Sino-Forest or sigh-no-forest?

Considered strictly as entertainment, however, an analyst’s report into the company’s activities is remarkable

Timber company Sino-Forest is locked in a fascinating battle for survival against Carson Block, a stock analyst with a mixed record of publicity attacks on Chinese-based enterprises. With professional analysts reluctant to say what they make of Block’s “strong sell” report on Sino-Forest, I’m in no position to endorse it as a piece of financial advice or investigative journalism. Considered strictly as entertainment, however, the report is remarkable.

Block has documented that Sino-Forest operates with extraordinary opacity for a company whose holdings are surely very widely distributed—particularly, one assumes, within Canada. Sino-Forest claims to be doing hundreds of millions of dollars’ worth of sales through mostly unidentified “authorized intermediaries” in China—traders who are apparently happy to let the company buy title to trees, hold them as they appreciate, take on the bulk of the costs and risks in the meantime, and then snap up revenues when the trees are eventually converted into wood products. Block, having poked around a bit in the literal Chinese backwoods, questions whether much if any of the reported underlying activity is happening.

Defenders of the company compare the business model to “property-flipping” in the real estate markets, and its CEO has emphasized that Sino-Forest is not at all like a typical Western forest company that sees trees right through to the part where they’re giant stacks of two-by-fours. I suppose the question I would have as an investor might be “Is ‘tree-flipping’ a game I want to be in, even if Block’s accusations are false?” Testing the veracity of those accusations is a process that the company acknowledges will take some time and legal/technical trouble, even as journalists cover the same ground as Block and find discrepancies and mysteries of their own. Globe and Mail reporters tried to confirm some of Sino-Forest’s timber ownership claims with a provincial forest ministry, and when they received essentially a series of dazed blinks and shrugs, the company proffered this defence:

As a matter of course, when we purchase trees only, we obtain a confirmation of our ownership from the local county or city Forestry Bureau for the local area in which we purchase, not the provincial Forestry Bureau. Sino-Forest’s ownership of its forestry assets in the Yunnan province is voluntarily documented in each case by the local or city Forestry Bureaus, not at the provincial Forestry Bureau level. As a result, officials at the provincial Yunnan Forestry Bureau would not have an official record about Sino-Forest’s local forestry assets.

Again: this defence may be 100% accurate. But if you’re a Sino-Forest investor, how happy are you to hear that a simple double-check on the existence of an asset is so difficult? If I own shares in the Ford Motor Co., I can always go down to the lot on an off day and kick tires on some of the new models—make sure the “Ford” badge is still turning up on the trunk and whatnot. When I read that paragraph in the Globe piece, I want to run from Chinese investments like my hair is on fire. (Admittedly, I do come from a long line of dismal literalists. When I bought real estate for the first time last month I was a little disappointed not to receive some kind of enormous lambskin scroll like you’d see in a cartoon, with “DEED” written across the top in blackletter.)

Sino-Forest is refusing, despite intense pressure, to make a full disclosure of the identities of the “authorized intermediaries” who are making its money. The company claims that to do so would put it at a competitive disadvantage, which makes one wonder why its business model ought to depend so heavily on sheer obscurity. One possible answer is that Sino-Forest’s real, fundamental business is some sort of cryptic regulatory arbitrage; that seems like a game potentially worth playing with paper assets in places that have a strong rule of law, but it is surely a dangerous one in a nominally Communist country, where a nationalization could be arranged in the space of an afternoon. (Or where some regional Party functionary could simply be bribed to “lose” crucial paperwork.)

One also wonders why Sino-Forest is refusing to announce, or apparently even to contemplate, a buyback of its clobbered shares. The Financial Post’s David Pett pointed out last week how weird this is, especially considering the large cash hoard the company claims to be sitting on. “Sino-Forest said its counsel informed it that it is ‘precluded from purchasing stock in the current circumstances,’ but did not elaborate,” wrote Pett. “Since the company has claimed there is nothing of substance to the Muddy Waters report, it is unclear why it would be ‘precluded’ from such an act.”

Perhaps the most amusing part of this whole tale is watching the oddball behaviour of the analysts. Richard Kelertas of Dundee Capital Markets called Block’s report “a pile of crap” a week ago; he then converted quite suddenly to agnosticism and withdrew coverage of the stock yesterday. Fellow defender Paul Quinn of RBC Capital Markets is standing by his “outperform” rating on Sino-Forest, but has revised his price target downward to $14/share, offering this tidbit of practical epistemology:

Either a material difference in ownership, financial results, and legality of the company’s legal structure exists, with a loss in equity value, or it does not, and the company’s equity value increases measurably. While we remain objective to either possibility, further clarity is required to reach a definitive outcome.

If that is the case, one wonders, then why is Quinn pricing the stock at all? An analyst’s target is, by implication, a pretty “definitive” guide to an investor’s proposed action; there’s no third choice beyond “own this stock” and “don’t”.

Of course, Quinn is hinting at an important mathematical difference between kinds of “assets that are in some sense worth $14”. There’s the kind that might be worth $15 and might be worth $13, with about equal chances on either side. And then there’s the kind that has a 10% chance of being worth $140 and a 90% chance of being garbage. If you happen to have infinite cash to invest, you will be genuinely indifferent to this distinction. For the rest of us, that sort of thing matters.