Fraud alleged at Sino-Forest Corporation

A specialty research firm, Muddy Waters Research, released a report alleging that Sino-Forest Corporation (TSX: TRE) is essentially a huge fraudulent operation, backed up by quite a comprehensive research report. TRE was slaughtered in yesterday’s trading, down nearly 20% before it was halted for the day.

If the fraud allegations turn out to be true, this will be the biggest fraud story on the TSX since Bre-X. Sino-Forest had a market capitalization of about 6 billion dollars just two short months ago. In an eerie parallel, Bre-X collapsed after reaching a market cap of approximately $6 billion.

My own investment policy on China is simple – don’t. I am sure there are fortunes to be made investing in legitimate Chinese companies that actually have shareholder-friendly management (this is a contradiction in itself) that have been tarred-and-feathered by all of the rampant fraud that is coming out of China today. Such companies might be possible to find when you are across the wrong side of the Pacific Ocean, but how can you ever know without even knowing the local language?

Stock screening methodologies and a market omen

Whenever I do equity research, I perform a stock screen for certain metrics, and then I give a superficial scan of the stocks that get spat out of the screener. It takes about a couple minutes per equity for me to determine whether it is worth my time to look further into the company or not – typically I throw out 90-95% of the companies in this process. For the remainder, I queue them up to look more thoroughly using a fairly standard methodology (a basic guide), and then if I continue to like what I see, I do some more depth on the industry in question and competitors, and other research.

Most of the time, when I do this extensive research, the equity is over my accumulation price target. More times than not you can rationalize why the market is giving the company the value it is currently trading at, so I end up setting a price alert if the stock goes under a certain price. An email gets sent to my inbox when this occurs. I then “set it and forget it”, and usually do not keep the stocks on my watch list until the price target is hit.

Once the stock hits the threshold price, I then re-evaluate the position to see if anything has fundamentally changed in my original analysis to justify the drop. The point of this process is to make sure that the news the market is pricing in is not fundamentally damaging to the business. Once this is done, then I can set some buy limit orders and then accumulate.

The whole point of this post is that there are typically dry spells when nothing reaches the price target. Then there are times where everything you set a limit for has the price target alert hit your inbox. Today was notable in that a couple stocks are now below my alert price – perhaps an omen?

Bank of Canada keeping rates steady

The Bank of Canada has kept the target overnight interest rate steady at 1%. This surprised nearly nobody. Their statement is relatively unchanged from the prior one.

The chart to keep looking at is not the BAX futures, but rather the 10-year benchmark government bond yield:

With the yield spread from short-term rates to the 10-year at about 205 basis points, the bank is unlikely to lift rates anytime soon.

BAX futures are as follows:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 JN 98.695 98.705 98.695 0.005 12727
+ 11 JL 0.000 0.000 98.630 0.000 0
+ 11 AU 0.000 0.000 98.615 0.000 0
+ 11 SE 98.630 98.640 98.630 0.000 31347
+ 11 DE 98.500 98.510 98.480 0.020 37387
+ 12 MR 98.350 98.360 98.310 0.040 24564
+ 12 JN 98.200 98.210 98.140 0.060 13081
+ 12 SE 98.040 98.050 97.970 0.070 3855
+ 12 DE 97.870 97.890 97.790 0.090 809

The market has priced in a rate hike by year’s end, but I do not think this projection will come to fruition – come December, the 98.5 price will be likely around 98.7 – a thin value bet could be placed here.

Playing the risk aversion card

I have deployed a good chunk of the idle cash balances (presently earning 2%) into slightly higher-yielding debentures which should mature within a 1-year time frame with little risk – the underlying companies have cash and/or liquidity to pay off the debt without too much difficulty and could withstand a 2008-style financial crisis. The transaction can also presumably be reversed without too much difficulty in case if I need to deploy the capital into a more efficient area.

Researching the public markets is like trying to find those proverbial needles in the haystack – each hour you pour into the haystack increases your chances of finding needles, but in no way are you ever guaranteed to finding them. Also, the way you sort through the hay might be more or less efficient than other haystack sorters, but your own output is proportional to the amount of time you put into the effort.

The markets also give you some hints on how many needles are in the haystack – right now everything appears to be “stable” and there are no world crises occurring of any significance, hence, the broader markets are likely to be closer to efficient pricing than when things were really rocking a couple years ago. I would suspect the number of needles (at least the ones made out of platinum) to be found are few. There are likely to be more silver needles and a lot of lead!

I have not had a lot of time over the past few weeks to efficiently sort through hay, hence, I have been a bit inactive and parking my portfolio into a very risk-averse position. The easiest way to lose capital is to force trades through without some sort of justification why you are getting sale prices on what you are buying. Companies like Hewlett Packard (NYSE: HPQ) appear to be on sale, but I typically shy away from companies with such huge capitalizations, but you never know what you might get.

Here we go again – Market volatility

The main US indicies are down under the reports that more European countries are facing debt downgrades – Italy today is the prevalent one.

However, since I think it is safe to say the whole world knew that other European countries other than Greece are going to face similar meltdowns in their finances, investors should be aware that there are other possibilities – such as a slowdown in demand.

Such a slowdown in demand will not be in favour of commodity markets, but will be in favour of anything defensive – consumer staples, utilities and bonds. The insurance sector should also look good, but these companies are difficult to research.

It is also very difficult to make money in these sorts of marketplaces (at least long-only) since indexers will be selling their equity and thus it becomes a game of timing when the supply stops – this could be months down the road. It is a good time to prime that research list and take advantage if we are going to be seeing a significant drop in equity prices.