John Paulson – Sino Forest and a $500 Million Loss

John Paulson, currently the richest hedge fund manager has a paper loss of $500 million on his investment in Sino Forest Corporation, ticker symbol TRE.TO

According to securities filings as of the end of april, Paulson owned around 35 million shares of Sino Forest, a Chinese forestry plantation company listed on the Toronto Stock Exchange.

The stock was trading at around $19 just a few days ago.  That means Paulson’s stake of 35 million shares was worth around $665 million dollars.  After allegations of questionable accounting by Muddy Waters research, the stock dropped and closed at $5.29 on Friday.  That means Paulson’s stake of 35 million shares were worth just $175 million dollars.  Almost a $500 million dollar loss.  Now I do not know if Paulson cut his stake before the collapse or whether he reduced his exposure on the way down, but that is a huge paper loss for him.  Not to mention that if Paulson decides to dump a few million shares on the market the price will probably get pushed far lower, exacerbating the losses.  Sino-Forest Shares Take a Tumble WSJ

Now let us go into an order flow and liquidity analysis of the situation.

The market was slightly more sensitive to Chinese fraud stories over the past few weeks as china stock fraud stories were making the rounds.  Thus the sensitivity level of the market to such stories was higher than usual.

The market must of believed that the Muddy Waters report was at least semi credible, if not highly credible, because the stock dropped substantially.  When stockholders hear of such questionable accounting with chinese companies, there knee jerk reaction is to sell first, ask questions later.  That creates massive, aggressive bearish order flow.  There are some investors in the stock that are willing to tough it and determine whether the allegations are accurate.  However the vast majority will try to bail out, and ask those questions later.  It is basic human emotion to try to cut your losses in such a situation where there is a high level of uncertainty.

Therefore you have those investors that are selling the stock, then you have the short sellers that are jumping on the bandwagon.  There can the fundamental shorts like Muddy Waters piling into short positions.  That is more bearish order flow.  Then you get some momentum traders that see the stock dropping and try to get in on the action and start shorting as well citing technical and momentum reasons.  That is even more selling pressure.

Now against all this selling pressure who is left to buy?  Who is going to be on the bid?  The answer is not many people.  There are two kinda of people that would be on the bid.   There are the people who believe the Muddy Waters report was bogus, thus they still believed Sino Forest was clean and honest and thus for those investors this drop provided a buying opportunity to buy on a dip, as they believed the fundamental value has not changed and are willing to hold through temporary volatility.  These investors are hoping for bullish order flow and a snap back up in the stock to happen as people eventually realize the report is bogus.  At least that is what they are banking on.

Then the other group of market participants providing the bids are the short sellers who are covering their positions at a profit.  They are placing bids in to take profits on their short positions.  That group exists as well.  Some short sellers may have had enormous profit on the positions are decided to take some profit by placing some bids in the market.  They provided some bullish order flow.

Now, going forward what could potentially generate more order flow to move the price?  That will depend on a few factors:

1.  How much panic selling is still left to occur.  There may have been many people burned by the drop, that even if the questionable accounting turns out not to be true, those investors just want to cut their exposure to the company because they are still afraid.

2.  Whether the company can provide sufficient evidence as perceived by the market to refute the allegations made my Muddy Waters.  If they can assuage the concerns of the market, then the stock may bounce back.

3.  If further questionable accounting practices surface that further reinforce the view that the company is a fraud, then the stock may fall further.

There are many investors in the stock that face a tough decision.  They need to determine whether or not to cut their losses and sell whatever they can now to take whatever money is left.  They need to make the determination if the company is a real fraud, because if it is, then the stock can drop a few more dollars further exacerbating the losses.

Therefore, people like John Paulson need to make a decision.  Does he sell now and still get around $175 million for the shares he has left?  Or does he wait for the stock to bounce up?  Because if the stock drops further down to $2 or so, that is a heck of a lot more money to lose.  If the stock drops to $2 that means his 35 million shares are worth just $70 million dollars.  Getting $175 million dollars is far better than just getting $70 million.  But then again, if the stock can bounce back up then his shares can recover.  So many questions.

Order flow and liquidity can be very interesting and a lot of fun.

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