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The hedge-fund star who cashed in on the subprime debacle has lost a fortune to an allegation that a big Chinese timber farmer is a fraud, writes MoneyShow.com senior editor Igor Greenwald.

If you’re feeling very lucky or excessively rich—or preferably both—there’s a stock out there selling for a P/E ratio of one.

There’s a catch or two, of course.

  • First, it’s a Chinese reverse-merger concoction trading in Toronto, and alleged to be a giant sham.
  • Also, its largest shareholder, a famous hedge-fund manager who made billions by sniffing out the subprime scam before almost everyone else, has just sold his entire stake at a huge loss.

Other than that, Sino-Forest (Toronto: TRE) is doing great, thanks very much.

It claims operations from Inner Mongolia to the Burmese border in China, and interests beyond stretching from South America to New Zealand. Its 3,900 employees are said to tend, harvest, and trade 788,700 hectares of timber, covering almost twice the area of Rhode Island.

Sino-Forest asserts “a strong 16-year record of growth and prosperity,” and boasts that it’s “achieved compound average annual growth rates of 41% in revenue, 24% in diluted earnings per share, and 41% in cash flow from operating activities” since 2005.

The problem is, the numbers are a fraud, short seller Carson Block and his Muddy Waters Research outfit alleged on June 2. They cited numerous discrepancies between Sino-Forest’s accounting in Toronto and the audit documents its many subsidiaries have filed in China.

Many of the agents the company claims have bought trees on its behalf are actually straw entities and/or related parties, according to Muddy Waters. Also, the volume of harvesting it claimed in one key region would have overwhelmed the available land and infrastructure, Block charged.

On Saturday, Canada's main national newspaper, The Globe & Mail, published an investigative article supporting some of the allegations.

The company claims it’s been maligned and misunderstood, and says it's cooperating with the several probes now under way, including its own. Of course, it also claimed that top shareholder John Paulson has been “very supportive, giving us suggestions” on coping with the scandal.

But late Monday, Paulson disclosed that he has sold his entire Sino-Forest stake, absorbing a $720 million loss by Bloomberg’s estimates.

He’s not the only big-time company supporter with egg on his face. One of Sino-Forest’s directors is Simon Murray, the consummate Hong Kong boardroom insider (and a longtime associate of the territory’s most powerful billionaire). Among other things, Murray was recently named the non-executive chairman of the international commodity giant Glencore.

Funds managed by value investor Chris Davis owned the next largest slug of Sino-Forest, as of April. These holdings have also lost hundreds of millions.

But Paulson is the poster boy for this fiasco, based on his better-known role as the visionary who made up to $15 billion in 2007 by shorting dubious mortgage securities (with some now-notorious assistance from Goldman Sachs (GS)).

The notion that he may have been duped into investing in a Chinese mirage—that even the fiercest predator can be gulled into becoming roadkill—will taste delicious to many. Sino-Forest shares plunged a further 27% on Tuesday after Paulson flew the white flag of surrender.

I happen to feel Paulson’s pain, and not because I feel particularly sorry for the zillionaire. My feelings have more to do with a personal investment in Chinese chip maker Spreadtrum Communications (SPRD), and how that stock has performed since the Sino-Forest fertilizer hit the fan.

On June 1, SPRD closed at $18.53. That was well off February’s record high near $24—but not bad at all for a stock that traded below a buck at the 2009 bear-market nadir, and was at $5 and change as recently as March 2010.

I had edited a positive review of Spreadtrum by newsletter author Nicholas Vardy last December, and then mentioned the stock admiringly in a column a month later. A few weeks after that, I took the plunge.

The business kept exceeding even the bullish analysts’ expectations, as Spreadtrum took market share from a Taiwanese arch-rival in the burgeoning market for cheap mobile chipsets. And though the stock had not kept up, its losses could be ascribed to routine profit-taking after the monstrous run-up in 2010.

Then Muddy Waters napalmed Sino-Forest, and what had been an orderly pullback became a rout for just about every Chinese stock listed in North America, including Spreadtrum.

In the ensuing 19 days, Spreadtrum shares dropped 34%.

  • It didn’t matter that the company hadn’t been accused of fraud, except by anonymous trolls on message boards.
  • It didn’t matter that its business has continued to thrive, and that management has come out and affirmed guidance for the current quarter.
  • And it certainly didn’t matter that the stock had passed muster with Silver Lake Group, a prominent US private-equity group that bought a stake a year ago. Or with Fidelity, which had shuffled nearly 5% of the outstanding shares into various funds as of March 31.

It would be easy to blame short sellers, but—witness Sino-Forest—it’s just as plausible to speculate that some prominent longs decided the whole thing wasn’t worth the bother. At any rate, the chart is broken, and valuations impaired by the shadow of suspicion that now surrounds every Chinese stock peddled in North America.

Spreadtrum now sells for six times this year’s earnings. But the only obvious buyer is the company, which recently authorized a buyback of up to $100 million, which would represent 16% of its shrunken market cap.

I haven’t sold, and will not sell unless I learn something new about a business that still looks promising. But I’m certainly not holding on because Fidelity was aboard as of March.

As Paulson shows, the big guns are as prone to misfiring as any peashooter.

Tickers Mentioned: TRE, SPRD

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