Famed short seller John Hempton, CIO of Bronte Capital, recently did an interview with Global Capital in which he discussed how and where to find fraudulent companies, short selling during the pandemic, and what makes shorting frauds fundamentally very dangerous. Here’s an excerpt from the interview:
Q. You short a lot of companies that you believe are either fraudulent or close to that. And yet, you rarely make your shorts public. Don’t you need someone like a short seller to reveal a fraud?
Hempton: I’m not averse to exposing them myself, but it’s fraught with risks. There are certain jurisdictions you struggle to do it in. The UK is hard as your defamation laws are insane — I know talking to UK journalists about UK defamation law is like teaching grandmas to suck eggs. But it makes it very hard to go public.
In Australia, you can’t defame a corporation with more than 10 employees but you can defame the executive. And, if a particular executive is heavily associated with that corporation, you can be got for defamation through that.
And that’s a problem. Most of these fraudulent companies have some guiding power; the person who makes it all work and who everyone believes in.
Australia has a bad combination of a historically weak financial regulator, a large amount of dumb money, and very strong defamation laws. If you put those three together it will be no surprise if we find A$30bn, A$40bn or A$50bn lifted by various frauds along the way. I know one or two of them but I can’t tell you because they’ll sue me for defamation.
But there’s another problem, which makes shorting frauds fundamentally very dangerous. As I say, don’t do this at home.
The iconic example is a fake gold mine. As Mark Twain reportedly said, a gold mine is a hole in the ground with a liar on top. Gold mining frauds are as old as the hills.
Imagine I have two gold mines.
Both have a small capitalisation of around $250m and are thought to have roughly 1m ounces of gold in the ground, both with a plan to extract between 2024 to 2037.
In one mine, the gold is really there and is run by a guy who spent his entire life developing this gold field he found. His politics may be to the right of Gengis Khan — think of him driving around in a pick-up truck with a dog and a shotgun — but he’s triangular shaped and hard working. If he wanted to marry your daughter you wouldn’t be unhappy about it.
The other one is run by a crook and if he wanted to marry your daughter, you’d want to grab a baseball bat. But he’s slick and a good salesman and manages to convince the market there’s a good amount of gold in there.
There’s a few ways you can work out he’s a fraud.
The most extreme way to find out is quite simple. If there’s gold in that hill there’s gold in the creek below the hill, as it’s been eroding for a very long time. If you hire a professional planner, and you find no gold in the creek, there is no gold in that hill. You should be bet-your-life certain.
So, being an idiotic little hedge fund manager you put 5% of your fund short this stock, figuring out it’ll go to zero and you can make 5%.
Now, that will happen eight times out of 10. But one day this crook will say: “Hey, we actually have 10m ounces here,” and there’s always a journalist that likes to write a hypey story, and if the market believes it, the stock is going up 10-fold.
Your 5% is now a 50% short position and your capital has gone from 100 to 55. So your 50% short position is really 50 on 55 which is 95% short. Now your good friends at [the bank] are putting you out of business on a single stock in which you’re right!
The answer is, you cannot afford to be 5% short a fraud for long — not more than a day or two. The reason why is that frauds are completely disconnected to reality.
So there are two ways to skin this cat. One way is to do what we do, and just put a slim 0.1% on. The other way is to put 5% on and either be Carson Block or hire Carson Block. Go loud and [for] long and hope you knock 30% or 40% off the share value.
I’ve never known Carson to criticise a company in which he’s wrong. His arguments have always been pretty good but the loud strategy still only makes sense if you’re prepared to be 5% short a fraud.
You can read the entire interview here – John Hempton Interview – Global Capital.
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