Over the weekend, I got the chance to watch “The China Hustle”, a financial documentary by Jed Rothstein. The documentary explores the sinister nature of Chinese companies reverse takeover into US stock exchanges.

The “Hustle” part of the title refers to the fraudulent nature of many of the listings. It explored patterns of faked numbers, technologies and facilities. The documentary shows the journey of sceptical short sellers to uncovering the misconduct and profit from them.

One of the largest scandal of this type was the Sino-Forest case. The fact that it wasn’t even covered in the documentary shows how many examples the film-makers could have picked from. In that particular case, the company inflated asset and revenue that resulted in “fraud, breach of fiduciary duty, and negligence.” The Canadian court recently awarded a C$2.6 billion damages against the CEO. Not small money. These Chinese reverse takeovers are not exclusive to North American stock exchanges and can even be found in the ASX.

It is a worthwhile watch for the everyday investor. It certainly adds another dimension for the investor toolkit in the recent spate of alleged misconduct by Australian companies.

Again and again, these situations show the potential benefits of allowing short sellers in the market. Contrary to their criticism, it showed that high profile short sellers can bring accountability to misbehaving companies.

The effectiveness of the short sellers has led me to believe that we (as a predominantly long-only investor) can learn some valuable lessons:

• Be sceptical of company’s claims. Especially for a company that is new to you where you have not developed the “feel” for what kind of announcements they usually provide. Are they overly optimistic, brushes over negative events or more fact-based? How do they provide guidance?
• Don’t overly rely on “signalling.” Big 4 audit names cannot help a management that is intent on covering things up. At the same time, pay attention to the old adage that seemingly random changes to status quo is a red flag.
• Research the way great shorters research. The great short sellers do plenty of ground work and original roll-up your sleeves, primary research. Companies usually have a network of firms that is incentivised to keep up the façade, so most of the time their reports are biased.
• Really try to break your own investment thesis. Elicit other trusted advisers to try to break it. Even Warren Buffett needed Charlie Munger. Be wary of red flags. If your thesis remains intact, then it is probably a good investment idea.
• If you plan to disseminate your investment ideas, have simple and logical thesis. They will be the most compelling. One of the key tools of a short seller is the “report” that shows how xyz is worth $0. They are simple and offers compelling graphics of their evidence.
• If after doing more and more work you are convinced that a fraud is present, then think hard about possibly taking the short side of the trade. The short sellers mindset is different than the long. John Hempton talked about the importance of portfolio sizing and having small positions in the event that the short doesn’t work out. Short selling’s payoff is considerably different to going long. Your maximum payoff is 100% while your losses is potentially unlimited.