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Warren Buffett’s Mosquito
Marc Cohodes, the short-selling chicken farmer who is facing off against the world’s greatest investor.
Marc Cohodes was out with his wife and friends at a Bay Area Vietnamese restaurant, the Slanted Door, when he got a text message. Berkshire Hathaway was buying a stake of at least 19.99 percent in Home Capital Group for C$153.2 million — a steep discount to where shares were trading — and furnishing it with a new C$2 billion credit line.
Cohodes had been shorting shares of the troubled Toronto subprime lender for years. The news this past June came as a shock. “I think the spring roll came out of my ear,” he says. “What would [Berkshire Hathaway CEO] Warren Buffett want with this thing?”
“This thing,” as Cohodes calls it, had a troubled history. Home Capital’s founder and erstwhile chief executive, Gerald Soloway, had misled investors beginning in May 2015, blaming bad weather and the economy for declining loan originations. The Ontario Securities Commission demanded the company issue a statement admitting that the real reason for the drop was that it had sacked dozens of brokers for falsifying loan documents. Even after that, Home Capital was forced to issue a second release with more detail. It also disclosed that the fraud was twice as large as initially reported.
The list went on. Among other things, Cohodes had also uncovered that Soloway had years earlier admitted to a securities law violation.
By this June, however, Soloway was gone, and on news of the Berkshire Hathaway deal, giddy investors immediately bid up Home Capital stock 27 percent — unpleasant news for anyone shorting the company.
Cohodes is nonplussed by Buffett’s bold move. “He did no due diligence,” he says. “I think this thing is sick. I think it’s toxic. I think the equity at Home [Capital] is worthless.” (Buffett was unavailable for comment, according to his assistant, Debbie Bosanek. Home Capital declined to comment.)
Cohodes is now in a battle royale, one that pits him against the world’s greatest asset allocator. The Chicago native points out that he has gone up against marquee names in the past, as in the late 1990s, when he successfully shorted Lernout & Hauspie Speech Products, a maker of malfunctioning speech recognition software, whose largest shareholder was Microsoft Corp.
“I’m not trying to pick a fight with the Oracle of Omaha,” he says. “But of all the investments Warren Buffett has made over the years, this one is the bottom of the barrel.”
Despite the swagger, that Cohodes is in the short-selling game at all today is surprising. During the 2008–’09 financial crisis, as other short-sellers were minting fortunes, Goldman Sachs forced Cohodes to shut down his $2 billion-plus fund, Copper River Management. His former partner over more than 20 years, famed short-seller David Rocker, had stopped talking to him. And his marriage fell apart. Cohodes moped around the chicken coops and horse stables at his 20-acre ranch, Alder Lane Farms, in Sonoma County.
“I’ll never be in the business again,” he told a reporter a few years after the crisis. “Underline ‘never.’”
Today, Cohodes is back. He has lost weight and remarried. He manages his own money from an office inside his house that overlooks the Santa Rosa Mountains. He has no firm or research team backing him, but works with a partner, Luke Chellis, who has a master’s in finance from MIT and is, Cohodes says, “a smart motherfucker.”
Going solo, Cohodes insists, suits him fine. “I’m much more effective,” he says. “It’s sort of the David and Goliath thing.”
Without outside investors to babysit, Cohodes can focus on his passion — sniffing out accounting fakery and dubious business practices. “I think he has one of the best noses for fraud I’ve met,” says Brian Horey of Aurelian Partners. “He’s kind of relentless in pursuit of information and the heart of the matter.”
Yet after a near-decadelong bull market in stocks, Cohodes’s chosen métier is in full-fledged retreat.
The number of hedge funds focused on short-selling has dropped to just 16 in the second quarter of 2017, from 54 in 2008, according to Hedge Fund Research. Over that time assets under management at such funds have shrunk to $4.19 billion from $7.77 billion. Fund returns, on average, have been negative in six of the past eight years.
Short-sellers like Cohodes are purgatives for bloated markets. “It’s absolutely necessary for efficient markets and price discovery,” says Suraj Srinivasan, a professor at Harvard Business School, who co-authored two case histories of Cohodes’s short-selling campaigns. “Imagine if in the run-up to the financial crisis there were more short-sellers — and if people paid more attention to the short-sellers.”
But Cohodes, 57, belongs to a generation of short-sellers that, if not past its prime, is aging. In addition to his 25-year old partner Chellis, Cohodes mentors others in the craft of short-selling, emphasizing skills that have helped him — pattern recognition, persistence, and a relentless work ethic.
Among his disciples is Christopher Crum, 34, of $35 million Aylstone Capital Management in Dallas. “You figure out the scenarios where things can go wrong, and you wait,” he says. “When it starts to unravel, you swing and you swing hard.”
In the Home Capital campaign, Cohodes noticed that directors were earning fees attending ad hoc meetings mentioned in government filings. The meetings, it turns out, were to address the fraud. “He’s kind of shown me that there is information out there in the public domain,” Crum says. “Keep digging, and you’ll be surprised.”
Growing up in Chicago’s Near North Side, Marc Cohodes didn’t benefit from that kind of mentoring. He was the oldest child of Donald and Meryl Lyn Cohodes, who divorced when he was a child. The younger Cohodes spent little time with his father.
Cohodes attended the Latin School of Chicago, which emphasized the classics. A tenth-grade economics class got him interested in the financial markets.
From there it was off to Babson College in Massachusetts. With its business curriculum, the school turned out many entrepreneurs. A favorite course of Cohodes’s was policy formation, which looked at business case histories.
Cohodes worked part-time for a Merrill Lynch broker and learned the underbelly of the financial markets — how, for example, accounts were churned to generate commissions at the customer’s expense.
After graduating in 1982, he headed back to Chicago, landing a job as an investment officer at Northern Trust, where he was taken under the wing of food and beverage analyst Paul Landini.
With the Dow Jones Industrial Average mired in a bear market, Cohodes, always contrarian, turned bullish. He bought “a shitpot” of shares of Archer Daniels Midland, which soared more than 500 percent over ten years. He and Landini teamed up to call executives after the markets closed to pump them for information about their own companies, or those of their rivals or suppliers.
But Cohodes wanted to manage money. He landed a breakfast interview in New York with David Rocker, an alumnus of famed hedge fund Steinhardt, Fine, Berkowitz & Co., who was looking to hire talent for his new venture, Rocker Partners. The two hit it off.
An eclectic group, Rocker Partners staff worked out of offices in New Jersey, New York City, and Boston. When his son was born with cerebral palsy, Cohodes decided the best treatment was with a specialist in the San Francisco Bay Area. Rocker Partners soon opened an office in Marin County.
Rocker Partners and its successor earned serious profits in most years, shorting companies like Lernout & Hauspie and NovaStar Financial. After David Rocker retired in 2006, Cohodes took charge and rechristened the firm Copper River.
Copper River’s demise played out in the fall of 2008, when stocks were plunging and the company should have been minting profits. Against all logic, in September the stocks that Copper River was shorting began to rise — Joseph A. Bank Clothiers up 53 percent, Tempur-Pedic International up 51 percent, and OpenText up 31 percent.
Cohodes believes that Copper River’s prime brokerage firm, Goldman Sachs, initiated short squeezes against it. He says Goldman never borrowed stocks on Copper River’s behalf despite telling him it had, saving its own costs while charging Copper River for the bogus loans. By killing off Copper River, Goldman Sachs would not have had to make good on the short positions the fund believed it held. Cohodes closed the fund with a 53.8 percent loss for the year.
Goldman Sachs has denied Cohodes’s allegations. In January 2016 the investment bank agreed to pay $15 million to settle Securities and Exchange Commission charges that its securities lending practices violated federal regulations. Specifically, the SEC said Goldman Sachs told clients it had found stock for them to borrow when in fact it had not done so. Goldman declined to comment on the settlement.
“What defines someone in this business is how you deal with adversity,” Cohodes says. “If the Goldman stuff didn’t kill me, nothing will.”
With his penchant for khaki shorts and flip-flops, Cohodes cuts an unlikely buccaneering figure. He is 6-foot-2 and weighs 210 pounds, and shaves only when he feels like it.
Although Cohodes describes himself as a chicken farmer, he’s a savvy media operator. His Twitter account boasts more than 16,000 followers. He sets up websites for target companies to bolster his bearish views and to attract former employees of his target companies and others, who often pass on tips.
But it was a plain old hunch about a possible housing bubble that got Cohodes interested in Canadian stocks three years ago.
Today he remains engaged with two Canadian companies aside from Home Capital — an air service operation called Exchange Income Corp. and Badger Daylighting, a hydrovacking company.
“I have great respect for the Canadian people,” Cohodes says. However, he notes that complacent government oversight fosters an environment that is “extraordinarily fertile” for skullduggery, citing what he calls a national penchant for steering clear of controversy. “It’s common practice to not call it out,” he says.
That leaves openings for fraud. Cohodes calls Calgary-based Badger the best candidate for short-selling in North America. He got interested when he realized a big Home Capital shareholder had invested in Badger too.
Badger is in the hydrovacking business, making and operating truck-mounted systems to facilitate digging around pipelines and cables by injecting water into the ground and then vacuuming up the liquefied soil. It then disposes of the often toxic soil at government-approved sites in Canada and the U.S.
It’s a rough trade. Tumbling oil and gas prices have cut hydrovac demand, even as Badger has helped saturate the market with franchisees.
Cohodes describes unannounced trips he made to Badger locations, where he often found empty lots with a cell phone number on a sign. In other cases, at peak business hours, half of the trucks or more at a location would be idle.
Cohodes began shorting the stock in the spring of 2017, when it was trading in the mid-C$30s. It closed recently at C$26.64.
Cohodes noticed high C-suite turnover. Departing Badger executives since May 2014 have included a chairman, a CEO, and a CFO. Ernst & Young stepped down as auditor in April 2015.
Cohodes is deeply skeptical of the executives’ replacements. In his first analyst call, for the second quarter of 2016, newly named CEO Paul Vanderberg said, “I know very little about hydrovac.” CFO Jerry Schiefelbein joined in June 2014 from the top finance position at Ivanhoe Energy, which filed for bankruptcy just a year later. In the first-quarter 2017 earnings call, Schiefelbein appeared to contradict Badger’s own government filing for the same quarter, saying the cost of building trucks had risen.
Cohodes raises an eyebrow when discussing Badger’s accounting. Nearly 60 percent of Badger’s accounts receivable at year-end were more than 30 days past due. Cohodes says many are uncollectible because hydrovacking is typically paid on completion of a job. In a report filed with various agencies, Cohodes furnished a list of more than 20 customers that had filed for bankruptcy and of which Badger was an unsecured creditor.
Though revenue per truck at Badger has fallen in each of the past three years, Cohodes calculates that EBITDA margins have remained stable, declining just slightly to about 26 percent for calendar year 2016. That compares with rival Lonestar West, whose margins were just 5 percent. Cohodes believes this may be partly because Badger is capitalizing costs, such as the manufacturing of its Hydrovac trucks, that in his view should be expensed.
But Cohodes is convinced there are other, bigger reasons for Badger’s results. In the process of interviewing scores of Badger employees and franchisees, he claims that he began to hear stories about the dumping of contaminated soil at unapproved locations. Badger is paid by utilities and pipeline companies to dispose of toxic soil at approved sites in the U.S. and Canada, but Cohodes says he believes that the company uses unapproved sites as well.
Such illegal dumping stands to be extraordinarily profitable, he notes. The cost of soil disposal at approved sites runs in the tens of thousands of dollars. Cohodes believes that Badger may simply be charging customers for expensive, government-approved disposal while dumping soil in unapproved lots for far less, pocketing the difference. (Badger did not return phone calls requesting a response to these allegations, and the extent of such dumping, if any, has not been independently verified.)
Cohodes points to public evidence. In 2012 the Wyoming Department of Environmental Quality issued a violation order to Badger for “the unpermitted release of a petroleum pollutant into a storm water collection basin.”
Cohodes also points to aerial and other Google Maps photographs showing a Hydrovac truck dumping material at a purportedly illegal site at 29350 Pacific Street in Hayward, California. The truck appears to have a Badger logo on its side.
“This is a toxic and hazardous waste company,” Cohodes notes. It is, he says, likely to collapse in any number of possible lawsuits down the road, brought by either former customers or, perhaps, the Environmental Protection Agency. “The Feds will sue, the EPA will sue,” Cohodes asserts, adding that the liabilities will wipe out the company’s equity. “I think it ends in bankruptcy or a low-asset-value sale.”
In the spring of 2017, Twitter followers began asking Cohodes to examine Winnipeg-based Exchange Income Corp., a dividend-paying holding company that owns a group of small airlines, including Bearskin, Calm Air, and Keewatin Air.
The airlines, catering to aboriginal peoples in northern Canada, had egregious on-time and safety records.
It also turns out that Exchange Income chief executive Michael Pyle and chairman Gary Filmon share a history. Both had worked with Arctic Glacier Income Fund, another dividend-paying company that filed for the Canadian equivalent of bankruptcy in 2012, unable to meet its dividend obligations.
Sharpening his pencil, Cohodes quickly figured out that Exchange Income was in somewhat similar straits, consistently failing to generate free cash to pay a dividend.
From 2012 through 2016 the company racked up a deficit of C$537.1 million, by Cohodes’s calculations. To make that up the company issued C$232.9 million in new equity and increased its debt by C$427 million. “They were literally burning the furniture to heat the house,” Cohodes says. In other words, Exchange Income was taking in money from new investors to pay off existing ones — an arrangement Cohodes labels a Ponzi scheme.
Nobody risked death in Charles Ponzi’s machinations, however.
Pilots and maintenance workers have inundated Cohodes with claims of flagrant safety violations. He sifted through industry records, which turned out to be as harrowing as some of the flights. Calm Air alone, with a fleet of 15 planes, had 13 serious incidents over five years—mostly cases of engines shutting down unexpectedly, according to Canada’s Civil Aviation Daily Occurrence Reporting System. A rival airline with 24 planes booked only three incidents in that time period.
Without proper deicing vehicles at some airfields, pilots were instructed to use jugs of deicing fluid and consumer-grade handheld applicators, former employees told Cohodes. Once, without even those tools, a pilot used his credit card to scrape the ice off the wings. Parts were purchased from local hobby shops.
“[If] these planes keep on flying, they are going to kill somebody,” Cohodes says. “Forty-five people don’t have to die.”
Management was obscuring the reasons behind cancellations and other problems. According to pilots and maintenance workers, Pyle publicly said planes had been grounded owing to the weather when in fact they had failed inspections by Transport Canada, the country’s airline regulator. A spokeswoman for Exchange Income said the company declined to comment on Cohodes’s allegations “other than to say they are unfounded.”
Cohodes began shorting Exchange Income in the summer of 2017 at about C$33 per share. The stock closed at C$34.75 in late September.
This past July, Cohodes had his lawyers send a letter about Exchange Income to Transport Canada. He says he received a request for more information. “The regulatory framework there is just so weak,” Cohodes says. “Look no further than the bailout of Home Capital.”
Cohodes’s interest in Canada’s big subprime lender was triggered by the country’s sizzling real estate market. With Chinese and other foreign capital flowing into Toronto and Vancouver, home prices skyrocketed.
Home Capital, though, was underperforming, missing analysts’ quarterly earnings projections. Cohodes began to pull together a mosaic of seemingly unrelated facts to bolster his conviction that there were fundamental problems at the company, which in the end would crater the stock.
One piece of the puzzle was a multiyear project, meant to upgrade Home Capital’s enterprise management system to custom-built SAP software, that had gone awry. That tripped up underwriting controls and support, which are mission critical for any mortgage lender.
Home Capital, like Badger, was having trouble holding on to talent. Toting up announcements and trolling the Internet, Cohodes composed a list of 40 executives who had left within the previous three years. Some of them talked to or emailed him. Tellingly, turnover was highest in risk management, an area that would have been key to assessing lending standards.
Cohodes came to believe that the loan fraud — which included the falsification of incomes and other data by borrowers and brokers — is far more pervasive than investors believe and must have been obvious at the top echelons of Home Capital.
One question is why loan losses at Home Capital have not risen with news of the fraud. Cohodes suspects that’s because the company is selling them or rolling them into sales, general, and administrative expenses.
With some $25 billion in loans on its books and shareholder equity of $1.5 billion or so, Home Capital could see its equity wiped out by loan losses of 5 percent, Cohodes figures.
As for Buffett, Cohodes says he doesn’t believe the legendary investor examined Home Capital very closely, pointing out that doing so would have required him to examine tens of billions of dollars’ worth of loans.
A June 22 article in The Globe and Mail, in which Buffett was interviewed, said the deal came together in just three days. In the same article, he says he was unaware of a key term of the deal — that Berkshire Hathaway be required to hold the shares for at least four months. “It must have been something the lawyers stuck in,” Buffett is quoted as saying.
Cohodes says that Buffett was likely a last resort to rescue Home Capital, given that none of Canada’s big banks stepped up.
Cohodes and others say they suspect that the Canadian government may have promised Buffett special consideration in future state-linked investments in exchange for the rescue package. “This is Warren Buffett’s ante to the poker table,” Cohodes says. “The Canadian government used him, used him to do a backdoor bailout. They bought him and probably promised him something in the future.”
In an interview on Canada’s Business News Network after the Berkshire Hathaway purchase, Finance Minister Bill Moreau acknowledged that he and Prime Minister Justin Trudeau had talked with Buffett. “It was probably not a coincidence that the prime minster and I were in Seattle meeting with Warren Buffett a few weeks before Buffett came in and decided to make an investment in Home Capital,” he said, adding that the company was not specifically discussed.
The Home Capital investment amounts to pocket change for Buffett. “Two hundred million [dollars] means nothing to him,” says Cohodes. Nevertheless, the Berkshire Hathaway CEO bought his Home Capital shares at a steep discount. As part of the deal, the conglomerate also provided a C$2 billion credit line to Home Capital with an initial 9.5 percent rate. Home Capital repaid a loan from the credit line in August.
Despite the run-up that followed the Berkshire announcement, Cohodes says his short position in the lender is in the black: He began shorting Home Capital in the fall of 2014, when shares were trading in the low C$50s. They closed recently at C$13.92.
“In retrospect, I should have sold it at C$6, but I’m not that smart,” Cohodes says. He has been getting some vindication. This June, Cohodes obtained a copy of a report by KPMG, which had been engaged by Home Capital in 2015 to investigate the falsified loan documents that the brokers had submitted.
The report listed the same problems Cohodes had identified, as well as other ones — a focus on sales instead of risk and compliance, poor training, overworking of the company’s credit review team, and having four chief risk officers in three years. “Broker relations enjoyed preferential treatment and were allowed to function without adequate governance,” the report said.
On August 9, a week after Home Capital reported a quarterly loss of C$111.1 million, the Ontario Securities Commission ordered the lender to pay C$10 million for its disclosure violations.
The OSC also barred Home Capital founder Soloway from serving as an officer or director of a public company for four years and fined him C$1 million. Former CEO Martin Reid and ex–chief financial officer Robert Morton were each barred for two years and ordered to pay penalties of C$500,000 each.
Buffett’s investment does nothing to lessen Cohodes’s conviction.“Home Capital ends when the credit cycle turns down and the new management has to admit how bad things are,” he says. “When the loans go to shit, the taxpayer is on the hook.”
Until then, don’t expect Cohodes to keep quiet about dubious businesses he uncovers. “I operate with a chip on my shoulder,” he admits. “I’m very proud about speaking out about horrible people doing horrible things.”