shareholdersunite.com

Opportunities in smallcaps

shareholdersunite.com header image 2

The opposite of pump and dump is..

March 12th, 2010 · No Comments

“Short and distort.” Comical, this…
We know the business model, but here it’s explained once more (from eqwitty.com):

  • Mark Cuban, in the back of my mind, was already a game fixer, so I had no trouble believing that he would be involved in market manipulation and securities fraud. The Sharesleuth scheme is simple.  Hire a couple of second, possibly third, rate journalists.  Short sell a company that isn’t too well known or heavily traded.  Have aforementioned journalists write a reasonably convincing and highly incriminating article on the company.  Watch the share price dive.  Profit.

Indeed. Is this the Marc Cuban who shorted InterOil? No. Actually this is about another stock we’re following:

  • A year ago, Patricia Gray wrote a wonderful story for us about Sharesleuth, Mark Cuban’s quirky and perhaps brilliant effort to save journalism and make himself some dough. He hired an investigative reporter who digs into businesses and then publishes the kind of exposes that newspapers used to run much more frequently than they do now. Cuban finances the venture by shorting stock in the companies before the stories appear. 
  • In March, the site dinged China Fire and Security Group, a NASDAQ company with some shady connections. The stock promptly plummeted, losing half of its value almost immediately. Another success for investigative journalism: enterprising reporter finds problems in little-known company, market responds to information, etc… right?
  • Well, maybe not. Since then, two things have happened. First, the stock price has totally recovered and is now trading slightly higher than in March. There could be lots of reasons for that; but one unsettling possibility is that the story overstated the company’s problems and that the market overreacted. Second, it turns out that Cuban has already covered his short positions.
  • To the Motley Fool, this is wrong. They argue that Cuban should maintain his short positions to zero or, more realistically, at least until the company in question has addressed the problems described in the story. Doing that would indicate that he thinks the story has indeed uncovered fundamental flaws that should affect the company’s value. Otherwise, it may look like he’s just trying to manipulate the market to make a quick buck.

The latter link to the Mothely Fool (of which we’re no fans for unrelated reasons) puts minds at ease, so it’s worth republishing:

Mark Cuban Should Be Better Than This
By Bill Mann and Tim Hanson
July 29, 2008

We consider Mark Cuban a friend of the Fool. He’s a passionate businessman and basketball team owner, a fiery commentator, and a generally interesting guy. But he’s also prone to making bad decisions (see the Mavericks late-season trade for Jason Kidd) and even engaging in some questionable behavior.

July 23 provided an example of that latter point. His investigative financial blog Sharesleuth.com — one that’s dedicated to “exposing securities fraud and corporate chicanery” — perhaps revealed that it’s engaged in some chicanery of its own.

But let’s begin at the beginning.

How it all went down
Back on March 10, Sharesleuth editor Chris Carey published an article impugning the management of China Fire & Security (Nasdaq: CFSG) — a micro-cap company that makes fire detection and extinguishing systems for use in Chinese power and industrial plants. Carey documented a byzantine ownership structure at the company and called into question the propriety of China Fire’s reverse-merger IPO as well as its ongoing transparency and disclosure practices.

The crux of Carey’s argument was that China Fire CEO Brian Lin had linked up with stock promoter Martin Sumichrast (a character with an indisputably checkered past) and was thus guilty by association. That guilt was confirmed, in the eyes of Sharesleuth, by a series of less-than-forthright disclosures by Lin and China Fire about the qualifications of a company director and the ownership interests in the company.

After the article was published, the stock promptly dropped more than 65%.

Mr. Carey also disclosed that Mr. Cuban had taken a short position in China Fire stock prior to the publication of Mr. Carey’s research (as is the policy of Sharesleuth).

That, in and of itself, is questionable
Though we frown on that kind of advance trading here at The Motley Fool, we don’t necessarily begrudge Mr. Cuban for shorting the stocks Sharesleuth uncovers. The proceeds are ostensibly used to fund the website’s operations, which advance individual investor education and help build a more reliable marketplace.

But our understanding of the website’s strategy was that Mr. Cuban would short these stocks to zero or until resolution of the problems that prompted the Sharesleuth report. For example, according to Sharesleuth, Mr. Cuban remains short Xethanol and has profited as that stock has dropped from $12.65 per share to just $0.47 today.

In the case of China Fire, however, an updated post of Sharesleuth reveals that Mr. Cuban “has no position in any of the stocks mentioned in this story.” In other words, he’s already covered his short … a mere four months after Mr. Carey’s attack on the company was published. The stock certainly hasn’t gone to zero and Brian Lin remains the company’s CEO.

Why do we care?
We’ve taken particular interest in this story because we visited China Fire’s headquarters and met with management in Beijing during the summer of 2007. We eventually recommended the stock to thousands of subscribers to our Motley Fool Global Gains service.

We believed that China Fire had the potential to capitalize on an enormous growth opportunity as its home country enforces broader safety standards in the workplace. We also liked that the stock was trading for a compelling price.

What’s more, we believed that CEO Brian Lin was looking to build his company for the long term and that — though Chinese transparency and disclosure policies need to be upgraded — he would prove to be a shareholder-friendly manager despite the questionable guidance he received during the reverse-merger process. Indeed, Mr. Carey qualified China Fire in his own article as “an established business with substantial revenue and several sizable customers.” That customer list includes PetroChina (NYSE: PTR) and China Petroleum & Chemical (NYSE: SNP). China Fire is no operational fraud.

The good news for us and for our subscribers is that we were able to advise them to take advantage of the irrational drop in China Fire’s stock apparently caused by the Sharesleuth article to open (or build out) a position in the security. Those who did so have been rewarded. The stock quickly rebounded and today trades for more than $9 per share.

Though it still hasn’t fully recovered from where it traded in early March, we expect that it will in time — and go on to reward shareholders for many years to come. From the disclosure that Mr. Cuban has since covered his short position, it would appear that he no longer disagrees.

Despite that
By covering his short position in just a few months’ time, Mr. Cuban likely made good money on this trade. Since China Fire has seen only a string of good news, including new contracts, positive earnings surprises, raised guidance, and share buybacks — both before and after Sharesleuth’s article ran — it appears that Mr. Cuban’s profits were earned solely from his website’s attack on the stock. That, to us, smacks precisely of the kind of manipulation and executive enrichment at the expense of public shareholders that Sharesleuth itself was supposed to root out. And we have a real problem with that.

While Sharesleuth could call itself a blog that should largely go unregulated, its opinions, as well as those of Mr. Carey, carry significant influence in the investor community. All of the publicly traded stocks Sharesleuth has profiled, for example, dropped significantly on the day Sharesleuth published its article. We believe Sharesleuth should hold itself to higher standards of accountability and transparency.

Here at the Fool, for example, we have especially strict disclosure requirements and trading restrictions for those of us who write premium research. We’re restricted from trading in a stock as soon as we know we will be writing about it.

Thus, we call on Mark Cuban and Sharesleuth to disclose the dates and prices at which they opened and then covered their China Fire short position, as well as their reasons for doing so in such a short period of time. We also request that they revise their trading policy so as to prevent the appearance of future stock price manipulation. Doing so would benefit the editorial integrity of the site — something we know Mr. Carey works hard to maintain.

A broader point
Short-sellers have come under fire recently. Overstock.com (Nasdaq: OSTK) founder Patrick Byrne famously attacked them a few years ago; David Einhorn became a target of Allied Capital (NYSE: ALD) for presenting his short case for that stock; and we’ve recently seen the SEC enact a 30-day rule to prevent “improper short selling” in financial stocks such as Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

But let us be clear: We are not against short-selling. It is an absolutely crucial part of healthy and functioning markets.

Rather, we’re against individuals benefiting — on either the long or short side — from action that they caused through a published report, a lack of disclosure, or any other means. Mark Cuban and Chris Carey are better than that.

Tags: CFSG