Tencent recently published an interview conducted with famed US short seller Carson Block of Muddy Waters Research on April 15th, 2020. The interview covers a lot of ground, including several of Block’s current and former positions (Luckin, IQiyi, Anta, TAL), short selling strategies, China capital flows, and teambuilding.

*While the article and transcription were published in Chinese, the interview itself was done in English. This is my transcription (lightly edited for grammar and fillers).

For more fun stuff, you can follow me on twitter @kgao1412. And definitely check out my compilations page.

Some people say that Snow Lake Capital is your partner is China. Is that an accurate description?

We don’t have partners in China, but I certainly know who Snow Lake is. I’ve talked to the principal a few times over the years, but we don’t have a partnership by any means. We don’t have a partnership with anybody in China.

Before reaching short sellers, the report was sent to shareholders on the secondary market. But that didn’t move the stock price. Did that particular make Luckin a very difficult short target for you?

So I think there’s a hidden question here, right? You’re asking me who’s behind the Luckin report? That’s really your question. I’m not going to comment on who’s really behind the Luckin report. But I will tell you that I knew who the author was, so in my tweet that I sent out I referred to the report as unattributed as opposed to anonymous. So I knew who the author was. It’s somebody whom I’ve known for some years, and I felt is very credible in the space. It’s somebody who I found was very measured in what he said.

We got access to a data room behind this report, so we were able to do a sampling in order to validate the work. And then there were aspects of this report, I mean, on the cover page it talked about how the author stated that he suspected that one of the ways they round tripped money was by working with Focus Media. So look, anytime you want to talk corruption, you have me at Focus Media. We exposed them in 2011. They were able to go private. Carlyle and another PE firm, Fountainvest, drove the getaway car. But they still after going private, settled with the SEC for about $56MM. So, I think that’s an admission of something. But in any event, you have me at Focus Media.

Yes, but my question is that other shareholders also got the report even before you. And actually, after your tweet on January 31st, their stock price still went up. So what did you do then?

Okay, so, a couple of things. I’d never tweeted out somebody else’s report and saying we’re short. But we knew that a lot of other people had this report. We figured it’s only a matter of time before it gets out, and we also thought we were up against the clock, so to speak, because we thought it would get out anyway. So we made the decision to put it out ourselves.

Now, why didn’t the stock continue to go down? If you look at most of the page one holders, and this goes back to what I was saying earlier. I think they felt that the report was correct. They just felt it didn’t matter. You’ll have these large, sophisticated hedge funds say, “Yeah. It’s a fraud. It’s a big fraud. But whatever. We should still own it.”

After January 31st, the stock price remained stable. What did you do back then? Did you keep building or selling your position?

No. Most of our positions we now try to beta hedge. We had a very manageable position, and wanted to see what would happen. The way that short activism works when it’s successful, the analogy I’ve often used is, you’re knocking over a bunch of dominoes when you begin your campaign. How many dominoes will continue to fall, which dominoes will continue to fall, is very difficult to predict. But a lot of times, the vast majority of times, when we go activist on something, a lot of dominoes do fall. And things inside the company start to break. And those things that break can be, maybe the auditor decides to do its job, which in this case, is what I think happened. Maybe board members or managers get uncomfortable and they won’t continue to commit fraud or do things that are very aggressive.

So, things broke. But we don’t, especially when it’s not our report. The only thing that was really, that factored into how we ran the position was, “It’s not our campaign.” It wasn’t clear to me that the author of the Luckin report would do anything to follow up. So that was one risk factor that factored into how we ran the position.

Did you expect the size of the fraud to be so big? $300MM?

Oh. [chuckles]. Yeah. [chuckles]. And I think there’s more to what actually happened than what’s been released. I don’t believe that it’s one guy. That doesn’t hold water. And I suspect it’s larger than that in terms of the revenue.

What is a derivative of a company that’s committing fraud at the most senior levels of management worth? I think zero. But like I said, other people might have different views there.

Do you think David Li and Er-Hai Liu were both well aware of the big fraud of the company?

They probably are the big problem. [chuckles]. That’s my view.

20 years ago, with the Enron scandal, one of the big five auditing firms disappeared. Do you think history repeats again?

No. So first of all, two things changed since then.

Number one: It seems like immediately after that happened, the US government and policy makers came to feel that it was a bad idea to put an entire auditor out of business, or an entire firm out of business. And that’s one of the reasons why enforcement since the Enron days has been pretty loose. That’s number one.

Number two. What the auditors did was, they set up what I really think are legal fictions, but they’re now structured as these networks of independent entities. And look, I hate the auditing profession. I think it has absolutely bamboozled investors and continues to do so. Because up until the moment something goes wrong, Partners move, people move freely from one entity to another. They’re seconded. And money moves freely. And the global partners will make money off of these local affiliates. The moment something goes wrong though, the story totally changes. “Oh, no. That was our local affiliate. You can’t hold us in the US or in the UK, the global groups, you can’t hold us responsible.”

At the end of the day, you have to blame investors, right? Every year, every one of the big four will have a major blowup. And yet everybody thinks the big four brand means something. Every time we short a company, especially if we say it’s a fraud, I just see all of the responses on Twitter. And it’s all “Oh, but it’s audited by so and so.” Like, come on man. So and so last year had three major audit failures.

So anyway, the audit profession, it will continue, it will be business as usual. I think nothing will change in that respect.

You just mentioned the auditor of Luckin. There were also other Tier 1 agencies on the deal, like Credit Suisse, Morgan Stanley, CICC, Haitong. Are they also to be blamed? What’s their role in the whole thing? What will happen to them after this?

They’ll settle for some money. It’s a cost of doing business.

What’s their role? Years ago, right after we published Sino-Forest, I spoke with the credit analyst at one of Sino-Forest’s investment bankers. This analyst told me, “I figured out that Sino-Forest was a fraud over a year ago. I went to my boss, and I said that.” And my boss said, “Listen, you just be quiet. You don’t have to cover the company.” But, that’s it.

So on the equity side of the house, that firm, which is one of the major firms in the world, maintained a strong buy on the equity. That firm continued to do underwriting business for Sino-Forest. They don’t care. Caring is bad for business. They’ll pay settlements every now and then.

It’s kind of funny. I had a discussion several years ago with somebody at a major investment bank. We’d been talking to this investment bank about a prime brokerage relationship. They said, “I’m getting some pushback here because what you guys do, it’s sharp-elbowed, it’s kind of edgy.” I said, “You’re sitting in the headquarters in New York right now. You know at this minute, this very moment, somebody in that building is doing something that is going to lead to at least a $50MM penalty for the bank somewhere down the line.” He went, “Yeah. Yeah. It’s true.” But that’s the thing. Banks look at it as a cost of doing business when they occasionally have to settle for something that they do, like, in underwriting.

I don’t want to ask this question myself, but as you know, a lot of my friends always turn to me for this. Do you think Starbucks is behind the short selling of Luckin?

[Laughs out loud]. You know, every single time I shorted a Chinese company, that’s the defense. “Oh, it was the competitor.” No. I don’t think so. I don’t think Starbucks cared. [chuckles]. I don’t think so.

To what degree did you participate in Wolfpack’s investigation into IQiyi?

We did a decent portion of the research, and Wolfpack did some of the research. Wolfpack ended up directing a good portion of the research. We supported what they wanted us to do in certain areas. We were working on that one for literally a little more than a year.

The report of IQiyi only samples only 613 persons in Tier 1 cities, far from the 107MM members they published. Do you think it’s an appropriate sample size?

Actually, no. There were over 1500, approximately 1600 people sampled in Tier 1 cities. That might be referring to the percentage who responded that they’re VIP members.

So we ended up bringing in a statistician to help us evaluate whether the results were statistically significant. That’s something to which we were very sensitive. So there were certain data points where the sample size wasn’t big enough to draw a conclusion. There were certain questions where the sample size wasn’t big enough. But what we based those conclusions in the Wolfpack report on, were confirmed to be statistically significant because we were getting very tight ranges regardless of the day, regardless of the city. There were certain questions to which the answers were very consistent.

And also the report quoted only former employees for illustration. Do you think this is solid evidence?

So, if you were to go public and say, “I spoke to a former employee of IQiyi or XYZ Company, and that’s why I think it’s a fraud,” then that would be very, very poorly sourced and supported. And it would be highly problematic.

But when we looked at IQiyi, there are so many data points, and so many arguments, that support the conclusion that it’s a fraud. So citing the conversation with a former employee, was really just to try to further illustrate this and how this works as opposed to saying, “Aha! Here’s the proof! This former employee said XYZ.”

IQiyi doesn’t have, it’s not inventing 90% of its subscriber numbers. It’s not inventing 90% of its revenue. But it’s well north of that 30% bar that we want to clear.

So putting aside, that’s not inventing everything. The work, to me, the number of arguments, the amount of proof, that this company is inventing a substantial portion of its users and revenue is overwhelming.

So to single out just this one reference, I think really downplays the significance of everything else in the report.

What do you think about the fundamentals of Chinese stocks right now? They are quite different from Chinese companies that got listed 10 years ago, right?

I can’t really opine on fundamentals as opposed to, say, fraud risk. Do we think the revenue is substantially more than 30% fake? If so, can we prove it? What resources are needed to provide it? That’s really what the decision points are.

Now, when you look at TAL Education, which we wrote on two years ago, that’s not one where we attacked the revenue. We attacked the profit. We took a different angle there. Because we found periods in which the profit was substantially fake.

Sometimes we will break out of that framework. Because when we looked at TAL, we thought, “Ok, this is priced for perfection. This is a stock that everybody who’s invested in China loves. Yes, they really have learning centers. Yes, they really educate students. But, they’re lying.”

It turns out that that doesn’t really matter that much to investors in a bull market. It was worth a try. But anyways, here we are.

Speaking of TAL, you didn’t win in each and every case, like TAL and ANTA. They are still favorite kids of Wall Street. And also Pinduoduo, one of the most successful IPOs in recent years. What do you think of those so-called “failed cases.”

Ok, so we didn’t do Pinduoduo. That was not us. So yeah, Anta and TAL.

I wouldn’t call TAL totally unsuccessful. It wasn’t a win. It wasn’t a loss. TAL went down, and then it came back up with beta. So when people say, “Oh, but TAL’s back up,” I say, “Well yeah, but if you look at these PRC stocks since then, it pretty much came up in line, so [trails off]” Anyway.

Anta… Anta was a big loss. What can I say. It’s a fraud. I mean, it’s a real company. They’ve done impressive things. But the operating margins aren’t real.

But I think part of the problem for us when we look at Anta, and also when we look at TAL, is that you have so much money that is allocated to the China space. So these are decisions that are made by large allocators on a macro basis. “We’re going to be X percent US, Y percent Europe, Z percent China.” Ok, so now they’ve got Z amount of money going into China. Well, “we need things that are large and liquid.” So that crosses off a lot of names. “We don’t want to be in state-owned enterprises.” So that crosses off even more names. Ok, “What are we left with?” You’re left with a handful of companies that are just going to, no matter how problematic those companies are, I shouldn’t say no matter how problematic they are, but absent a showing of enormous problems, I guess, they’re going to continue to receive capital flows, at least in the environment that we had been in where central banks are just globally trying to force up asset prices as their economic playbook.

All these years of stimulating asset prices had really left investors, and not just investors, I think everybody in society in a way, but had really left investors anesthetized to risk. In other words, it’s like your brain has risk sensors, and for investors they’ve just been dulled, if not totally switched off by all these years of stimulus.

So in an environment in which people are reminded that there are risks, whether those are risks of things crashing, or financial assets crashing, or risks of global pandemics, or risks of natural disasters, or whatever, in that environment, I don’t know that this will continue to work. But obviously, the central banks, especially the Fed, are doing everything they can to push asset prices and make everybody forget about risk.

So we’ll see, next time around, whether these stocks, like a TAL, like an Anta, can continue to attract capital flows.

Given it seems that Chinese companies bear more risks, do you spend more time researching Chinese companies vs US counterparts?

The dynamics that I just laid out make it riskier for a short seller, because we don’t think there’s an issue that we proved, we don’t think there’s an issue that we proved that TAL has committed fraud. We don’t think there’s an issue with Anta having committed fraud. But, “do those things matter?” is the question.

That’s golden time for short sellers.

[chuckles]. It’s never a good time, right? Because everybody hates us. When the market’s going up, everybody’s trying to squeeze us, and everybody complains about us. And Elon Musk thinks that we’re the scourge of the planet. And then when stocks are going down, everybody hates us and blames us. So it’s never a good time to be a short seller.

You do it not because you say, “What’s the best way for me to make money in the stock market?”

You do it because you say, “I just feel like I know too much. I just don’t believe in so many of these stories that people chase in the equities market.” And that’s why you go into short selling.

After IQiyi and Luckin, do you think there will be another wave of attack on Chinese companies?

It’s tough to say. Effectively what I was saying earlier is, I don’t think that the incidence rate of fraud has really stopped. Now, the different between companies today and companies back in 2010 to 2012 is that those companies were 90%+ fraudulent top lines. We find a few of those now, we shorted China Internet Financial Services a few years ago, CIFS. That thing was as much as zero as NQ mobile or any of those other names.

But by and large, let’s say the universe of companies from China committing fraud. I think it’s still large. The amount of fraud is not, in terms of the percentage of revenues, is not what it was.

So the question really becomes, “Do investors think it matters?” That’s what we’re trying to figure out. Even outside of the world of China fraud, this is a question that we have to constantly answer. Because when we look at our bread and butter type of shorts, highly misleading accounting, etc. The bar has gotten higher each year because investors are just more and more unconcerned, just more and more oblivious, or deliberately oblivious to, risk.

So we’ve had to find things that are more shocking, or things that we think are more shocking or are just more problematic each year.

What’s the company size of Muddy Waters?

We’re now up at 7 core members of the team. But not everybody is working on China-related names.

What kind of roles do they play on your team?

We do have a former auditor.

We have somebody who has spent most of his career in manufacturing and sourcing. So he really helps us understand how people and material move through businesses.

We have somebody whose background was with a hedge fund in Hong Kong where he did a lot of behavioral type analysis. So he continues to do a lot of that behavioral analysis for us.

We have a junior financial analyst who is pretty, he’s a very sharp guy, but maybe the most traditional finance pedigree.

We also have somebody whose background is in restructuring and complex capital structures.

And then myself. My background is first investing, then law, then real world entrepreneurship, and back to investing.

For more fun stuff, you can follow me on twitter @kgao1412. And definitely check out my compilations page.