carson block

Carson Block: Three Amazing Short Calls From Muddy Waters Research

Disclaimer: Lean Investments is a financial education and entertainment website. None of the content below should be misconstrued as investment advice or a recommendation. The author holds none of the positions mentioned below.

Quick Summary: Carson Block’s history of short calls shows both the pitfalls and potential of betting against stocks. Here we profile three of his most notable calls on TAL Education, Luckin’ Coffee and GSX Techedu.

Introduction: Carson Block’s Amazing Short Calls

Being a short seller isn’t easy. Investors who are vocal about their short ideas in betting against a company often face backlash from the targeted company’s executives, bullish investors and sometimes even regulatory bodies.

Short sellers attempt to profit from a stock that declines in value. They borrow shares from a broker at the current price and then sell them with the goal of turning a profit by buying the same shares back at a lower price later and keeping the difference.

Beyond the bad publicity, short selling is extremely risky. Your thesis that a stock has problems could be correct, however if it’s not timed correctly the stock could continue to rise in the near term, presenting the prospect of unlimited losses if you remain short.

Even legendary short seller Steve Eisman of “The Big Short” has had missteps in shorting stocks, from Tesla, where he called it quits due to the stock’s “cult-like following” and also had to reverse his position on Zillow, as the company benefited from the enormous tailwind of real estate interest in 2020, despite ultimately having his thesis proved correct.

In fact, according to Breakout Point data cited in the Wall Street Journal, “between 2017 and 2019, short sellers accused 32 U.S.-listed companies of accounting misdeeds…in the six months following those allegations, 25 of the stocks gained and the rest declined.”

Furthermore, interest in meme stocks such as Gamestop and AMC have villainized the practices of many hedge fund short sellers, who are increasingly at risk of being on the wrong end of a “short squeeze” as stocks with high levels of short interest are driven up by retail investors. This has even driven some short selling firms, such as Citron Research, to stop publishing short ideas entirely.

That is why successful investors who focus on the short side are relatively rare and those with consistent track records of big wins, even more so.

One short seller with a fascinating track record is Carson Block, the head of Muddy Waters Research. By focusing on US-listed shares of Chinese companies, he has made a strong name for himself in uncovering “business fraud and fundamental problems” in these companies, which often have opaque or misleading accounting practices.

Below are three of the most notable short ideas published by Muddy Waters Research in the past few years that turned out to be hugely prescient, even if the outcome took time to materialize. At one time all of these stocks were flying high and now they trade mostly at penny stock levels.

TAL Education Group (TAL)

All-time high price: $90.96
Current price at time of writing: $2.79

TAL Education is a Chinese for profit education provider that specializes in test prep and tutoring. TAL stands for “Tomorrow Advancing Life.”

According to Muddy Waters Research, TAL was also advancing a narrative of fake profits. The research firm published their first report about the company on June 13, 2018. Referencing the popular documentary “The China Hustle,” which exposed up to 400 publicly listed Chinese companies engaged in defrauding US investors, Muddy Waters accused TAL of “fraudulently overstating its profits since at least 2016.”

In a series of subsequent research notes, Muddy Waters went on to accuse TAL of inflating profits by more than 28% from 2016 – 2018.

At the time of the first report, TAL Education was trading near $40 per share. Partly as a result of these accusations the stock would slide to just above $22 per share by the autumn of that year.

TAL would embark on an incredible revival in share price afterwards, however, with the stock rising from the low $20s to peak at more than $90 per share in early 2021. While the stock was able to shake off the accusations from Muddy Waters, it could not do the same against a crackdown by the Chinese government on for profit education providers in the country.

By the summer of 2021, the stock had dropped all the way to $5.00, en route to true penny stock status later in the year. Today the stock trades at just $2.83 per share, with the prospects for its industry in tatters. While Muddy Waters could not have anticipated such a harsh crackdown that would so severely impact the stock, their early detective work hopefully warned off many investors from suffering the full peril of being long TAL Education.

Luckin’ Coffee (LK, LKNCY)

All-time high price: $51.38
Current price at time of writing: $9.40

Even more dramatic than the fraud alleged of TAL Education Group was the case of Luckin’ Coffee, China’s answer to Starbucks. Notably, the research that uncovered the fraud in this case was not authored by Muddy Waters, but was emailed to a number of different short selling firms anonymously. Carson Block did play a huge role in highlighting the situation by publishing the full report on his Twitter account and taking a short position in the stock, the first time he has done so based on third party research.

It was later revealed by The Wall Street Journal that the report originated from Snow Lake Capital, a China-based hedge fund. The research was extremely detailed, involving more than 1,500 individuals across 15% of Luckin’s 4000 stores. After analyzing data ranging from counting customers in stores and customer receipt data, the report’s author concluded that Luckin’ was significantly inflating sales based on observations of activity at the monitored locations.

Unusually for a company accused of significant fraud, the executives at Luckin’ Coffee ultimately admitted a scheme where a group of Luckin’ employees began engineering fake transactions ahead of the company’s May 2019 IPO via bulk purchases from dummy companies.

After the report was published, LK shares dropped briefly before rising again, following a similar pattern for many companies accused of fraud. The company initially denied wrongdoing and was even backed up by major Wall Street names such as Credit Suisse, that defended the company in a report. However, as the fraud became increasingly clear and executives and its auditors began to a admit something was amiss, LK shares would crater from a high of near $50 per share at the start of 2020 to penny stock territory by the summer, when the shares experienced a trading halt and ultimately were delisted.

Investors who were unfortunate to hold the shares through the entire ordeal ultimately were somewhat lucky, as instead of going to zero, the shares were reborn or the OTC market under the stock symbol LKNCY and currently trade for more than $9.00 per share, still a dramatic loss for anyone who bought near the stock’s high or even initial IPO price.

The reality is that most shareholders holding the original LK share class likely had to liquidate their positions at a far lower price as the drop was so sudden and the uncertainty around the stock’s delisting made for too much uncertainty.

Today, Luckin’ Coffee has nowhere near the prospects as it did before the scandal and has a long road ahead of it to redeem itself in the eyes of the investment community.

Gaotu Techedu F.K.A. GSX Techedu (GOTU)

All-time high price: $149.05
Current price: $1.55

While lesser known as a brand than Luckin’ Coffee, the collapse behind GSX Techedu, now known as Gaotu Techedu, is even more stark in terms of shareholder value lost. Investors who have held the stock since IPO currently are looking at an 85% loss, while investors who entered the stock 12 months ago are sitting on a 94% paper loss.

In the wake of its success publicizing the fraud at LK Coffee, Muddy Waters published on GSX Techedu, a company the research firm characterized as a “near total fraud.” Downloading data from the Chinese for profit providers classes, Muddy Waters concluded that “at least ~70% of its users are fake, and we think it’s quite likely that at least ~80% of its users are fake.”

The report would go on to state that a fomer GSX manager corroborated the firm’s analysis of a high-level bot operation used to fake user traffic and concluded with the devastating assessment that “regardless of how one cuts it though, GSX is an almost completely empty box.”

The first report on GSX shows just how dangerous it is to be actively short a stock. GSX shares traded around $30 per share in May 2020 when the report was published. The stock would go on to exploded upwards, closing as high as $114.55 by October. Anyone who initiated a short position based on Muddy Waters initial research would be extremely uncomfortable with their position at that point.

Reflecting on the price moving so far against his call, Block told Bloomberg TV: “We got squeezed way up by what was really a consortium of funds who I think engineered this. The game’s been different since Covid. We adapted last year and I think we’ll adapt going forward.”

While the stock made new highs and some questioned Block’s wisdom of continuing shorting the stock, nobody is questioning him now. Similarly to TAL Education, GSX was caught up in the Chinese government crackdown on for profit education and tutoring providers in early 2021. Combined with the continual allegations of fraudulent business practices, the stock sunk from more than $86 in March 2021, to trading in the mid-20s less than a month later. Today, it’s a penny stock, trading well under $2.00 per share.

The entire episode shows both the difficulties and potential rewards of short selling for those who have the financial resources and rock solid convictions of their research. It also shows why trying to ride on the coattails of major investors can be so difficult. Anyone who initially bought puts or sold GSX shares short off the back of Muddy Waters report likely lost money and would have had to have conviction to keep at it to see any potential profits.

Above you have three of the most dramatically successful short plays in recent history for Carson Block. While the stocks didn’t all drop due to his research alone, he succeeded in identifying three companies with major problems that hopefully investors steered clear of before the worst came to pass.