#246 - Short Selling with Muddy Waters' Carson Block

This episode features Carson Block, an activist short seller from Muddy Waters, discussing his journey in the field, key short-selling campaigns, and his views on market dynamics and corporate governance.

1. Carson Block’s Introduction to Short Selling: His background and disillusionment with corporate governance led him to uncover substantial frauds in Chinese companies listed in the U.S.
2. Impact of Short Selling: Block discusses how short selling serves as a counterbalance in markets dominated by bullish sentiments, often revealing underlying financial and ethical issues in corporations.
3. Detailed Case Studies: He provides insights into his investigative work on companies like Orient Paper, Sino Forest, and Fairfax Financial, showcasing the depth of analysis required for successful short selling.
4. Market Dynamics and Risk: Block emphasizes the importance of understanding market dynamics and maintaining a risk-averse approach to short selling.
5. Ethical and Financial Implications: The conversation highlights the broader ethical and financial implications of corporate fraud and manipulation in global markets.

1. Introduction to Carson Block and Short Selling

Carson Block discusses his background and how he became a prominent short seller. He shares his early experiences with fraudulent companies, setting the stage for the episode’s focus.

• Carson Block: "My journey to short selling was quite circuitous, influenced by my family background in financial markets."

2. Key Short Selling Campaigns

Block details his investigative work on Orient Paper and Sino Forest, explaining the analysis and impact of these short-selling campaigns.

• Carson Block: "The exposure of Orient Paper and Sino Forest highlighted significant fraud in Chinese companies listed in the U.S."

3. Short Selling Philosophy and Methodology

Discussion on Block’s approach to short selling, including risk management and ethical considerations in choosing targets.

• Carson Block: "Short selling is not just about profit; it’s about exposing financial discrepancies and corporate misgovernance."

4. The Fairfax Financial Case

Block elaborates on his bearish stance on Fairfax Financial, citing accounting manipulations and ethical concerns.

• Carson Block: "Fairfax Financial’s manipulation of accounts and unethical financial practices led to our short position."

5. Market Trends and Future Outlook

Exploration of current market trends and potential areas of concern for investors, particularly in real estate and corporate governance.

• Carson Block: "Real estate and corporate governance remain critical areas for potential short selling due to underlying market vulnerabilities."

1. Conduct Thorough Research: Before investing or short selling, thoroughly research companies to understand their financial health and ethical practices.
2. Risk Management: Implement robust risk management strategies to mitigate potential losses in short selling.
3. Ethical Considerations: Consider the ethical implications of investment choices, focusing on companies with transparent and honest practices.
4. Market Trends Awareness: Stay informed about market trends and sectors with potential vulnerabilities to make informed investment decisions.
5. Skepticism and Due Diligence: Maintain a healthy level of skepticism and perform diligent due diligence, especially with companies in high-risk markets or sectors.

March 13, 2024 - On today’s podcast we welcome special guest Carson Block of Muddy Waters. Carson is an activist short seller who conducts in-depth fundamental short analysis focused on business fraud, accounting fraud, and fundamental problems. On the show, we discuss:

• His fortuitous path to short selling as a profession
• Sino Forest and the short that put him on the map
• The thesis behind his bearish view on Fairfax Financial
• His approach to risk management
• And more

People

• Carson Block

Companies

• Muddy Waters, Orient Paper, Sino Forest, Fairfax Financial

Guest Name(s):

• Carson Block

Content Warnings:

• None

Julian Klymochko

Hey, what's up, everybody? Welcome to the Absolute Return podcast. On today's show. We welcome special guest Carson block of Muddy Waters. Carson is an activist short seller who conducts in depth, fundamental short analysis focused on business fraud, accounting fraud and fundamental problems.

On the show, we discuss his fortuitous path to short selling as a profession, Sino Forest, and the short that put him on the map. The thesis behind his bearish view on Fairfax Financial, his approach to risk management, when short selling and more a point of disclosure accelerate, may have exposure to securities discussed on this show, long or short. With that said and no further ado, here's our show on short selling with Muddy Waters, Carson block. All right, we're here with Carson block of Muddy Waters. Super excited to get into things today on short selling, which is a strategy that not a lot of people do, not a lot of investors, obviously.

Most are long biased. I always say short selling, save it to the pros because Carson, as you know, can be perilous and dangerous, but when approached in the right fashion, can be extremely lucrative. And you've had some huge wins as one of the most prolific short sellers out there. Granted, there aren't too many these days, just given the extreme speculation that we've been seeing in the market. But that being said, given it's such a unique profession and short sellers, they kind of view them as the cops or the sheriffs of the market, you try to keep things in check, a rare counterbalance to the unrelenting bullishness that we can see in some particularly speculative markets.

Now, that being said, what got you interested initially in the unique profession of short selling?

Carson Block

I'll try to nutshell it, because my journey here was quite circuitous. But I grew up in the markets. My father was a sell side analyst. I would later come to learn that he was literally viewed as being among the most bullish and credulous of management sell side analysts, if not the most credulous. Little joke.

A guy who used to work for my father, as his trader used to tell my father, and we're talking about the 90s, he used to joke that the day my father retires, there's going to be this one guy out there who's quit, who's just despondent because he shorted everything my father ever put a strong buy recommendation on. And fast forward many years. 2010, I had just published on orient paper. That was the first report, first short report I ever published on. And I was in New York and I sat down with veteran journalist Bill Albert of Barron's, and referring to my father, he said, I first heard of Bill block years ago when I took a sabbatical from journalism and worked with a hedge fund.

And we had a strategy where we shorted everything your father ever put a buy recommendation on. So my takeaway was, it was probably not one guy. But the thing is, with my father, he really believed these guys. He's somebody who saw the best in everybody and was really taken in by charisma. And I grew up initially editing his reports when I was in 7th grade and going to management meetings over my summer vacations with him and learning that managements are good and can be trusted.

But when I graduated from university in 98, I initially went to China looking to open up an Ashare research firm. Realized way too early, went back to the states, worked for CIBC World markets for that brief moment in time when it was a bulge bracket bank. Learn how bankers love to mess around with the Ray Rock calculations, the risk adjusted return on capital. The managing director standing over my shoulder saying, like, start juicing the sales growth rate a little bit and see if this will clear our hurdle. And then after a little bit of that, I went to work with my father, covering on the long side, I mean, covering micro cap equities 99 to two.

This is a period when we were getting lied to regularly by these managements. And it wasn't just micro caps, right? This is the same time that the largest companies in the world were blowing up in scandal, like Enron, Worldcom, Health south. So by 2002, I was embittered. I had always wanted to be an investor.

I had trained for this most of my life, and yet I suddenly felt as though I couldn't do that job because I couldn't trust the people in management. And that didn't make me say, hey, I want to be a short seller. That made me go to law school in order to put some tools in my toolbox to make myself a better defensive, you know, things got circuitous. I'll reuse that word. After that, I ended up back in China as a lawyer.

Then I opened up the first self storage business in mainland China. I thought that was going to be huge and we'd raise venture capital, but it ended up just being a series of getting kicked in the balls pretty much every day. And then my father got interested in these chinese companies that had listed in the states via reverse merger. I really didn't want to take the time to look at them. I had no notion that they could be significant frauds.

I mean, I thought, okay, maybe chairman so and so is going to be taking too much money out of the company via reverse merger or, sorry, via related party transactions. But the first one I ever looked at was Orient's paper, and I was stunned that such a thing could actually exist. It had a market cap of $150,000,000. It had just reported revenue of 103,000,000, and the real revenue was probably two and a half to $3 million. And it was just so obvious to me by that point in time because I guess I was seeing the matrix in China, having just barely kept my real world business from failing there.

So I think it was June 2010, I put together a report exposing it. I was broke at the time. I just eviscerated my savings in China in that self storage business and was borrowing money from my father. So I bought about $2,000 worth of puts that I'd financed with my credit card and published this report on orient paper. It went viral, and one year later, Bloomberg Business Week named me one of the 50 most influential in global finance with like, Ben Bernanke and Warren Buffett and Christine Lagarde.

So it was like winning the lottery, really, but I didn't know what I was doing at the beginning. It was just like, look, there are these chinese companies that are lying, and I have a skill set to expose them. So write the report. Short the stock. I pretty quickly hooked up with people who had a lot more money than I did, which was zero at the time or negative.

Eventually, after almost a couple of years of doing that, I took a step back and realized that the same conflicts of interest, mediocrity, laziness, that enabled these completely empty boxes from China to list in the US and in the case Sino Forest Canada.

It's really the root cause of what chased me out of the industry when I was on the long side in the first leg of my career. So with the wisdom to know that wherever there are rivers of money flowing, as in the capital markets, you're going to attract people who are doing the wrong thing. So if there's borrow and liquidity, then shit, man, I'm going to bet on the darker side of human nature and assume that there are going to be guys out there whose pants I should pull down for doing the things they shouldn't be doing. Yeah, quite the fortuitous route that you came upon from entrepreneurship in China to discovering these chinese frauds. And the first I did read that Orient paper report when it came out, and it just opened my eyes to something I never thought of.

Julian Klymochko

I. E. American listed securities with a business in China that was completely made up and their books totally cooked, which was just wild, but opened up a whole new opportunity set over the next few years of uncovering these frauds and scams, which you proceeded to do. You said Orient paper, small, 150,000,000 market cap, not a lot at stake, but one that I think really put you on the map was Sino Forest, which was a more consequential market capitalization, if I recall correctly. And that was in about 2011, I think probably about a billion dollar market cap with more reputable, quite a bit more reputable investors on the long side.

And it created a bit of a battleground stock where you had firms like Paulson Co. Some other smart folks on the long side fighting back on these fraud accusations. And then you ultimately winning the battle, the company going bankrupt. And it was finally unveiled that they really didn't have anything. And there was really canadian shareholders that thought they owned all these force in China when they in fact didn't.

And you did quite a bit of due diligence into that one, didn't you? Yeah. Well, it's funny though, that was early June of 2011 that we published it. So really like eleven, close to twelve months after I first published, after I'd published orient paper. So the funny thing is though, and final force, I think the market cap was four and change billion and had another 3 billion in debt or net debt back then, 7 billion.

Carson Block

EV was like a number today. Especially the stuff from China that are still things that are fraudulent. That number is nothing. But yeah, the more bitter battle which actually led Sino Forest was company that we shorted in, I think, February of 2011 called China Media Express, and that had a market cap right around a billion. Was that CMED?

No, this one was ccme. Okay. Right. CMED was great because later when it was delisted, they added a Y.com, I think it was. John Hempton had this brilliant blog post on it titled something like a chinese company called Mean honestly, for financial comedy, you really can't beat these chinese frauds.

But yeah, ccme, it was audited by Deloitte. So it was the first one to go down with a big four auditor. It had CV star as the largest outside. It's like all these retail investors who are long. This thing imagined that Hank Greenberg had lovingly poured over every detail of the business and with his connections in China, could not be defrauded.

And then also there was a small investment bank called Global Hunter that a lot of retail really pinned its hopes to as well. And they had an analyst who mean, I don't think she was just. And this is what I heard from somebody who used to employ her. She was just a complete idiot. But she ended up going over to China after her first report and saying, oh, I diligence them.

And I sat down with these companies that muddy Waters claims don't actually have deals with CCME, and it turns out they do have just, I don't know. Anyway, so that one was really bitter. And there was even a class action attorney, Andrew left wrote on it. Citron research wrote on it pretty much the same time we did. It was a really competitive business back in those days because they were all frauds.

It was just a race to see who could expose it first. So there was this one class action attorney who put this website up, this web page, where he was looking for plaintiffs to sue Andrew and me. And so there was so much vitriol directed at us. And it all was based on this, what I call the holy trinity of Deloitte CV star and global Hunter. And one day in March, the stock didn't open, and it was a company halt, pending news.

And then without opening, maybe after a day, it was turned into a regulatory halt. And after, I think, three days of not trading, the eight K finally hit the system. And it was a resignation letter from Deloitte. And it was one where Deloitte resigned with flying colors. I mean, talking about likely hidden debts and assets, that don't mean it was so graphic relative to the way these auditor resignation letters usually go.

So we won. That was an uncontested knockout. And after that, there was a hedge fund that called me up and said, want to talk to you about a company listed in Canada called Sino Forest. And so that's really what led sino Forest. And we expanded significantly on the work that hedge fund had done.

But the funny thing is, Sino Forest, it wasn't really that hard because there were so many smoking guns. It had been public, I think, for 16 years in Canada, and it just had done so many bad deeds. Almost had been exposed a few years earlier. And I think some subscription research firm had questioned whether it was a fraud, and sino sued them or threatened to sue them, which bottled that up, and they quickly swept stuff under the rug. But, yeah, signing was incredible.

I mean, it was such a fun project to work on again. Every day it seemed like we had a crazy discovery where one of us would just burst out loud laughing all of a sudden, like, oh, my God, you're not going to believe this. Alan Chan, this guy was sued like 20 years ago by chinese state owned enterprise for twice bouncing a $700,000 check.

There had been a petition to wind up sino Forest filed by some supplier just two or three years earlier in BVI that nobody knew about. It was just insane how messed up that company was. So it was a lot of fun. Yeah. And if I recall correctly, I think it was rumored that Macquarie was potentially going to acquire the company.

Julian Klymochko

All sorts of wild rumors. Yeah, I think Macquarie had looked a few years earlier, seriously looked at acquiring it. And speaking of, these first few shorts worked out very well. They all basically went to zero relatively quickly. And you guys were proven right now on another one that I thought was a great report.

You guys did awesome work on luck and coffee, which is another sort of chinese fraud in which they admitted the fraud. Yet somehow the stock continued and continues to trade very, very well. So it's a case where you're absolutely right in that scenario. You figure, okay, we should make money on the short or the stock should go down. But this one was a unique one in that the stock somehow did well, at least over time after the initial.

Carson Block

So. So there's a lot to unpack there. Number one, though, I just want to make clear this was not our research. We were contacted by a fund in Asia and they had done all this work. They were not going to publish for a list of reasons.

News of this work had gotten around and basically we were given access to the data room. We spent a few days in the data room validating the high level conclusions. I mean, we did it on a test basis. There were lots of photos and videos and uploaded receipts, things like that. But I then tweeted out that we were short, that we'd received an unattributed report and I tweeted out the link to the report and we felt after going through various validation procedures that it was largely accurate.

So stock dropped. I mean, funny enough, Andrew left is out there like an hour after we're out there. We were tweeting something like, with all due respect to muddy, Citron believes that luck in is 100% real and we're long.

So it recovered somewhat. It never got the scrutiny initially that it should have gotten because Andrew's tweet and being long had supported it. But then the fraud was so bad and so obvious that when it was going through the audits, keep in mind that this happened at the end of January of 2020. So this is during the audit. So I guess the auditors then looked slightly harder than they normally do and they found supposedly these huge clients who were buying, purchasing luckin coffee and gift cards in huge numbers, and they realized pretty quickly that those entities were actually controlled by the chairman of Luckin, and they were fake entities and these were fake sales.

So then luck in self reported, like, oh, yeah, we're fraud, stock tanked. And unfortunately we weren't short any at that point because I was sitting there like, all right, well, that worked a little bit, but fucking Andrew came along and whatever, and I had no faith in, mean, the incentives, especially with these china frauds, the incentives really are for the auditors to not find the fraud, because if they find it, then they end up being liable. So I'm pretty sure the auditor ended up having to pay something meaningful at some point. But, yeah, then the stock was delisted. It was in the single digits, I think, and then kicked out the chairman.

And I'm sure everybody left in the company is on the up and up, right? And I'm being massively sarcastic here, but I can't prove that they were in on the fraud in the first place. But whatever chairman gets thrown under the bus, luckin gives back a portion of the money that it's raised.

And then basically it's like, oh, look, we're growing again. And, oh, no, these numbers are real.

I've just lost so much faith in the typical american investor because they want to have amnesia. This is not accidental that they have amnesia, it's volitional amnesia. So a couple of years has gone by, oh, no, these guys are good. Let's buy it. I'm enthusiastic.

So here we are, and the stocks back up there. And, hey, look, you can say to people all you want, fool me once, shame on you. Fool me twice, shame on me. But they don't care. So here we are.

And that's why I have a job doing what I do. And talking about american investor amnesia, we have a similar construct in Canada as well. But let's move to your most recent campaign, your recent short on Fairfax. Can you explain why you're so bearish on the stock? Yeah, it has three legs of income, and two of those legs are from investments.

So share of profits and associates and gains and losses from investing. And the thing is, Fairfax has been massively manipulating the PNL from investments since at least 2018.

When we looked at the book value of Fairfax, based on, we think we're reasonably conservative in this, but based on a lot of these machinations and games that Fairfax had played with the accounting, we think book value should be haircut by approximately 20%. And Fairfax right now is trading at a premium valuation relative to where it has historically.

As far as I can tell, at least in our look back, it's never been more manipulative of its accounts than it is now and then relative to other insurers. And one of the things I think people don't appreciate, because if we go back to the willful, the volitional amnesia and what I call the lie to me culture that pervades so much of equity investing post GFC, the problem. So you could say, well, hey, they just want to pump their earnings. Like, isn't that good for me as an investor? And the answer is no, because it costs them real cash to do it.

They are destroying cash in the process. And I'd say a very clear example and very recent example of this was Q. Four earnings of last year got a boost of about $300 million through this transaction called Gulf Insurance. So Fairfax already owned a slight majority of Gulf insurance. I think it was 50 some odd percent.

And this is listed in, listed in Dubai. So as of March of last year, when Fairfax owned like 55%, stock was trading at about 1.3 x book value. Now, Fairfax got interested in acquiring it, and somehow that interest leaked to the market, so the stock suddenly spiked. Now, what a normal, rational acquirer usually does in a situation in which it leaks, that they're interested in the target, they do not buy it at a premium to that premium. That's baked in because it leaked.

Usually they tear people new assholes. The bankers, the lawyers who did this. Why did this happen? We're walking away, but not Fairfax. Fairfax, for some reason, you know, we must pay now a premium to the current premium of the stock.

So Fairfax ends up buying the rest of the company out for roughly double where the stock had been pre ripping on the rumor that Fairfax was interested in it. Fairfax buys it out and I think the rest of it at 2.4 times book for a company. Again, this is an insurer, this isn't a software company. So why would Fairfax do that? In what world is that rational?

Well, because it allowed Fairfax to book a 300 million, I think, $290,000,000 gain on the slug valuation gain on the slug of stock that it already owned. Now, I got to tell you, this is something that we'd seen companies in China do. These were generally real companies or companies with real businesses that had fraudulent financials. We saw this with Tao Education, on which we wrote in 2018, where they would deliberately overpay, in our view, deliberately overpay for minority shareholders. Interests so they could take valuation gains and run them through the PNL.

And that's what I think Fairfax did here. I don't think there was any rational economic basis to pay that kind of premium for golf insurance, unless the whole point was just to juice the earnings in Q four, which, by the way, without that, they would have lost a lot of money because of the change in interest rates. So if my interpretation is correct, here's your problem. Yeah, they got earnings, but they're like fake earnings there on that, and it cost real cash. So there are a number of other examples that we've laid out in our report that many of which are more complex and harder to follow, but that basically requires Fairfax at some point in time to pay real cash in order to avoid a loss or to book a gain.

And there are real questions. I mean, there are discrepancies. For example, in the Riverstone transaction, Fairfax seemingly received about $300 million less cash than it should have. We published questions on this right before the call, hoping they would explain the delta. That's the transaction that they did with OMErs.

Did Omers get the know? But this is a key question. Or is there a bigger problem where the money actually wasn't paid at? And this is one where Fairfax is also on the hook. It provided a guarantee that some of the assets would be worth no less than $1.3 million.

And this just kind of speaks to Fairfax's accounting machinations. So that's basically Fairfax putting a floor on the value of what the buyer bought off it so that the buyer would feel confident in overpaying. But Fairfax, the way they structured it is, though, if these assets happen to end up being worth more than 1.3 billion, Fairfax gets money. But this transaction, I think it's like a snowball's chance in hell that those assets end up being worth more than $1.3 billion in the time frame for which this arrangement exists. But from an accounting perspective, it didn't show up as debt.

And having that theoretical potential upside allowed Fairfax to book this big gain on sale. But again, there's cash, presumably that's going to come out of Fairfax's pocket on the back end of this. So that's one of the more complex and sophisticated ways that Fairfax does it. So, yeah, it's generating non substantive earnings, or, I would know, kind of fake earnings to be a little bit colloquial about it, that cost cash. Now, one thing I want to make clear, Fairfax says in its defense, that our accounting, everything that we're doing complies with IFRS.

Well, yeah, nobody said it didn't comply with IFRS. I mean, that's one of the crazy things about this world. And I think something that most people who inhabit it understand, at least in western societies, is that you can violate massively the spirit of the rules or the spirit of the law without actually violating the letter of the rules and the law. And I think that's one of the reasons why there's been so much erosion of trust in institutions and society. And I think this is honestly the bigger problem.

The companies like Fairfax Holdings, Fairfax Financial Holdings, I think are more emblematic or are the bigger problem in the world than the sino forest are, because the abject frauds are, especially if you put aside everything from China that's listed in the US, real frauds are actually rare. But this sort of behavior of, well, I'm within the rules and I've got a bunch of lawyers, and the lawyers have issued legal opinions and they're well reasoned legal opinions and prosecutors going to hate to prosecute this because they'll probably take a loss because it's all in the gray area. This is what kills trust in markets, in institutions, in society.

It actually, even though I don't think from my chair, nothing Fairfax has done is illegal, this is the sort of thing that actually pisses me off a lot more than the abject frauds do. Right, and so what you're pointing towards is manipulation of income statement and balance sheet items and transactions meant to manipulate earnings that come at a real cost, a negative cost to shareholders. And we've seen that time and time again. GE was notorious for massaging at its earnings per share to meet the analyst forecast number, quarter in, quarter out. And we continue to see that, and not necessarily illegal, but it does not inspire trust and it certainly does not advocate for quality of earnings out there.

Julian Klymochko

And with that said, Fairfax Canadian listed, Sino Forest was, of course, Canadian listed as well. Do you think shorts and good short targets are more prevalent in Canada, or was that more so circumstantial? No, I think Canada does have maybe more governance problems as a percentage of listed companies than the US does. Disclosure is not as great, but I think one of the also, this is a problem that I really see with Europe, but it's similar to Canada, is that you have balkanized.

Carson Block

Now, it's somewhat worse in Europe for a reason I can get to in a moment. But, yeah, I know that a few years ago, Canada did form a federal securities regulator, but my understanding is that its powers are pretty know it seems to me that among the provincial regulators, you have almost this race to the bottom. It was similar to banking regulation in the US pre GFC, where you kind of want to shop for the lightest touch. And so that's been a real issue. I think that's one of these structural issues in Canada.

But I think there's also. Canada is very clubby. And the problem with that is that judgment can easily be bent. And I go back to the comments about my father. My father was always a sucker for charisma.

And you don't get to lead an organization, usually without having some level of charisma, especially a larger organization that's publicly traded company. So I think that the fact that so many people in Canada know each other and they have personal relationships know, they just can't imagine that so and so would have misled them or lied to them. I think that that helps make Canada kind of like a filthy environment. Because when you look at malefactors and what they look for, they look for that weakness, right?

There are a lot of actors out there, and I know people might find this hard to believe, but supposedly 4% of the population, four to 6% from what I've read, are sociopaths or psychopaths. And then you've got outside of that, the people who are psychopathic. Sociopathic. And by this, I don't mean that they enjoy chopping people up into pieces. That's called bloodlust.

And so the combination of sociopathy and bloodlust is actually quite rare. But these are people who they know how to manipulate when psychopaths and sociopaths are master manipulators of other people. And time and again you see them turn up in the financial markets and it's hard for a lot of investors to admit that they might have misjudged somebody. That's like a real blow to the ego. And that's one of the hard things that we as activist short sellers face, is that there's so many people feel insecure if they've got bamboozled, that rather than taking a step back and looking at things dispassionately and saying, yeah, look, I might have been bamboozled here.

They dig their heels in and hear any bit of what we have to say. And when you look at what we've done in the past, I have to hand it to John Paulson. So when we came out on Sino Forest, he didn't do that. He got really serious, apparently. I've never spoken to him, but what I understand is he got really serious internally.

And he, hey, spin up some investigators who know what's going on, who know their way around China, get them on this immediately, and see whether muddy waters. Right. And they came back pretty quickly and confirmed know we were at least largely correct. And so he got out of, you know, there have been professional investors numerous times on the other side of us who just refused to admit that they were misled. And to be fair, there are a couple of things that I think people should keep in mind in these situations.

And I've learned the hard way, I mean, even after I started this business, I was massively defrauded in the early days by a couple of guys who I had led into this business. And what I learned from that is that if I'm looking to be a buyer, if I'm looking to see whether something makes sense for me to be long, whether it's talent or a stock, it's an entirely different mode of thinking than if I'm trying to find holes in the story. I can't go into something thinking, is this a good investment? And I'm not expecting to possibly come out on the other side being like, oh, man, this thing's a fraud, I'm going to short it. You have to think entirely differently.

And so I don't think people should really kick themselves too hard if they have been misled or bamboozled. But the point is, don't live in self delusion about it. Get real, and then try to learn from that experience. But, yeah, that's one of the harder dynamics of my business is dealing with that built in desire that so many people have to just ignore what we're saying because of the ego blow. There'd be ego as well as the long only manager.

Michael Kesslering

I mean, really, all they can do. The tools in their toolkit are just risk management in terms of diversification and things like that to be able to defend themselves. But on that topic, wanted to talk a little bit about your approach to risk management and trade structuring. When you're looking at these situations, how are you typically structuring the trade? Are you looking to just short the common shares?

Are you looking at derivatives like put options or CDs default swaps? How are you structuring these?

Carson Block

Usually, there's not enough liquidity for options to matter if there is an options market, because if you go big in the options market, the tail ends up wagging the dog. Like, if you just start buying a bunch of puts, the vault blows out on the puts, stock drops because of the hedging and like I said, we manage outside capital, so we generally can't buy enough puts to make it worthwhile, but we can buy enough puts that would screw up our entry price, so we usually don't do that. CDs. Yeah, man, I missed the golden age of mean. We're set up, we have pipes where we can do CDs.

But know, ever since the Dodd Frank reforms took the banks out of using their own balance sheets and taking prop positions, there's just not a lot of liquidity, not a lot of these names have, even if they have public debt, they just don't have CDs. Nobody's making CDs on them. So, yeah, if I started doing this pre GFC, man, I'd probably be worth more by an order of magnitude than I am just because of usually. So we're usually just shorting the underlying. And what we often do is we run our positions usually factor and market neutral.

So we have a software package that identifies the factors that supposedly explain beta. It might be 30% growth and 15% momentum, 10% financial services. And so then we go to a counterparty and we say, okay, we want to construct a basket of 30 to 50 names that we can be long that represent these factors. We try to line up the time zones of the markets, basically, and meaning that if we're shorting something in Asia, we tend not to want the names to be us names because of the time know, we try to make it generally for every dollar of the underlying that we're short. We're long that basket in a.

And as we run the position, we rebalance as needed. That makes a lot of sense. And I think risk management is so important when it comes to short selling, and the list is seemingly endless of those who got just absolutely destroyed on a short that went against them. So I think running it in that market neutral manner makes a lot of sense in terms of risk management and career longevity, to say the least. Now, Carson, before letting you go, one last question.

Julian Klymochko

As you look into the current market environment, where do you see the best short opportunities? And for our listeners that are perhaps long only, where should they stay away? Where are the major red flags and risks in the current market, man? Well, the thing is, we're seldom thematic on the front end. It's in the rear view mirror that we'll say, oh, wow.

Carson Block

It turns out that we were shorting a lot of ESG grips or green tech grips, or we were shorting real estate or stuff in Europe. So, look, I get the impression in December, we revealed that we're publicly short BXMT which is Blackstone mortgage reit. And that was based on its exposure to office. But since then, we've gotten the impression that real estate, that Cre, across classes, especially multifamily, in the Sunbelt, could be the next shoe to drop. And I had lunch with a commercial real estate investor just a week ago, and this guy got his start before, got his start in the lead up to the SNL crisis.

So he borrowed money from these SNLs and made his first fortune. And then next thing he knows, he's handling workouts on these properties with the resolution trust Corp. So he's seen two massive booms and busts already, and then the boom that we've know talking with him and some other people, Cre could be a major, major issue. I think Keith Briet and Woods put out a report a couple of weeks ago about insurance companies that have significant exposure to, I think, was it multifamily? Maybe.

Anyway, it's just some of these insurers have, their exposure to vulnerable Cre spots in the US is double their capital, which I'm not saying that it erases their capital, but the impacts and the knock on effects of this real estate bus that's sort of moving in slow motion right now could be profound. And I say moving in slow motion because in 23, the market was really locked up and everybody was waiting for rate cuts. You had some sponsors that were willing to kick in additional equity, but the rate cuts that everybody was really hoping for, the magnitude and timing don't appear to be materializing. And so maybe the market stays jammed up a little bit more, but at some point in time, the market is going to clear and the valuations at which things are clearing, not just on office, but quite possibly, like I said, on multifamily, are going to be significantly lower. And this potentially could have a lot of effects.

So banks, insurance companies and beyond. So that's something I think investors should pay attention to. I'm not a macro guy, so I don't have a strong view as to what dominoes will fall and when, but it's potentially profound and it's something that in spare minutes, trying to think about and come up with some ideas. And that's a really good red flag for investors to pay attention to. Just this week we saw NYCB get bailed out due to these real estate loans, and you can only do so much kicking the can down the road, extending and pretending until you got to face the music.

Julian Klymochko

There's that saying, how'd you go bankrupt? Well, gradually, then suddenly, and it can happen very quickly. Whether it's these regional banks, whether it's the mortgage REITs, there's all sorts of highly levered risks that the House of cards can come down very quickly. So thanks for flagging that. Thanks for coming on the show today.

Just an awesome review of all the work you've done on the short side of the business, which is rare and seems to be getting more rare these days with a lot of the grizzled short selling veterans hanging up the gloves. But it's great to see you be successful doing that, and we continue to hope you do so for a long time into the future. So thanks, Carson, for coming on the show today. Cool, thank you. Enjoyed it.

All right, take care. Bye everyone.

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