their total.

Take into account whether the business is attempting to manipulate its equity or debt. Reverse factoring, or supply-chain finance, is one tactic used by those who are on the verge of junk status or investment grade credit to pass off debt as account payable. Growth-oriented businesses may suddenly see disproportionate expansion in one or more areas; therefore, you must consider whether this growth is sustainable.

Kaylie Pferten: Which industries are seeing these frauds at the moment?

Carson Block: "It's important to emphasize that only about 25% of the companies we short are outright frauds, meaning that the firms' actions are likely to meet the legal standard of intentional material factual misstatements." More frequently, our shorts feature a lot of hype that is extremely deceptive but not illegally fraudulent. The largest issue facing markets and investors is this gray area.

Even though this usually happens in industries like biotechnology or technology, where it is thought that early investors can make huge profits, we don't begin by concentrating on specific industries.

However, because there are many subsidies in the green technology sector, we once shorted a number of companies in that sector. We believed that many US solar tech companies were either committing outright tax fraud or abusing tax incentives.

More generally, you will discover that the best products, the best services, or the best value are not what determine the winners and losers in an industry or sector that depends at least partially on government subsidies. Getting as many subsidies as possible in the shortest amount of time may come at the expense of quality and service.

Kaylie Pferten: You have stated that investors should "date the Chinese market rather than marry it," which means they should take short-term strategic positions rather than considering it as a long-term possibility.

Carson Block: It's true that the market appears to be very volatile and dangerous. Just the Chinese government poses a serious risk. You run the risk of President Xi Jinping choosing to launch an invasion of Taiwan. But there's also the chance that Xi Jinping will dislike a sector and choose to close it down, which has happened before. Ant Financial, the ride-hailing app Didi Chuxing Technology Company, and the for-profit education industry were all kneecapped by him just prior to their flotation.

Things worsen, though, when you consider the political risk of an unreliable and antagonistic US government. Nobody is really sure what tariffs will bring about. Tomorrow, they might abruptly drop to 10% or spike to 3,000 percent. Given the general lack of transparency and the fact that there is no way to hold Chinese executives accountable for misleading US investorsas demonstrated by the Luckin Coffee case, in which chairman Lu Zhengyao was fined for fabricating financial statementsthe market is simply roiling with danger.

I would advise anyone thinking about making a long-term investment in China to ask themselves, "Do you have anything better to put your money into".

Kaylie Pferten: What do you think the US market will experience during Donald Trump's second term?

Carson Block: I might be able to roll the right answer on that one if I had a 16-sided die. That Trump is never binary is the only thing you can say. Do A or B, or perhaps A, B, and C; it's not a case of hell. In actuality, he may consider options A, B, or C but ultimately choose option G, and it proves to be a very poor idea to try to predict Trump. Additionally, I find it very difficult to forecast movements in US tech stocks in general because cash flows rather than fundamentals can influence them. No matter how absurd the valuation, index funds simply continue to purchase the stocks. Until they have to sell it due to outflows, they will not sell that stock.

In this setting, you will find absurd valuations for these businesses that continue to draw in new investors. In order to receive inflows from exchange-traded funds associated with the Nasdaq 100, Palantirs director Alex Moore acknowledged that his company relisted on the Nasdaq. Overall, I don't want to try to steer the ship once you reach valuations that are disconnected from economic reality, such as many US tech shares.

Kaylie Pferten: Lately, you have begun making long-term investments in Afghanistan, India, and the mining industry. Why those specific locales?

Carson Block: It makes sense since we are in charge of funds allocated to those areas. Since the turn of the century, there haven't been many talented graduates interested in entering the mining industry, so you can add a lot of value if you can tell the difference between worthwhile and worthless companies. In general, we thrive anywhere there are significant information asymmetries. The two nations that stand to gain the most from the largest geopolitical realignment since 1945 are Vietnam and India, as we realized in April 2020.

Although China and Vietnam share a lot of similarities in their political and economic systems, China has been smug and acts as though it needs foreign investment more than it does. Vietnam, on the other hand, will never be as large as China, so it will need to handle foreign investment far better than China.

In India's case, it completely bypassed export manufacturing in favor of exporting services, but it now has excellent domestic consumption thanks to a young and expanding population. It might grow into a significant force in export production. However, even if it doesn't, we believe that the economy and asset prices will continue to be driven by the increase in domestic consumption for some time to come.

The founder and CEO of Muddy Waters Research, an investment company that specializes in activist short selling, is Carson Block. Carson and Robert Collins co-wrote the book Doing Business in China For Dummies.