Blessed by the Potato

Sino-Forest (TRE on the TSX) is, ostensibly, a forestry company in China. I say ostensibly because yesterday research firm Muddy Waters released a scathing report claiming the company is a massive fraud, and has been from the get-go.

I’ve been following the stories on Chinese reverse-takeover frauds for some time, and have been admiring the work of Muddy Waters, etc. So I’m not about to try to dismiss what they’re alleging out of hand, or attack the source.

I had the poor judgment (and luck, but I shouldn’t try to dismiss my failures as bad luck) to get into this just a few days ago. Sino-forest has long been a top pick of the analysts at TD. Indeed, if you can believe the numbers in the company’s reports, it was quite attractively valued. Of course, the key is whether those numbers can be believed. I had been avoiding investing in part because I was concerned about the fraud issue, and wasn’t sure how to settle the issue: I was hardly going to jump a plane to China to check on forest holdings myself.

I had some weak evidence (in hindsight, extremely weak) that Sino-forest might be different:

• All other RTO frauds to date were American, Sino-forest is Canadian.
• The other RTO frauds came public in the mid-2000’s, a time period where fraud (e.g.: mortgage fraud) seemed a little more prevalent. Also, that only gave them a limited amount of time to fly under the radar. Sino-forest has been operating since 1995 (though Google Finance only has a chart going back to 1999).
• The other RTOs were small companies, with a max market cap of about $250M. Before yesterday’s sell-off, Sino-forest had a $5B market cap.
• The other frauds, being smaller companies, were poorly followed by analysts. Sino-forest was well followed (by TD, whose reports I have access to, as well as 8 other analysts).
• A warning sign in the other cases was often a high turnover rate in auditors. Sino-forest has has the same auditor for years.

But that still wasn’t enough for me to invest. TD kept coming out with these glowing reports, and I have to admit, I wanted to believe. I knew I likely wasn’t going to have certainty on the matter — you don’t get paid when there’s no risk — but I wasn’t sure what evidence I’d need to tilt the odds in my favour. TD’s analyst Sean Steuart had nice things to say:

Presentations from management and the board highlighted Sino-Forest’s “culture of accountability” and strove to differentiate the company from others with operations in China that have encountered recent accounting and governance problems. […] We attribute a portion of recent share price weakness to investors’ concerns that Sino-Forest could be susceptible to accounting irregularities that have undermined other equities with operations in China. Management and the board highlighted the company’s long-standing relationships with reputable auditors (Ernst & Young for the past eight years), consultants (Pöyry for the past eight years), and lawyers (Jingtang & Gongcheng review legal title to forest assets). We also note that the company has added two independent directors over the past year, bringing additional accounting (ex. E&Y partner) and capital markets experience.
The audit committee is comprised only of independent directors. While we would welcome improved quarter-to-quarter disclosure, we are comfortable with the company’s controls/governance.

This started to calm me down, perhaps too much. I tried to think of what I’d look for if I was looking to show it was a fraud. Nothing in the financial statements seemed overly fishy. They did have a 3rd party consultant (Poyry) check their forestry holdings, to audit for things like estimated yield and valuation. Though in the wake of the subprime mess investors shouldn’t put much value on credit ratings, they did have debt that carried investment-grade ratings — many other RTO frauds were debt-free (perhaps in part because debt investors are often more credulous than us equity freaks). Then I thought to check the board of directors, see if any of them were involved in scandalous activity before, or had no history at all. Not being an investigator or someone who speaks Chinese, I didn’t get very far… until I found a familiar name. An old acquaintance was on the board, someone with auditing experience. I hate to say that on that flimsy piece of evidence I bought in, but that was what finally made me think that perhaps the odds were good it was legit — surely old so-and-so wouldn’t be on the board of a fraud!

So now Muddy Waters comes out and basically ruins my whole day. The stock was down 21% before being suspended. It might go straight to basically zero when trading does resume, if it does. They’ve blown holes in many of the planks above: apparently Poyry doesn’t audit the ownership of the land that Sino-Forest claims to own. They just go and say “yes, there is a forest here, and the size and density of the trees would support a 90 m³/ha yield” type thing. Muddy Waters isn’t saying the trees aren’t there, they’re saying Sino-Forest doesn’t own them, and can’t be harvesting at the rate they are.

The claims here aren’t quite as outrageous or obvious as with some of the other RTO’s that have been debunked: there’s no missing website, or empty classroom, or underfed Adonis. Instead it comes down to hard-to-audit agreements for forestry rights. From what I was reading, it appears as though there are some agreements, but they’re not with the parties we were lead to believe they were, and they’re not for nearly as much standing forest as we were lead to believe, either. So I briefly held onto the hope last night that it’s more likely that this is the time Muddy Waters will be wrong.

Unfortunately, the company hasn’t responded yet. It’s less than an hour to the market open as I post this, and still nothing. That’s not good. Not good at all.

And of course if Sino-Forest can be a sham, then really just about anything can be. Migao was down 16% yesterday, and if I owned it, I’d be jumping ship as well.

Updates:

I’m sure this one will have lots of updates to come.
8:45am: A quick bit at the Globe reports that was asked just days ago to provide proof of ownership for its Chinese timberlands but declined, according to BMO Nesbitt Burns analyst Stephen Atkinson. […]”At the analysts’ presentation after the annual general meeting on May 31, 2011, proof of ownership (Forest Certificates) was requested but the Chairman and CEO, Allan Chan, did not want to release this information for competitive reasons,” Mr. Atkinson said in his note.” Wow. Why didn’t that make the analyst reports before the fraud allegations?

I’m also reading some other articles on it this morning, and one other point I forgot to mention above that lulled me into complacency is that it wasn’t too good to be true in all respects: it did miss earnings expectations from time-to-time, rather than continuing to rocket higher without a hitch, which is often a hallmark of fraud.

9:45am: The company said to Bloomberg that it would report before the market open today. Well, the market’s been open for a few minutes now, and still no report, and trading is still halted. If they can’t come out and just shoot from the hip, saying with confidence they they’re not a giant fraud, or in ~18 hours refute at least one point in the Muddy Waters report, well, that’s very bad. I wasn’t sure what to believe, as you could maybe tell above, but the silence from the company is damning.

10:45am: The company finally put out a release, including something hopeful:

David Horsley, Senior Vice President and CFO of Sino-Forest commented: “I am confident that the independent committee’s examination will find these allegations to be demonstrably wrong, as for example:

(a) Muddy Waters fundamentally misunderstands and misrepresents the most basic items in our published Management’s Discussion & Analysis with respect to revenue generated from Yunnan Province, which we report as being approximately 45.5% of the Company’s standing timber revenue of approximately US$508 million. Muddy Waters alleges that it is impossible that such revenue existed because achieving such levels would greatly exceed allowable cutting quotas and it would be impossible to truck close to that volume in the period. However, that revenue was very clearly disclosed in our MD&A filed for Q1 and Q2 of 2010 as revenue resulting from the sale of the standing timber – there is no cutting or transport involved, as the trees were sold but not harvested and therefore are not considered part of the quota for the region until the harvesting is conducted by the buyers.

Trading will resume today at 11:15. Now I have to decide if I’ll cling to the weak hope in that release (I’d have felt better if they had more than just two points to pick apart), or just dump.

What a crazy couple of weeks. This last week in particular featured back-to-back all-nighters as I tried to finish my thesis revisions. The crazy thing is the revisions weren’t even that bad, I just have enough trouble writing the fluffy bits that go around the sciency bits the first time around, and re-writing them seems to completely drain me. Since this week was largely fuelled by my discovery of delicious home-made onion rings, I’m afraid to even step on a scale to see where I’m at now. Anyway, it’s over, the latest revised version is out of my hands, and I just slept 24 of the last 30 hours; feeling much better now. I’ve got the penultimate exam to study for now, and hopefully a week of working out to make up for the weeks featuring dozens of hours in a chair per day…

On with the links!

The Neurologica blog has a few neat posts, including a follow-up to the CBC Marketplace report on homeopathy. A homeopathy advocate complained to the CBC, but their review found that the report was fair. “The achievement of balance does not mean mathematical equivalence; rather, the important principle is that different views are, in the words of the CBC policy, “reflected respectfully.” Also, a post about human echolocation.

A pair of articles in the Financial Post on condo speculators and using the housing bubble to sell out and fulfill your dreams. I know a few people my parents’ age who realized in the last few years that they could sell their house and retire off the proceeds if they moved even just a little ways outside the GTA. I’m surprised it hasn’t been more.

Google’s using its search data to discover interesting trends, such as uncovering the spread of flu-like symptoms. There are a lot of other possibilities for the correlation of search terms with real-life events, like getting a leading indicator of unemployment.

The CDC has created a clever page to use the threat of a zombie plague to inspire disaster readiness for more mundane emergencies.

Via BoingBoing, an interesting case in Texas on radiation in the drinking water, and the implications of margin-of-error. On the one hand, I can see the rationale for using the most liberal interpretation of the stats: who wants to tell a bunch of Texans that there’s slightly elevated levels of radioactivity in their drinking water (less than the margin-of-error above the limit), especially if the regulatory thresholds are set conservatively anyway. But, it’s not proper to consistently subtract the margin of error like they did. That’s the most optimistic interpretation of the data, but not actually the correct one. If it was a one-off reading, you could perhaps make that argument, but when it consistently happens then no, you know that the “true” value you’re measuring is indeed above the threshold.

Germany has decided to shut down nuclear power by 2022. I find that surprising: that’s a big shift to make in a deceptively short time period. According to the article, 23% of Germany’s power came from nuclear prior to the Japanese tsunami. In the wake of the fear that followed, Germany promptly shut down its 7 oldest reactors, and I’m surprised to see that sentiment following on for so long to have this much impact even on their newer reactors. 23% is a lot of power to have to find elsewhere. For comparison, roughly 8 years ago Ontario vowed to shut down our coal plants within 5 years, and it was a challenging goal to meet — indeed, the goalpost was moved to 10 years down the road pretty quickly (2014). We’re pretty close here in 2011: 8 of 19 units have been shut down, and the remainder are seeing less utilization. And coal was just about 20% of our energy mix before the phase-out. So the Germans have some pain ahead of them, and some hard choices: what on earth are they going to use to replace that much baseload power? Or will they have to pick one fifth of their things to turn off when the brownouts and rolling blackouts threaten?

I don’t understand what’s happening with TEPCO – the Japanese power utility that is the owner of the damaged Fukushima nuclear power plant.

I made a small speculative bet on it a few months ago, based on the theory that it was oversold based on nuclear fear. I figured the weak point in my analysis was the clean-up cost, as there was a Japanese law to protect nuclear operators from liability in the event of a natural disaster such as the tsunami.

Then in the wake of the disaster, the government seemed to be avoiding the implementation of that law, and I couldn’t figure out why. Sure, the optics weren’t great, but the lawmakers surely knew that a nuclear accident as a result of a natural disaster would be messy — that’s exactly what the law was for. The government seemed to be groping around in all directions: on the one hand trying to create bailouts and schemes for TEPCO and other nuclear operators, and on the other hand trying their darndest to sink them.

One less-important point in my analysis was that with the nuclear plants off-line, TEPCO was surely going to make higher margins on their thermal plants as power prices rose. Instead, the government has not allowed the prices to increase, forcing TEPCO to eat the loss (as fuel costs for thermal plants increased).

Anyway, I probably should have bailed when my initial thesis looked like it might not be true (legal protection to limit the risk of bankruptcy). It’s down over 20% this week, and based on the action in Japan last night, will probably open down another 10% today, putting me at a 60% loss. It’s a small position — I knew it was speculative from the start — but still hurts.

One big factor making me consider bailing is this recent article, which I simply cannot wrap my head around. It makes no sense for the government to be calling for loan forgiveness at this point, to try to pass the burden off to third-party lenders when there are other tools available (e.g.: direct government assistance, as per the previously-mentioned law). If a step as drastic as debt modification is needed, then that’s an indication the common shares are worthless, and it’s time to bail. Unless they’re also modifying that section of the law, where debt holders come before equity holders.

“Tokyo Stock Exchange President Atsushi Saito struck a slightly more incisive tone, and was quoted in the Nikkei business press as saying that Edano’s comments regarding debt waivers were “illogical.” “

But like I said, the government can’t seem to make up its mind on what to do, and it’s not yet clear how much this will cost TEPCO — we’re still largely in the period where fear reigns supreme over information, so it’s hard to say what the value is. Maybe months from now when the spotlight has moved on, the government can “do right” by TEPCO. Maybe it is doomed to bankruptcy and the banks will have to shoulder losses.

I just can’t tell anymore with this one what’s crazed government officials saying stupid, nonsensical things (which is often an opportunity for mis-pricing), and what’s an actual risk of total loss (which is to be avoided). My gut is telling me that this is perhaps the moment of maximum pessimism, and that this is a chance to buy, not sell. But, my brain is saying that the initial reasons for buying have been proven wrong, so it’s time to cut the losses, and that’s what I’ll do.

It’s been another rough few weeks over here. I have revisions to make to my now-complete first draft, and though there aren’t that many, they’re taking me forever. I had hoped to be done these almost two weeks ago. I seem to have serious issues concentrating (also why there haven’t been many blog posts here), and my stress levels are once again through the roof. But it’ll be over soon (just months now!) and then I can worry about what to do with the rest of my life. To try to get my science groove on I’m even going out to give some rah-rah science! outreach talks at high schools soon, which I hope goes well.

Mother’s day seemed pretty hectic here, with dinners and brunches and last-minute shopping. I ended up getting a new pizza cutter for myself while I was at Caynes. I’m impressed enough with it that I had to give it a quick mini-review: it cuts through pizzas way better than my old ones. That might be because it’s new and sharp, but even then it seems to do a better job than they ever did: I’ve always had to go back-and-forth to get a clean cut, but this did the job in one swipe. It has a rather heavy handle (vs. the cheap plastic or wood handles of my other two), and the blade disc is held securely with no play: the other two both had fairly significant wobble in the roll of the cutter.

I was recently interviewed by a reporter from the Globe & Mail, and had a brief mention in an article as a result… but although it was my website and Potato identity that brought me to his attention, the article had no mention of either. So at least my quasi-secret identity remains safe, and I don’t have to write a tedious “welcome, G&M readers” post. However, if my understanding of comic-book lore is correct, this reporter is now in grave danger, as those who possess the information of a person’s secret identity — especially reporters with privileged sources — are abducted with uncanny regularity: whether by targeted schemes or pure evil happenstance. Fortunately, I believe the last time I updated my arch-nemesis page I selected “the geese who block the bike path by the river” and they are not the hostage-taking sort of villains.

Rob Carrick agrees with my earlier post that TD’s e-series funds are great, but hard to buy. I think it’s really weird that the fund you have to trade online requires faxing/mailing in an application to open an account, but weirder still that people like me have to write third-party user guides on how to actually manage the things.

CC weighed in before I got around to publishing this post, saying that he didn’t find the e-series that hard to set up. I don’t find it that hard from the instructions either, and have helped people set them up… but Wayfare did run into issues, mostly with the branch staff being clueless and trying to sell her on higher-MER funds, and with that conversion step not going through right away. Plus some of the other steps (like withdrawing under the HBP) are a little less clear, as Krystal found out. As much as I love the e-series funds for average investors, something’s not right when the best instruction sets and knowledgeable people are outside of TD. Anyway, I’ll repeat my best advice: use TD Waterhouse.

Deliquencies are rising in Alberta as the housing market there flattens out. I consider it more evidence that delinquencies are a trailing measure, so not very relevant in a discussion on the health of Canada’s housing market, but take it however you want (i.e.: too small to be meaningful at all is also a good way to take it).

A little article on Home Capital Group also points to some more warning signs: “He said the company is being cautious when considering loans that will go toward properties in Vancouver or downtown Toronto, because the markets are showing signs of overheating.”

Canadian Business revamped their website, breaking the RSS feeds and leading to many 404 errors for old links to their articles. The ability to comment also seems to have disappeared. But, I’ve found Larry MacDonald again, and now he seems to be moving towards believing that Vancouver at least, is in a bubble.

I’m a bit late on this, but Freddie Mac actually reported a profit this quarter. The preferreds I own (a very small speculative bet) are actually in the black now by over 30% (given the timeline though, still no better a performance relative than the index). I still don’t expect a final resolution for years yet, and this only suggests that rank insolvency is perhaps not as much of a risk — but political risk still looms large, as it didn’t look like the conservator allowed them to repay any significant portion of the bailout. Despite the recent run-up, they’re still only trading for 10 cents on the dollar, quite a reasonable discount given the return to profitability. Though I was tempted to buy more on the news, I figure I’d hold pat with my thimble-full of exposure. There’s still lots of risk here, and I don’t need to bet any more than I already have.

A short post by Saj Karsan on learning from your history, but not letting randomness influence that. I can’t dig it up now, but Michael James had a similar idea some time ago: a good decision is not necessarily the one that lead to the correct outcome in the way things played out, but one that made the most sense given the information available at the time.

A cute tongue-in-cheek site about the benefits of coal-fired electricity.

Right up the street here is the Ivey School of Business, which has the Ben Graham Centre for Value Investing. I’ve never been in person, but they do have some good presentations by renowned value investors up on their website.

I like the most recent appearance by Prem Watsa:

“If you ask 10 chemical engineers to design a refinery. If you took the average of their designs, you’d get a pretty good refinery. If you were building a bridge and had civil engineering, or any human activity, and took the consensus, you’d get a good… whatever you were designing. But if you asked 10 oil company analysts for their opinion, and they were all positive on oil, you would not want to buy an oil stock: you’d be very disappointed. Because their opinions are already in the stock market. If one of them changes his mind, the prices come down. All of what you do in human activity, in terms of going with the consensus, does not work in investing; it works just the opposite.” [Transcribed quickly, not exact]

Just because you’re a financial blogger doesn’t necessarily mean you’re purely rational with money: Krystal from the very popular and successful Give Me Back My Five Bucks just bought a townhouse (in Vancouver at 260X rent!!), and had a 20% down payment ready to go, but then decided to pay off her 0% car loan and had to pay CMHC insurance with the smaller downpayment. As one commenter put it: she just turned a 0% loan into a 3.75% one, and paid $5k for the privilege. I’m of course more concerned by the extreme price: her own spreadsheet of costs shows that she’s spending about $200 more per month to own instead of rent, and that’s with an interest rate below 4% — what’ll happen in 5 years at renewal?

Similarly, Echo grapples with the decision of whether to take an offer of 3% below ask on his house, or turn it down and hope for more, putting at risk his ability to close on the next house (that’s already lined up). In all fairness, it is a very tough decision, and for such large amounts, a few percent here or there (indeed, if houses typically go for 1-2% under asking as he suggests in the comments it may be only a percent) can be serious money: up to $8k in his case. But I think of equities a lot, and there, a 1-3% move is just a rough day, nothing to go changing plans over.

Mike at Money Smarts gives us a walkthrough on how to optimize your PriceLine bids.

Patrick describes some of the ridiculous reversals of causation spouted by realtors. I also like the comparison at the beginning: high prices in anything but shelter are met by outrage.

Larry MacDonald questions some housing bear logic in a Canadian Business Magazine article. As you can guess, I disagree. In particular, rent control largely doesn’t distort the price-to-rent metrics in Ontario because rent control goes away upon vacancy (and the rental amounts I use are taken from listings). All it does is strengthen the case for renting when the price-to-rent gets out of whack because you don’t need to worry too much about that measure correcting via skyrocketing rents (vs falling prices). “I must confess to feeling somewhat dismayed at hearing others trash what is one of the most important components of my and most other Canadians’ net worth.” That “most important” part is where some of my dismay comes from: real estate is too much of the balance sheet for too many Canadians these days. It’s not sacred, and it’s not risk-free. He then mentions the affordability indicator is not very out-of-line. Unfortunately, affordability indicators are to a large extent interest-rate indicators, and yes, interest rates are low. Will they stay low? Is that a bet you want to lock-into for years to come? Larry suggests that they will stay low, but that argument is based on “the Bank of Canada likely will only allow rates to rise as long as the economic recovery is progressing” i.e.: that rates will stay low as long as economic growth is poor and we’re in a near-recession state. But that contradicts the other part about previous corrections occurring in periods of higher unemployment: if our economic growth remains poor enough to keep rates low, we can’t really count on a strong economy to counter the high price-to-rent readings. Plus I highly recommend taking a look at Barry Ritholtz’s trashing of the US affordability measures: what good is a measure that, even in the midst of one of the worst housing bubbles ever, never indicated that there was an affordability problem?

A Wired sciblog entry on a measles outbreak in the US, with some requisite preaching about getting immunized.

Just days after deciding to continue to pass on RIM, it lowered guidance and plunged 14%. I’ll be watching it a little more closely now to see if sentiment gets negative enough for it to become truly cheap.

Penny Arcade linked to Good Old Games today: a direct download service offering old games at reasonable prices with no DRM. They also include “working on Windows” as one of their selling points, which is tempting: I haven’t put much effort into trying to make it work, but I can’t seem to get my MOO2 to work on Win7, so that could be tempting.

And finally a question: do you have any tips for cheap science demos for high school students in electricity? I may be doing an outreach activity in a few weeks…