Shielding portfolios against next Sino-Forest

It’s certainly no easy task for advisors to avoid portfolio bombs like Sino-Forest Corp. and Armtec Infrastructure Inc., both of which lost over 80% of their value recently. The reasons for the losses are different, but the pain is still the same.

Up until mid-April, Sino-Forest stock (TRE) was humming along quite nicely. It had risen to the $24 level, having grown at a compound rate of 52% over the past two years. Then the stock started to fade over the course of May. It would only be revealed later that the likely cause of this drift was that Muddy Waters Research was pre-marketing a damaging research report to hedge funds, who were establishing short positions over this time. The reported number of shares shorted on the over-the-counter U.S. listing for TRE more than tripled during May to over 26 million. The unreported short number was likely even higher. Then the bomb hit on June 1 as Muddy Waters, having established a short position itself, released the now infamous report on its website. The shares dropped 21% before being halted.

The company, reeling from the no-holds-barred accusations, issued a rebuttal that, while well-reasoned, could not address all the damning concerns laid out in the Muddy Waters report. After trading began again, the stock lost another 64% to close at $5.23. Two days later it closed at $4.01.

While the company could surely have handled the response better (that is, faster and with more definitive and concrete rebuttals), they likely couldn’t have soothed all concerns. The elephant in the room was that TRE’s assets were located in China, a country with a poor reputation in the West for everything from food safety to the environment, never mind something more mild-mannered like accounting and securities regulation. With the assets half a world away, many primary documents not available in English, and communication barriers caused by differing time zones and language gaps, Muddy Waters was able to capitalize on latent doubts in the minds of investors regarding Chinese stocks.

And while Muddy Waters liberally tossed around references to Bernie Madoff, all they really had to do for Canada was mention either Bre-X Minerals or YBM Magnex to get the attention of investors. Muddy Waters reminded the market (as we often do) that large scale frauds are more common than investors like to think.

This will continue to hang over TRE for some time, and also stands as the first marker as we tally up the red flags to keep in mind for the future. The second fear that Muddy Waters played upon was the fact that TRE gained its listing on the TSX via a reverse takeover (RTO). The recent story of Chinese RTOs is not attractive. Bloomberg tracks an index of such stocks, and it’s down by 45% this year. In the case of TRE, the RTO angle is a stretch since the company’s RTO occurred in 1994.

So, what else should investors have been leery of?

Non-arm’s length transactions are always a concern, and often are a key aspect in pulling off large frauds. Muddy Waters has made serious accusations in this area, while the company has come back to say all related-party transactions have been fully disclosed. The fact of the matter is that there is not enough information at this point to know which side is right. Unfortunately, this is more a failure of the accounting rules: they don’t require the auditors to seek out the existence of potential unreported related-party transactions. As a result, this red flag would have been difficult for investors to identify.

One trend investors could clearly have identified is the source of TRE’s growth. In essence, the company was cash-flow negative from an operational standpoint, which means TRE was raising substantial cash though debt and equity offerings in order to grow through acquisitions.

Anytime a company’s growth strategy is predicated on raising funds, investors are usually taking on risk that is routinely downplayed in the market—until something comes along to rattle that confidence.

While some of the major allegations in the Muddy Waters report are proving to be false, it has nevertheless caused analysts, investors and ratings agencies to re-examine the business model of TRE. Unfortunately, the report has done damage to TRE that likely cannot be undone in terms of a loss of confidence in the business model, at least as it pertains to easy access to capital.

In addition, the company has already noted the extensive internal investigation will take several months to complete, acting as a major distraction for management, and putting the brakes on acquisitions and growth. In addition, the company might be pressured into releasing confidential information in order to allay fears, which could damage the company’s competitive advantage.

Therefore, even if all the allegations in the Muddy Waters report prove to be completely false, it is unlikely TRE will be able to regain its former status as a market darling. There is now simply too much attention focused on the fact TRE grew so quickly because of almost unshakeable market confidence. In other words, investors were lulled into a false sense of security, due in no small part to positive analyst coverage.

TRE has raised almost $2 billion in debt and equity capital over the past two years, and six of the seven analysts covering the stock on Bloomberg participated as underwriters in the company’s last equity offering. Before Muddy Waters released its report, all seven analysts had either Buy or Strong Buy recommendations on TRE, combined with an average target price of nearly $32.

It’s almost as if TRE had too many supporters. It’s worth noting, because it seems to come back to bite investors more often than they like to think. Take Armtec Infrastructure as another example. On June 9, the shares lost 59% of their value to close at $4.35 after the company announced it was suspending its dividend.

Less than two months earlier, Armtec closed an equity issue that raised $58 million at $16.20 per share. No doubt many investors bought and were holding Armtec for the dividend yield (13.3% at the equity issue price of $16.20). In fact, during the marketing of the equity deal, the company’s CEO noted, “We continue to believe that stronger operating conditions in 2011 along with increased financial flexibility provided by the repayment of debt will enable us to comfortably maintain our current level of dividends.”

However, like TRE, Armtec also suffered from an overly positive bias in its coverage. Even though the shares had drifted downward to $10.50 from the issue price of $16.20, the seven analysts on Bloomberg still gave Armtec an average target of $17.50 the day before the dividend was slashed. Perhaps not surprisingly, six of the seven had helped raise money for the company just two months earlier.

While Armtec is destined to spend considerable time in the doldrums, the story with TRE is far from over. The company has just released its first quarter earnings report, which did not provide many immediate answers for investors. But even if TRE is able to clear up all of the specific accusations in the Muddy Waters report, the shares have likely suffered damage that cannot be undone. All the attention will prompt investors to question the company’s easy access to capital moving forward. It’s worth noting when a company seems to be growing quickly through acquisitions financed by large issuances of debt and equity.

With both TRE and Armtec, advisors were lulled into a false sense of security by sell-side firms that profited handsomely by raising significant money from investors, who were then left holding the bag.

• Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.