The Economist May 2nd 2020 pp63 Buttonwood “Pulp Fiction”. “Carson Block, a short seller, on the joys of detecting false accounting and fraud”
Mr. Block through his firm “Muddy Waters” roots out and exposes fakers-businesses that are essentially creating fraud by maneuvering financials or blatantly cheating. He thoroughly researches firms with red flags like;
1) Financial statements featuring practices that are not GAAP AKA Generally Accepted Accounting Principles and for which these actions significantly fluff-up the apparent enterprise value.
2) DSO and DPO unusual for the industry. By collecting from customers quickly the “Days Sales Outstanding” metric is lower than usual effectively putting more cash in hand. Combine this with slowing payments to suppliers (Days Payable Outstanding) and you have even more cash on the books. At least temporarily.
3) “Firms with dressed-up earnings also tend to pile on debt because they lack strong underlying cashflow".
4) Companies with many acquisitions in the best light complicate evaluations. In the worst light the acquiring company is in charge of “aligning the accounts of acquirer and acquired [giving] ample scope for fiddling”.
5) Investment Risk disclosures seem to be written, by crafty lawyers, on an obscuring “pay by the word” basis.
6) In reading transcripts of earnings teleconference there’s a pattern of “moving the goal posts”
After researching and identifying a target, Muddy Waters borrows shares and sells them at the current going rate (Short Selling of Put Options). Mr. Block then publicly announces his findings like on CNBC for example. He's developed a reputation for this and is believed . As a result of the exposure and convincing argument the stock tanks. Muddy Waters then return the shares back to the "lender" (Share Value Lower). If successful an activist short seller makes a profit. After tallying his first such episode he believes he actually lost $600. “There are easier ways to earn a living”.
Block came up with his firm’s name from a Chinese proverb “muddy waters make it easy to catch fish”. As John Kenneth Galbraith said “’the bezzle’-varies with the business cycle”. It's harder to sell the "bezzle" in a bull market. Don't confuse a bull market for intelligence. These deceptive schemes peak in the boom-high tide raises all boats and found out in the bust-at low tide-in muddy waters. “For short-sellers, these are good times”.