Thursday, June 09, 2011

Here There Be Dragons

There has been plenty on the wires over the past few days of the powers being wielded by blogs in bringing various companies share prices to their knees. The response of the companies involved is to SUE. Which is of concern to TMM, not because we feel we are in the same camp as the litigants, but because it seems an asymmetric response to risk and a sign of regulation entering the webosphere.

The asymmetry of response is clear as we have never heard of a company suing an information source for publishing things that result in their share price going UP. The risk of regulation on the web does worry us much more. Not because we feel that it would be a slight on free speech and all the normal moralistic things, but more that we strongly feel that it is vital for the web to contain huge amounts of made up nonsense and complete and utter twaddle. As long as it does, and everyone knows it does, the reader is forced to make judgment calls on the validity of what he reads and take responsibility for the actions he takes based upon it.

Regulation works as long as it is impervious and leak free but partial regulation is much like trying to store water in a net. You only have to look at the fall out from the financial crisis to see how it doesn't work with all casualties blaming all other parties for their own lack of risk management. Whether it was banks blaming regulators funds blaming banks for the toxic paper, the borrower for being allowed to borrow and depositors who thought 7% in an Icelandic bank was risk free. Profit will drive resources to bypass the restrictions whether by developing new products or moving jurisdictions. Where would the fields of finance and law be without regulatory arbitrage?

This is all the more topical as Giethner is warning on the front page of the FT on "light-touch" oversight, which will no doubt lead to "heavy petting" oversight which will lead to the destruction of the remaining financial Himalayan Pink Salt mines.

As we have mentioned many times we feel the importance of doing your own research and taking responsibility for your own actions is paramount, especially in the Thunderdomes of the East. This lesson is being particularly sorely learned by investors in Chinese companies with ADR listings of which a good number appear to be frauds of one sort or another. Just how fraudulent they are is a subject of some debate - as one expert on the matter, John Hempton of Bronte Capital noted "sin has morphology" and just whether these guys have done something along the lines of "aggressive accounting" or listing businesses that entirely do not exist is up for some debate, though TMM are leaning towards the latter.

The problem with these ADRs goes beyond that of most EM investing: you have companies listed in a country where transparency at the best of times is awful and whose managers generally live in that country. That's not ideal - just look at the shenanigans in Asian equities listed in Asia - but it is hardly catastrophic because ultimately if the managers are exposed as frauds they have lost local retail money and that retail money will go completely buts trying to get square. Just look at the Hong Kong minibond scandal.


Equities listed abroad whose managers sit in the local country and cannot be extradited are a whole other ball of wax and have serious adverse selection problems. If you were fraud, would you list domestically? No. Would you get a dumbass whiteboy CFO to legitimize you? Yes. Would you overpay him and let him live in Vancouver / Beijing / etc away from the main city? Sure. It isn't hard to see that Chinese companies that list abroad need to answer one question first and foremost: what are you doing here? Well, probably the same thing Bre-X was.

With all that in mind, you would think the great and the good of long/short, private equity and the like would be halfway competent at avoiding these land mines, right? Oh no they aren't. Just look at the holders list of Longtop Financial before it was suspended and it reads like a grade A list of hedge funds - or perhaps a litter of tiger cubs. To be fair TMM understand the local bank branch colluded with Longtop to fabricate financial statements which is pretty mind blowing to think of in a western context. Kind of like finding a fraud manufacturer having JP Morgan tell them they'd print whatever they liked as their cash balances. Nonetheless, if a couple of funds including one guy sitting by the beach in Sydney can figure you out then what are these guys doing wrong?

TMM think they know why it seems a ragtag group of shortsellers, distressed debt traders and the like are doing better than most on this: skepticism and having to take responsibility for all their research. The China law blog has a good guide on how to actually do diligence on Chinese companies and it comes down to this: assume anything too good to be true is a fraud and work from there with a keen eye to people's incentives. Money apparently does not grow on trees. It seems that people who are doing their own work are working out what makes these businesses tick rather than to work out next quarters earnings (they're in the dock) and continue to win this game. TMM think this may be because they are cutting out the conga line of institutional investing ass-covering that seeks to ensure no one is responsible for anything:

Fund of Funds guys: "The consultant said they were good! I didn't do nuffin'!"
Equity Analyst: "The GLG guy said everyone uses their products and are awesome! Whocudanone?"
PM: "The equity analyst put together a bajillion powerpoint slides and talked me into it! It wasn't me!"

Save the money on GLG consultants and spend some time working out a business' supply chain, how they bill customers and the like. Or, even do something as simple as compare revenue per student at TAL Education and New Oriental Education per student and compare it to GDP per capita. Sometimes this stuff really is painfully obvious - and if your equity analyst does not pick up on this stuff he's a goose.

Looking across some equity research on our desk, TMM can't help but feel that short selling is likely to stay lucrative simply because the whole structure of the broker dealer industry makes it easy. Analysts are so petrified of not getting next quarter's earnings they completely ignore primary drivers of businesses to the extent that they miss out on the business being a fraud. Similarly, no one likes the boy who cries wolf, especially downstairs in the investment banking division.

For those not dedicated to the intricacies of corporate investing TMM can only say that if you aren't doing the work stick to your knitting - trading baskets, ETFs and the like - rather than picking single names and if you do stick to larger cap liquid stocks. Sure every now and then you get an Enron, but most of the frauds we are seeing are thoroughly mid or small cap. Caveat emptor for those not well versed in the black arts of due diligence or forensic accounting.

32 comments:

Anonymous said...

Sino-Forest!

"Terence Corcoran: Who is the villain in the Sino-Forest meltdown" -financialpost.com

Ontario Securities Commission "may lack the wherewithall to get to the bottom" of this saga.

Anonymous said...

Isn't this another example of that most favourite of subjects - Real Money/Money Manager man is now a lazy version of Pavlov's dog? He is used to doing what he is told because he is told to do it. Not thinking about why because someone else is always available to bail him out when it wobbles or wait for the great and good to change the rules to protect the gang with the cool guys in it....
The risk compass has been thrown in the back of the cupboard for so long that no one is left that knows how to use it. That includes doing the basics of what he is paid to do every day.
Looking at risk on assets over the last week or so I remain ever hopeful that Mr Pavlov and his dog are about to get taught a new trick or two.
db.

Leftback said...

Sino Forest.
There is never only one cockroach.

LB has had a dire month but probably better than J Paulson. No money manager ever bats 1.000.....

Pavlov's Dogs buying the dip today, reckon this one is a head fake and there is more pain to come.

Maiden Lane auction rumors, ABX decline may be connected to a few REIT stocks taking a tumble.

Tyler said...

LB - Here's to having a dire month.

cesiusd hit lowest level since late 2008; Put/call spike yesterday.

Anyone out there think this could be more than a headfake?

Anonymous said...

Are int. rates going up/down? Gross thinks they are going up. So are reits a sell? NLY?

Anonymous said...

So what exactly do auditors do anyway. Lol. Regulators and auditors should be ashamed. Sino forest is listed on tsx in Canada.

Forget about analysts bieng incentivized at least everyone complicity understands this what are regulators for ...

Btw I think a big concern was that muddy waters was shopping the report a few weeks ahead of it's official release...

Last but not least.... Algo's don't do forensic research !!

Leftback said...

Interest rates may not go anywhere much for a while, and they are certainly not going up to the stratosphere in any kind of major bond market meltdown. So the interest-rate sensitive sectors should be fairly stable. As for REITs, it depends what assets they own...

Yesterday was indeed a head fake, as many here suggested. This isn't going to be over until we have a high velocity, high volume down day. Crude, energy seem especially vulnerable to an accelerated sell off.

Leftback said...

More on REITs:

REITs Diverging

We have seen spreads widen between higher quality and lower quality paper this week and the recent outperformance of AGNC and NLY relative to other REITs with sub-prime exposure reflects that. Know what you own...

Leftback said...

As if the market wasn't difficult enough....

Mountain Lion Spotted in Greenwich

Tyler said...

not what I would like to hear LB, but i suppose you're right. The move needs to be painful enough to get long only guys like me to act.

Now the question is merely whether I am acting before others, or along with others (thus, creating the bottom).

Polemic said...

Lb.. more likely just a Cougar.

Leftback said...

Cougars are endemic in parts of Fairfield County, Polemic. One must be vigilant at all times.

Speaking of vigilance, it isn't just portfolio managers who need to keep their eyes on the ball:

Goalie Pays the Penalty for Premature Exultation

Anonymous said...

This weeks price action in energy, the dark variety,seems to be giving off signals only the mother of a short term momo program could love.
In my language thats telling.

Vasastan said...

Re scams: Does anyone have an opinion on whether Chaoda is an even bigger fraud than the ones already mentioned? I've followed this share up and down, and up and down again for several years, and while there has been smoke at regular intervals never any real fire. Will the cancellation of their last round of debt raising and the magazine accusations be the final straw?

Leftback said...

Market action turning ugly. Bad day for the 1275 "ambulance chasers" (dip buyers?). A lesson on what happens to weak technical support levels (farewell, 1295, 1275, and thanks for the fish). The black stuff also seems to be finally headed lower, perhaps a function of forced unwinding by DGDF diehards.

LB is glad he heeded the sage advice of TMM, and is keeping half an eye on credit markets, which so far seem to be slightly less distressed than their equity counterparts, for today at least.

Leftback said...

Every bounce has been very very weak. I suppose Tyler is still sitting on the sidelines.

Nokia.

Falling knife? Cash cow?
Death rattle? Poisoned chalice? Doomed dividend?
Maker of really nasty little plastic phones.

Discuss...?

Tyler said...

After re-reading the comments from Himalayan Pink Salt I made some pansy defensive moves...swapping a discretionary name for a staple and an industrial for some cash.

Leftback said...

High yield looking ugly at the end of the day.
No knives for LB. We'll see how next week opens.

Anonymous said...

LB,

Thanks for reits' info. You are always welcome at anony. traders.

Vasastan said...

Re Nokia: hard to see valuation go much lower than this, but previous experience at another Scandinavian company in the same segment gives me little hope for Nokia in the long term. Management most likely has no clue what has actually happened and even less about how to solve it, as the people who had ideas and resolve are gone. Company is known for massive scale, massive buereaucracy and an obsession with reinventing the wheel. Compare to MSFT, which has a much healthier and less threatened business model but similar valuation and no share movement in the last 10 years.
However, a management change can be expected which after one quarter will lead to massive kitchen sinking, layoffs and meaningless fluff about Win 7 phones and new in-house social networks - and a probable bounce in the stock price.

Nemo Incognito said...

Nokia looks like the next Dell to me - no in house software of note and just another manufacturer for Android handsets.

On Chaoda, boy oh boy do I have some stories. Suffice to say HK regulators have big balls right up to the point at which they are going toe to toe with a former PLA General. I'll leave this to Muddy Waters - its too damn easy but then again do you want to feel safe ever again? People like that tend to be above the law in China and can pretty readily make people disappear.

Ambo said...

Don't forget,TMM,the real thing runs around TODAY!

Ambo said...

Oops!

Leftback said...

The clavadista d'olio....

A big vertical plunge in gasoline prices is probably just what the doctor ordered for the US consumer. Market isn't going to bottom until the energy longs have finished jumping out the windows, though...

Yesterday was a classic sucker's rally in risk assets. Luckily, we were not tempted. LB is glad he has been paying attention to TMM. This has been a lot steeper and nastier than we had originally anticipated.

Still bullish on Japan and adding when opportunities present themselves. There has to be some kind of recovery in Japanese factory output before long.

Leftback said...

Beeb reporter on Greece.

Nice bit of reportage here. Note the comments at the very end about the widespread distrust of élite politicians, bankers and MEDIA.

BBC Report from Athens

Not only do people not want trust what the media is telling them, but they do not want to see or hear from the representatives of mainstream media.

This is really a sign that Greek society is close to breakdown. We are closer to reaching this point in other countries than most Europeans and Americans would believe.

When I was very young, Greece, Spain and Portugal were all military/fascist dictatorships. Democracy is more fragile in all these countries than we think.

WellRed said...

If $95 breaks in WTI, it will probably fall to at least $90, more likely mid-$80s, maybe lower. I don't follow the price action as much in Brent, but what level would be considered more 'healthy'? $100 give or take?

CV said...

Well, post Japan quake levels in SPY coming to a cinema near you very soon I think, so let us see whether the Fed pulls out the QE3 on this.

My working assumptionis that it takes a decisive move below 1250 for the QE3 argument to be there.

Generally, this is all very painful but really, I want to break that nuclear holocaust level on the SPY before I get worried (greedy).

Claus

Ambo said...

Phew!I just put in my fist all nighter(Sydney)I doubt they'll all be like that.Don't say you at Ascot today TMM,

Leftback said...

Claus

1) No QE3, not until the Winter of Discontent.
2) Don't care about SPY, not just yet.
3) Hoping EWJ holds above nuclear lows (!)
4) When does lower crude become a positive?
5) US 10s forming a bottom in yields?

LB posits that we eventually see a weak "self-sustaining recovery" on lower $wtic, $gaso, leading to increased US consumer spend, and stronger jobs numbers, and a modest flow of funds out of USTs drives an equity bounce.

Later in the year, China/EM slowdown and Euro banking saga really bites and then we get a big global dump, leading to QE3.

Leftback said...

Or to put it another way...

Q1 equities up, risk on.
Q2 equities down, risk off.
Q3 equities up, risk on.
Q4 equities down, risk off.

Like you we're not jumping the gun on SPY. If we are right, Nikkei and USDJPY will turn decisively first.

Leftback said...

Very quiet, TMM. Concocting another post on the latest drachmatic Greek rescue?

US markets finally seeing a spike in the VIX and put/call ratios this week, perhaps we are approaching a selling climax?

Polemic said...

LB as it happens .... yes . should be up in a few mins