Fraud in Focus

1. Sick of binary

I’ve always found it irritating how much those in finance love to label situations binary.

Example: ‘the Eurozone crisis is a binary situation, either the whole thing blows up, or markets will rocket’.

Er, how about it just muddles through and the world doesn’t end. Really that unlikely? (I ranted about this previously with ‘Chill Out on the Zone’.)

There are, however, some situations that are binary, and there is easy money to be made.

2. A willing buyer for a Chinese scam

Here is the company in question: Focus Media

It sells advertising space in China.

Recently Carlyle, a private equity group, put in a bid to buy the company at $27. While the bid could be raised (unlikely for reasons given below) the best case scenario for the stock is that the deal goes through and shareholders get $27.

It would be the biggest private equity deal ever done in the Middle Kingdom, and the deal junkies of Carlyle would surely love this tombstone next to the rest of their lives work on their desk.

Importantly, now that they have made a bid they have the right that the mums and dads of the stock market don’t have: They can go in do the proper due diligence. They will probably not like what they find.

See below if you want more detail on takeovers.

3. Why it’s almost definitely a fraud

John Hempton of Bronte Capital has a record of exposing frauds by fairly clever but completely reasonable methods (UK and otherwise international readers: Bronte is a sweet little beach around the corner from where I live – great park for bbqs, decent surf, but on all counts not quite as good as Tamarama) . Once a red flag comes up, for example, when a Chinese company claims to be vastly more profitable than its Western counterparts, he gets his hands dirty figuring out fairly ingenious but replicable ways of finding them out – like calling their suppliers and customers to see if they actually exist.

It’s the sort of strategy that lends itself to publicity – once he has a position, the more people who buy or sell the stock the faster it will be pushed where he wants to go – a far cry from the sneaky secretive hedge fund dudes in fixed income.

In this Focus Media’s case there are a number of red flags, chief being:

  1. Focus Media bought suspicious shell companies for significant amounts, then gave them back to the owners for nothing – an excellent way to explain to auditors why a very profitable company has no cash
  2. The business of Focus Media is vastly more profitable than its Western counterparts, and the numbers it provides for its business doesn’t make sense
  3. The company lied a number of times, and has even admitted its more egregious counts, e.g. how it reported posters as digital screens
  4. Other players in the industry don’t list Focus Media amongst their competitors

Jumping on the bandwagon (not sure which was first) is Muddy Waters, a research and investment firm that really kicked the whole Chinese fraud thing off last year with its expose of SinoForest, when it turned out there were no forests.

Anyway if you want the detail read Bronte Capital’s blog.

The main thing I care about is the price is $23, if the private equity firm completes its due diligence (and in doing so, fails its own due diligence test), the stock is going to $27. If it’s a fraud then it will drop dramatically, below $7. Definitely binary, definitely money to be made.

4. A perfect situation for options

This truly binary outcome throws up more ways to play it than you can count.

In this case, you could buy the stock and put options in much greater size.

Another way would be to load up on options both sides.. buy October $25 calls for $0.20. If the deal goes through you make 10x your money that day – more than enough to account for whatever you spend on puts.

5. My Take

There are some cheeky reasons to suggest this deal won’t going through.

Stocks have a habit of playing their hand: too many people know if a deal is likely to go through or not. Before takeover announcements stocks drift up, and before they fall through often they start drifting down. This is the case in the highly regulated West – in China the cheats are far more flagrant, and the recent steep falls in $FMCN suggest the Chinese have tipped their hand.

This whole trade, by the way, doesn’t rely on any properietary financial analysis. The fact that some people have good reasons think it’s a fraud, and others are willing to pay precisely $27 to take the company over, is enough. We can leave the forensic accounting to John Hempton.

6. A demonstration of retardedness in the option market

As a final possible trade, the nature of options means that over long time periods the pricing simply becomes ludicrous.

There are two effects: as you go forward in time the fair value of options increases rapidly for a given implied volatility, while the implied volatility itself also tends to increase (i.e. upwards sloping vol curve). The net effect is that long dated options are very richly priced (expensive).

Just looking at live market prices now, Jan 15 calls struck at $27 are selling for $1.50. Since the best case scenario  is that the stock goes to $27 and is taken off the market, this is pretty damn close to free money. If any economist amongst you wants to try and twist this in to efficient markets you have, as usual, completely missed the plot.

Tempted to put on a trade?


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