The Case for Short Selling: Muddy Waters LLC

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Is short selling a bad thing? Photo-bigthink

The recent proceedings taking place at Olam and Muddy Waters reads like a good quality thriller rather penned by Stephen Frey himself mixed in with cross borders trading and some mafia work thrown in for good measure. In this three part series, I will look into the three key stages of the event and how it will help to change the perspective of people of one of the most hated strategy of the Wall Street. Short selling. The first part will look into a brief history of short selling and how it has been demonized by the world. The Global Financial Crisis of 2008 was seen as a time of high turbulence and volatility leading to the markets being murky with misinformation and heavy losses being bared by many of the participants.

However, finance is a zero sum game. It means that when someone loses on one side, another side gains. The money that one party is losing on a transaction is somehow being earned by another. The motivations of both sides are diametrically opposite. When I buy a share, I expect to earn some money when it goes up. The other person is selling it because he thinks the share has increased high enough and will fall. This allows for more trading and liquidity in the market. Now if the other person has a stronger motivation, he will not even have to own the shares and he can sell his shares of by borrowing it from someone else.

The function being provided here is very important. Just like when I am buying the share, I will carry out the due diligence to see if the company is good enough. Similarly, the person taking the short position will also research his side and see the future prospects of the company on his own side. The critics of this strategy contend that it is a negative state of mind that people are betting things to fail which is dichotomous to progress and normality. They used the financial crisis by saying that when people are expecting the companies to fail, eventually the companies will. They usually force the short selling in the markets as they always view it as the anti-thesis to capitalist point of view.

What the critics fail to realize is that if only buying was supported, then more and more effort will go into finding a company better than it really is. It would be a world only seen with rose colored glasses and so companies can perpetuate or exaggerate their situation. The short sellers do the opposite by keeping the company true to itself and whenever the value goes out of line, they can bring it back to where it should be. Case in point, the short selling of Olam by Muddy Waters. The story seems like a rough draft off a publishing house’s table but it is a simple act of truth being stranger than fiction.

Short selling infographic
Short selling explained. Image credit Reuters Blog

19th November: Carson Block, the founder of Muddy Waters, takes a short position of Olam International Limited. Olam international is a Singaporean trader of agricultural products based on their accounting methods used. Speaking at a Conference, Block defended himself by saying that reading into the books of the company, he saw that the transactions were booking profit which had not yet been carried out and this would lead to a distorted picture being presented to the investors.

He clarified that any valuation based on these numbers would be untrue and that investors would be exposed to heavy losses if they take a position in the stock. He saw that the overvalued share would fall soon and so took a short position against the Singaporean company.

The first impact of the statement by Block was a plunge in the price of Olam which was the most the company had seen in the last four years. The 21 percent drop halted the trading of the share in Singapore. The statement caused a stir in the financial markets with Olam’s CEO, Sunny Verghese coming out and saying that the statement from Muddy Waters was dismaying and lacked substance. He said that Olam would defend its practises and its stock as it was based on transparency.

The fact that one man’s view is so important for the whole industry is the fact that Block recently shorted Sino-Forest Corp. based on their questionable accounting methods and the company filed for bankruptcy in March last year. Similarly, Block also shorted New Oriental Education and Technology Group Inc. based on the reasoning that the company was misleading its investors.

The domino effect of the fall in price of Olam was also seen in Temasek holdings as it has the major shareholding in the company which shows that markets were losing confidence in the company and was willing to jump ship rather than see the crisis played out. This early on, many of the research houses expected turbulence in the share prices but in the long run saw the company being strong enough to weather the storm.

The bone of contention raised primarily by Block pertains to the valuation of “biological assets” by the trading firm and believes that there has been misappropriation carried out in order to inflate the numbers. Olam still holds firm on its ground that they have been carrying out this practise in the past and nothing substantially different is being done now. It is worth stating here that even though people are following Block like an Oracle of short selling, he has been wrong in the past so this saga is expected to deepen.

People will say that if it is so easy to cause the price of share to fall based on a recommendation or a rumor, don’t the short sellers hold more power over the market than others. To those critics it can be shown that a mirror effect should also exist as for every short seller there are 4 or 5 buyers in the market and they can cause a price to rise if they give a good recommendation as well which is based on facts. And secondly, a short seller is just someone giving a recommendation. It is the people who add value and importance to it by paying heed to it and following it. If they are not followed, people like Block would be the crazy people shouting out the end of the world on street corners rather than be hailed as the oracles of the financial markets. Maybe he is pointing to the painful truth that no one wants to accept.

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