by Junheng Li
Jason insisted that we all use the same formula when we conducted each early round of our due diligence calls.
“Don’t get off the phone,” he cautioned me, “until you are well informed of the following: What are the products and services they sell? What differentiates them from their competition? What does the competition center on? Do they have a management team in place to execute the business plans? Do I trust the management with my money? If I invest in their business, what is my expected return?”
It was a steep learning curve, and I had my fair share of screw-ups. One particularly memorable mistake came during a call with a lifestyle and fitness media company based in Colorado. I had a call with the CEO scheduled for just after lunch. One of my coworkers had ordered in burgers for everyone so we could eat at our desks. By the time of my interview, the heavy food—plus the sleep deprivation that came from pulling an all-nighter researching the reviews on this company’s yoga products—began competing to knock me out.
“Joe, can you please walk me through your strategy in building the online yoga community and how you will realize the synergy with your core business?” I asked him.
As Joe, a legendary consumer-branding-guru-turned-entrepreneur, started his pitch, my eyelids became heavier and heavier, and his words bobbed about in my head.
“Yuppie interests . . . yoga video . . . social media” was about all I took in.
I wasn’t sure how long my eyes were closed until I opened them and saw Jason towering over me, arms crossed, shooting daggers from his eyes. It had been too long.
“Hello? Junh?” Joe was saying into my headset.
“Yes, Joe, that’s fascinating stuff,” I stammered, then sat straight up and plunged into jabber, asking directionless questions, one after the other, until I could shake off the fog.
I blew the call, and I knew it. Worse was that look of death from Jason, something that would haunt me for months to come. At that moment, I decided to give up eating a proper lunch altogether. Rather, I subsisted on nothing but vegetable juice and raw almonds, a habit I have continued to this day. It might sound austere, but it’s an effective formula that keeps my body and brain at peak performance throughout the day.
Despite the steep learning curve, it wasn’t long before I was working the phones like a champion. But calls could only do so much to get to the truth about a company’s prospects. It was also critical to see and experience the product in person.
Case in point: Once I figured out a creative way to check out a cosmetic laser company. The business had a new product that performed laser-assisted liposuction—an outpatient procedure offered at medical spas. The procedure is designed to disrupt fat cells and tighten tissues by inserting a laser through a tiny tube to melt and liquefy the fat before extracting it through another small tube. What could be a better way to learn the efficacy of body contouring than by experimenting with it myself? So I made a visit to the Medi Spa on Madison Avenue, which was just around the corner from our office.
“I’d like to book a liposuction treatment,” I told the receptionist.
She sized me up quizzically from head to toe, “What area would you like to treat?”
“My tummy?” I attempted.
I was worried that she wouldn’t believe me because I was so thin. But the receptionist didn’t bat an eye, presumably because the clinic already had plenty of inquiries from skinny Park Avenue socialites. This treatment was effective on any perceived flaw, which meant it was a great fit for the abundant number of narcissistic perfectionists who lived on Manhattan’s Upper East Side.
The nurse told me that the earliest available appointment would be in six months—the treatment was that popular. The procedure was minimally invasive, meaning patients could be in and out within an hour and the recovery was much faster than the normal liposuction procedure. Not surprisingly, that meant that lunch slots were fully booked.
That visit piqued my interest. I followed it up with a trip to Las Vegas the next week to attend the Aesthetic Show, an annual industry event where companies showcase their latest products. It was impossible to miss the buzz that this liposuction machine generated among the doctors, sales reps, and manufacturers. The line waiting outside the company’s booth was five times longer than at any of its competitors’ stands.
After reading through two studies and comparing my own financial model with the Street projections, I figured that the company was going to beat everyone’s expectations. I advised Jason that we should buy and accumulate the stock. Not long after, when the popularity of the laser liposuction treatment soared, our investment generated a handsome return.
This may sound like a way to make quick and easy money. In reality, however, it takes rigorous analysis to dissect a company and determine its strengths and weaknesses. As we saw with the laser liposuction company, one new product could establish its leadership in the cosmetic surgery industry and therefore influence a stock’s performance. Our job was to find ways to fill in that piece of the investment puzzle. Over time, these habits helped my natural analytical ability evolve into an intuition, a gut feeling for separating good investments from mediocre ones.
Short Selling
I first learned about the concept of short selling in business school. Unlike going long on a stock, which means you are betting that its value will increase, a short sell means you are placing a bet that a stock will lose value.
When most people think about short sellers, images of ill-willed capitalists and pernicious market manipulators who bet against a company’s success or even against its survival come to mind. These conclusions are groundless, uninformed, and entirely wrong. Shorting is critical to maintaining the integrity and enhancing the vigilance of the capital markets.
In essence, short sellers are the market watchdogs who indirectly encourage transparency and disclosure by exposing the dark side of company management. Since regulators are usually a few steps behind, short sellers represent an important self-correcting mechanism in the market. They also directly help investors minimize their risk by helping the market correct itself and by adding liquidity to the market through their trades.
Shorting stocks is difficult both because the market has an upward bias and because managers usually do their very best to preserve their companies’ stock prices. By and large, national economies, labor productivity, and therefore corporate earnings go up, not down. In an adverse environment, managers can also do a variety of things to boost their share price, such as buying back shares or paying dividends.
When shorting a stock, investors are effectively expressing their negativity about a company’s business model and the management team’s ability to deliver on its business goals. In a short sale, an investor “borrows” a stock at a cost. If a stock is heavily shorted, the borrowing cost can be almost 100 percent per year. In this case, unless the investor is highly confident that a catalyst—an event that triggers a movement in the stock—will soon cause the share price to sink, the short is probably too expensive to be worth pursuing.
Investors who take short positions need to follow the activity of their peers closely. If an investor who has shorted a stock believes its value is going to rise, he or she will buy shares back to limit losses, known as “covering a short.” But if an increase in the value of a stock encourages many short sellers to do this at the same time, that can push up the share price further and force other short sellers to liquidate their positions to avoid big losses—a situation known as a “short squeeze.” Therefore, I would make sure I was well informed on a stock’s short interest (which is also reflected in the cost to borrow) as well as the management’s dividend and buyback policies before starting any short position. I also never shorted any stock without a well-defined catalyst in mind.
Since the lowest price for a security is $0, the maximum return for a short position is 100 percent. On the other hand, the downside for the short seller is theoretically unlimited. If a stock does really well—if its share price doubles
, triples, or quadruples over time (think Google, Apple, and Amazon, to name a few)—that creates virtually unlimited risk for short sellers, who can lose 100 percent, 200 percent, or even 300 percent of their investment. The opposite is true for those who long the stocks: their downside is limited to 100 percent, but their upside is unlimited. To manage the risk of that downside of shorting stocks, most funds impose stop-loss disciplines. For example, at Aurarian, we had a stop-loss rule of 30 percent, which means that if a short or long position moved up or down by 30 percent, the position would have to be covered immediately—if Jason, the portfolio manager, deemed it appropriate, that is.
In reality, the execution of these rules is almost always subject to the discretion of the fund’s managers. And to manage risk, portfolios would always use options and other derivatives to protect their downside, in addition or as an alternative to the stop-loss rules. I had experienced multiple cases where shorts exploded in my face but, just the same, my short thesis didn’t change and sometimes even grew stronger. Instead of covering, I added to the position, after carefully reviewing the situation and discussing it with the portfolio manager. To manage the risk, I would write calls—the right to purchase the shares at a specified price within a specified period of time—to mitigate the downside.
To short-sell effectively, one has to distinguish between companies and stocks. “A good company doesn’t necessarily imply a good stock and vice versa,” Jason would repeat, until he was convinced it had been drilled into my head. “A stock has a life of its own, and it is different from that of a company. You will be trained as a stock analyst.”
What Jason meant is that the market constitutes a near infinite number of participants who each have a different view of what’s happening. A stock’s price reflects the collective view of its worth—its so-called market valuation. The collective view is based upon the consensus of the company’s future earnings potential, which the company can beat, meet, or miss, typically with predictable consequences for its share price.
In order to properly value a stock, therefore, an investor needs to develop his or her own independent view on the earnings potential of the business. Those who investigate a company with care can often develop a more accurate projection of the company’s future earnings than the market’s herd mentality. It’s only worth making a trade, however, if you have a significantly different view than that of the collective. The more your opinion deviates from the norm, the bigger the arbitrage opportunity becomes.
By shorting a stock you are effectively expressing your opinion that the business has a risk or flaw that the rest of the market doesn’t yet see. That’s why shorting is essential for price discovery—a process or mechanism of determining the price for a security, which is a primary function of the market.
To further complicate the issue, there are two types of short candidates: hypes and frauds. Hypes deserve to be brought down to earth. Frauds need to be exposed and busted. When you can identify a stock that is a combination of hype and fraud, you have the potential to hit a home run and land a big payoff on one of your bets.
A Big Little Short
In the spring of 2008, the market was flooded with deals to be made on “green” energy stocks. The sector was white hot. One Friday morning, a broker called me to pitch a “clean-tech” stock (a fancy name for green energy) that we’ll call Sunlight Systems. The Wisconsin-based company made light fixtures and had carried out a successful initial public offering (IPO) in December 2007, which was oversubscribed many times over. As a result of all that demand, its share price jumped from $13 to $21 on its first day of trading.
Sunlight’s management team marketed the company with a narrative that claimed it had a proprietary light fixture that reduced electricity consumption and saved its customers lots of money in the process. Its lofty valuation suggested that its management’s pitch resonated with investors who were hunting for additional clean-tech plays in the wake of prior rushes to scoop up solar and wind stocks.
To end the conversation on a high note, the broker added: “John Rogers, a longtime friend of the president of the United States, is one of its largest investors.”
I hung up the phone. I knew from my experiences in both Shanghai and New York City that when people rely on name-dropping, it often means their argument is lacking. In my business, making money depends on the ability to develop a variant or contrarian view from the consensus. You have to break free from the herd and be comfortable operating as a loner. And if people were buying Sunlight merely based on a celebrity recommendation, there might be an opportunity in moving in the opposite direction.
One Sunday afternoon, I came into the office as a part of my weekend routine. I loved to work in the silent office with no one around, with only four big screens staring at me. As I was flipping through Sunlight’s IPO memo, a slew of red flags caught my attention. First of all, Sunlight marketed itself as a “demand response” company—a trendy term meaning that it would be responsive to the needs of the electrical grid. Since none of Sunlight’s competitors made similar claims, it was an important point of differentiation. But as I read and reread the description of its products, I still couldn’t figure out what the secret sauce really was that gave this stock its premium valuation relative to its competition. In fact, the information the company provided on its technology was paltry at best.
I soon found other alarming clues. The CEO (let’s call him Manfred) was a high school dropout. Prior to founding Sunlight, his main experience was as a salesperson for a large industrial company. After he started his own company, he hired his wife to be director of operations with an annual salary of close to $1 million—despite the fact that the company was unprofitable. I smelled trouble.
That afternoon, I posted a question on LinkedIn, the professional social media website that I often use as a research tool. “I am looking for recommendations for lighting fixtures for a large commercial storage facility,” I wrote. “What’s your opinion on Sunlight?”
The following Monday morning, I received a long e-mail in response to my question from the CEO of one of Manfred’s main competitors, someone I’ll call Ernie.
“They make tons of claims and love to reference their patent portfolio but in the end they have a cookie cutter, one-size-fits-all solution,” Ernie wrote forcefully. He explained that more than 60 U.S. companies made high-intensity fluorescent lighting fixtures that were similar to Sunlight’s and that this competition was putting pressure on all these companies to lower their prices. He also shared the contact information for several of Sunshine’s distributors.
It all started to become clear to me. Sunlight was operating in a commodity business, and the competition was cutthroat. However, to get a high valuation in the stock market, the management decided to spin a clean-tech story by making false claims about how its proprietary light fixtures reduced electricity consumption. They were lying. I had seen this act before, but not to such a blatant degree.
But before I pulled the trigger to short the stock, I needed more data points to confirm my conviction. So I dialed up Sunlight’s distributors and pretended I was a purchasing manager looking for lighting fixtures for several large industrial warehouses in China. When a representative from Sunlight’s largest distributor picked up the phone and, after my introduction, began ripping into the company, I was stunned. “Their fixtures are extremely low quality, and their hardware and software are incompatible,” the man on the other end of the line told me in his midwestern accent. “Their bulbs also break frequently during shipment.”
“That’s terrible,” I said. “But how do they manage to sell so much? Their revenue has been growing nicely.”
“Those guys massively discount their products every three months or so,” he said. “And the CEO is great at marketing. He goes to the trade shows and tells people that his bulbs save more energy than others and that he has intellectual property that no one else has. But we talk to our customers every week, and I don’t think anyone who
has used their products has bought from them again. If you want to buy anything of quality, I’d advise you to stay away from them.”
Competitors often bad-mouth each other, but I had never seen a distributor bash the products he carried. I knew I was close to finding a home-run short. After the phone conversation, I borrowed and sold a small short position of the stock at $12 a share.
Three weeks later, Sunlight reported its quarterly earnings. Its revenue came in a staggering 15 percent below the average estimate that banks on Wall Street put out. Its earnings missed Street estimates by even more, as the company’s profits suffered from the pressure put on it by low-priced competitors. According to the company’s balance sheet, its inventory and accounts receivable both shot up significantly—meaning a higher percentage of the company’s sales came from extending credit to customers than from selling products and collecting its money in that quarter. The stock started to retreat but didn’t collapse. Together with the trading volume, this signaled to me that the die-hards were giving the company the benefit of the doubt and hoping this dismal performance was a one-time event.
The next day, analysts started to publish notes defending Sunlight and dismissing the poor performance as a slip-up that could be fixed in the near future. After all the work I had done on the stock, I knew it was not a misstep but a sign that management was cooking the numbers. My conviction was that the company was guilty of “channel stuffing” to meet Wall Street’s expectations. In other words, it was discounting its bulbs significantly toward the end of each quarter, which its distributors called “promotional sales.” Since the products were of inferior quality, distributors were not able to sell what they bought from Sunlight. As a result, inventory piled up. However, since the products had already been shipped from the manufacturer to the distributors, Sunlight recognized the revenues although its products had not actually been sold through to the final customers. This scheme is one of the most common methods that companies use to cook their numbers. When I added them up, these red flags all pointed to the fact that the company would soon be experiencing a severe deceleration in its sales.
