Has Muddy Waters Lost its Mojo?

Published Wed, Nov 28th, 2012   Matthew Weinschenk, Senior Analyst

Research firm, Muddy Waters, just released a damning report on Olam (OTC: OLMIF or Singapore: O32), a Singapore-based, grain trading company.

It follows Muddy Waters’ typical strategy of releasing an in-depth, heavily researched document that alleges either fraud or impending collapse.

Of course, Muddy Waters has already taken a short position in the stock and hopes that the report will lead to a selloff.

That’s Muddy Waters’ plan – and it’s been a profitable one in the past.

This time, though, Olam is only down about 10% now that the report has hit the market.

Could this be a sign that Muddy Waters – and other firms like it – are finished?

Let’s take a look…

Two Main Problems With the Short-Selling Research Business

The way these research firms work is remarkably simple. Like Muddy Waters did with Olam, they take a short position in the stock, and then release a report that causes the price to drop.

How is this not considered illegal market manipulation?

Easy. They always make sure to disclose that they have a short position.

They also spend a lot of time making sure that the facts in their research are true, and that the report’s conclusions are defendable in court… even if they might not be correct. (I’m certain that Muddy Waters’ legal team read the Olam report more times than a 13-year-old girl has read Justin Bieber’s album liner notes.)

Now, I’m not here to condemn this strategy. It’s the same thing that respected fund managers like David Einhorn or Jim Chanos do. And just because Muddy Waters releases its report on the internet – rather than make its case in front of the Value Investing Congress – that shouldn’t put these short sellers in a different class.

But these companies are facing two main problems…

First, even less reputable people are adopting the business model, too. Today, any yahoo with a Seeking Alpha account can trash a stock and try to cash in on any market panic that follows. And these copycats have undoubtedly watered down the impact of any truly investigative research.

And second, this sort of assassin-based research isn’t effective when you’re just trying to argue that a stock is overvalued or that a company can’t maintain certain growth rates. It works best when you can show outright fraud or lies.

And the trouble is that there’s just not enough legitimate fraud out there to actually dig up.

This has led to some failed accusations recently, and these short-sell reports have started to lose their luster.

For proof, let’s look at the short calls of two of the most well-known (I’ll decline to use the word “respected” here) research firms: Muddy Waters and Citron Research.

You can see that Muddy Waters used to trigger a much larger collapse after it released its reports than the 11% dip Olam experienced.

Muddy Waters clearly hit its biggest success with Sino-Forest Corp (OTC: SNOFF) by bringing up significant signs of fraud – besting even legendary investors like John Paulson.

But then it screwed up when it called out Focus Media Holdings (Nasdaq: FMCN) and New Oriental Education (NYSE: EDU). (If its accusation of fraud were accurate, there’s no way both stocks would have rebounded so quickly.)

So it’s no surprise that investors aren’t taking Muddy Waters as seriously anymore.

Citron Research is in a similar boat…

Citron has had some good successes, with stocks often plummeting over 20% after it released a damning report. Its short calls on China Media Express (OTC: CCME) and Longtop Financial (NYSE: LFT) were especially lucrative for investors who heeded the warning.

But, like Muddy Waters, a few botched calls had a clear effect on the company’s credibility.

It missed the mark with both Harbin Electric (formerly HRBN), which got bought out by its own management – and QIHOO 360 (NYSE: QIHU), which Citron published multiple reports about.

ZAGG Inc. (Nasdaq: ZAGG) actually increased after Citron’s report. It only fell later because Apple (Nasdaq: AAPL) announced the iPad 2 came with a cover, which rendered ZAGG’s aftermarket covers useless.

Bottom line: Since everyone knows that these firms are certainly not unbiased, their credibility is solely based on the accuracy of their research. So much so, that just a couple missteps have eroded investors’ confidence in the firms – and the industry as a whole.

That being said, it’s obvious – based on the charts above – that a company doesn’t have to actually commit fraud to be “exposed” by the Muddy Waters of the world. So just hope that none of your stocks get targeted by one of these short sellers.

Ahead of the tape,

Matthew Weinschenk