Muddy Waters Could Be a Victim of Its Success

 | Oct 01, 2012 | 10:30 AM EDT
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Over the past few months, the biggest target of the China-specialist short-seller Muddy Waters Research has been New Oriental Education (EDU). In July, when Carson Block's company accused New Oriental of fraudulently selling franchises to pump up revenue, the stock dropped from $22 to under $10 in one day. Its 52-week high is close to $31.

After Muddy Waters' attack on Canadian-listed Sino-Forest in June 2011, which led to that company's delisting, the short-seller had been riding high. In some ways, its reputation was just as powerful in its niche of Chinese companies as David Einhorn's is today.

Yet one challenge that Muddy Waters has faced since its sudden rise to prominence over the last couple of years is that the small, reverse-merger Chinese companies have all but disappeared from the landscape. They have either been delisted or have dropped so much in price that it's impractical to short them now.

So Muddy Waters has had to make a choice: start shorting non-Chinese companies or move up the food chain in China and start going after larger companies. It has chosen to do the latter.

First, last year, it went after Focus Media (FMCN), and then New Oriental this summer. Focus had been at $25 last November, just before the Muddy Waters report came out, and then it dropped below $10. It's now back to $23, and Focus is now trying to take itself private.

Both New Oriental and Focus Media have strongly denied the charges that Muddy Waters leveled against them. For the most part, you can say the market is really looking past the allegations now.

Earlier on Monday, New Oriental announced that an independent committee of its board concluded that nothing improper had happened at the company relating to Muddy Waters' allegations. That said, New Oriental also announced that it would delay filing its 20F annual report, which will contain full financial details of the company for the last year, signed off by its auditor.

The market doesn't seem to mind the delay. New Oriental's stock is up 3% as of Monday morning on the news.

Interestingly, as soon as the news of the independent committee's news came out on Monday, Muddy Waters tweeted that it wasn't surprised by the results and said that many investors had asked it what it thinks of Baidu (BIDU). Muddy Waters then said that it would be quite possible that Baidu could be fabricating its numbers if it wanted to but provided no evidence that Baidu was doing so, except for noting that Baidu co-founder Robin Li serves on New Oriental's board of directors.

When the markets opened on Monday, Baidu's stock was down more than 2% on an otherwise up market day, suggesting that the Muddy Waters tweet was causing concern.

Muddy Waters is in a difficult place now. It's obviously much more difficult to accuse a larger company of fraud than to accuse a small one. The situation is made more difficult because Carson Block refuses to go back to China to conduct due diligence because of safety concerns.

And now there's going to be trouble finding suitable targets as Block is forced to go after larger and larger companies.

For Muddy Waters to maintain its reputation, it must score another Sino-Forest hit soon. Otherwise, it will be increasingly difficult for its reports to cause a stir.

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