A canary in the commodities coal mine? 5 signs the rout has only begun.

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I’ve looked at the financial world through a new lens ever since reading the fantastic book Fooling Some of the People All of the Time by David Einhorn of Greenlight Capital. In dramatic fashion, Einhorn exposed the fraud at Allied Capital and ultimately profited by short-selling the company’s wildly overvalued stock.

Could a similar story be unfolding at the Hong Kong commodity trading company known as Noble Group?

The Noble Group has hit a rough patch – especially in the shale oil business. It’s stock has fallen 60% since July of 2014 and the short sellers are are winning. The Financial Times detected the whiff of Noble’s corporate shenanigans in it’s US edition on Thursday.

Mining

Using the template provided by Einhorn is his famous campaign against Allied Capital’s fraudulent practices, here are 5 classic signs that something is amiss at Noble Group:

1. Aggressive recognition of income. Companies that consistently book future revenues in current quarters start raising red flags. It seems that Noble has perfected this game. Noble Group has reported $2.5 billion in profits since 2009, yet cash flow over the same period has been a paltry $118 million. Yes, that’s an “m”.

2. Inflated value of a subsidiary. Noble Group owns a 13 percent stake in Australian miner Yancoal. The company is traded publicly and has a market value of $95 million. Instead, Noble carries Yancoal on its books at $322 million.

3. Opaque mark-to-market accounting. Noble makes no explanations for its valuations of long-term commodity deals in their financial statements. They have hired PwC to produce a more detailed analysis. If a commodity trader needs to be told how to mark positions to market by an accountant, it doesn’t exactly inspire confidence. This sounds like a good stalling tactic to allow investors to exit before the business implodes or to buy time for the market value of the trades recover.

4. Company owners create a smokescreen by buying shares. As with the Allied fraud exposed by Einhorn, Noble Group has thrown up the red herring that the company must be in good shape because insiders are buying stock. Richard Elman, the Chairman, has recently bought shares.

5. Attack the messenger. The most vocal critics of the firm have been Iceberg Research and the short selling hedge fund known as Muddy Waters. The S&P has also chimed in that Noble needs to improve disclosure or it will face a downgrade. Instead of disclosure, Noble alleges that the information presented to Iceberg is the work of a disgruntled Noble employee who was fired in 2013. Not coincidentally, this same former employee is being sued in Hong Kong by Noble. Einhorn was able to rattle cages at Allied by bringing a “whistleblower” suit. Such legal remedies are probably not available in Hong Kong.

As an aside, shouldn’t S&P downgrade Noble now? I mean, if they produce the transparency, they can be upgraded again. Right? Aren’t ratings companies supposed to be the ones who alert investors first?

In Noble’s defense, the FT provided few opportunities for the company to rebut the claims publicly. Also, Richard Elman is a cagey operator who started the Noble 30 years ago and began in Britain’s scrap industry during the 1970’s. His survival ability probably should not be underestimated by overconfident short sellers.

If nothing else, the FT piece is a canary in the coal mine that many other traders and miners may not be portraying accurate valuations in what has become a commodities bloodbath. If some of the trading firms start to unwind positions rapidly, it could lead to major market disruptions… and opportunities….

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