by Junheng Li
“Website? Search engine?” He looked completely lost. “I don’t remember what the company does,” he confessed.
Having been on Wall Street since the first day I left college, I had met many people in the industry who were less than competent. But owning a stock without knowing anything about its underlying business was something utterly new to me. I had heard the broker’s joke that there’s always a greater fool to sell a stock to, but it was the first time I actually had lunch with the phenomenon.
Over time, Knucklehead gradually ingratiated himself to me by always grabbing a seat next to me at the lunches. After a few IPO group dates, I had heard most of his story.
Once upon a time, Knucklehead was a successful trader on Wall Street, amassing most of his wealth in the 1990s when regulation was much less onerous. At the peak of his career, he had accumulated around a half billion dollars. But over the past 20-some years, he had lost 90 percent of his money. While he was still wealthier than 99.99 percent of Americans, he operated what bankers consider a modest family-sized business that managed around $50 million.
Knucklehead liked to think of himself as a hedgie. But unlike any true hedgie, he had never shorted a stock in his life. Shorting the S&P Index once in a while was effectively his only hedging strategy. Throughout his career, he had always taken long positions, betting that stock prices would rise and then leveling them up by borrowing from banks. In his mind, using leverage alone—borrowing capital to enhance his rate of return—meant he deserved the hedgie moniker.
More astonishingly, Knucklehedgie—as I now began to think of him—only bought stocks and never sold them. When a stock went up, he loved it more and therefore held onto it even tighter. When the stock went down, he loved it more because it was a bargain and so bought even more of it.
Knucklehedgie’s way of picking stocks was haphazard. He would share some of his tips with me from time to time. He especially liked to make bets using gossip gathered from the A-list weekend cocktail parties at his country house in Connecticut and his golf outings to a country club in Darien.
It took me very little time to realize that Knucklehedgie had completely lost it. Playing with his dwindling pile of money was just a hobby to fill up his lonely hours. He was in way over his head with his China tech stocks. But he wasn’t alone. He was just one of the casualties of a China gold rush that seduced even sophisticated investors. I was just beginning to find out how deep that story went.
* * *
One morning in early December, I got an unusual call in the office from a broker. The broker said: “Our analyst suspects a small company in China called China Little Fertilizer is going to miss its earnings estimates. He just spoke with the management, which told him business was affected big time by a flood in central China.”
“Thanks for the heads-up,” I replied, and hung up the phone.
Nine out of 10 trading ideas pitched by brokers are useless, but once in a while it pays off to follow through. With three computer screens in front of me, I pulled up a stock chart, a list of shareholders, and a map of China. The flooded area in central China was in Hubei Province, the home of about 5 percent of the company’s operations. Instantly my hunch told me that the flood might have been a cover story for declining business. It’s common for companies and governments of all nations to blame natural disasters for poor results so that none of the people in charge can be faulted.
Examining the shareholder list, I saw that some prominent Wall Street names and prestigious private equity firms were the primary investors in China Little Fertilizer (CLF). The stock chart showed that shares had fetched a higher valuation than CLF’s American competitors. I assumed the premium was a reward for the growth that Wall Street automatically ascribed to any China stock.
My gut told me that CLF was another gold rush story, so I hurried to set up a conference call with the Chinese CFO, a guy named Jackie Lau. The call took place at 10 a.m. Eastern Time, 10 p.m. in Beijing. The executive must have been at a loud party or a karaoke bar, as there were thumping and whirring noises in the background. His voice was raspy, as if he’d smoked too many cigarettes that night. When I asked politely about his strategy in the face of declining business, he replied with some nonsensical muttering about tightening the company’s payment policy from a 90-day grace period to cash upon delivery. It was an absurd answer: it’s Business School 101 that reducing customer credit plans drives away sales rather than increasing them.
From our spotty conversation, I also learned that the fertilizer business in China was extremely fragmented among lots of small companies, much more so than in the United States. Since most of these mom-and-pop businesses didn’t have enough money to invest in better technology than their peers, they competed with them solely on price.
After we hung up, I dug up information online about the CFO. There was no shortage of negative news about Lau. I carefully screened the information, and none of it improved my first impression.
Lau fit the profile of a new class of well-paid professionals who had emerged with the Chinese investment boom: IPO CFOs. Those CFOs were hired right before the companies went to the public market to raise money. They were not brought on as the permanent head of finance within a corporation, as most CFOs are in normal circumstances, but for a single purpose: to prepare and eventually sell the company to investors in a public market.
Their pay package was usually composed of two parts. They pocketed a base salary of around $100,000 to $200,000, a hefty price tag footed by oblivious IPO investors. But their real meat came from stock options. Options in Chinese companies typically have a two- to three-year lockup period—an amount of time during which company executives and other cornerstone investors are forbidden from selling their shares to protect the company price and limit trading volatility—which is much shorter than those of American companies. Once the lockup expires, the CFO can cash out his options to the tune of a few million dollars. The higher the stock price, the more value he or she can unlock from the option.
There is nothing wrong with making fast money as long as the money is clean—ask Mark Zuckerberg. But Lau had pumped up the valuation of the companies he worked on and then dumped them as if he were on steroids. Every company he touched had eventually crumbled.
All the facts suggested that CLF could be a fraud. The situation reminded me of Sunlight, one of our home-run shorts at my previous hedge fund. CLF had the same recipe of sketchy management, a highly commoditized business, and an overhyped stock. But most important, CLF’s products were not selling, judging from the fact that the management was trying to cover up declining sales with excuses that didn’t add up.
But here was the challenge. Unlike Sunlight, CLF was a retail stock, meaning private investors owned most of the shares, not institutions. Retail investors are slower to sell their shares when bad news breaks; they are more forgiving. That makes the stock difficult to short.
I needed a sounding board, so I e-mailed my old boss and mentor, Jason. “I need your advice on a stock,” I wrote. “It’s a Chinese fertilizer company fetching a 25× P/E multiple.” The price/earnings multiple is one way to measure how expensive a stock is in relation to the amount of profit that company generates, and 25 times is a premium price. I also spelled out the other red flags: CLF was a poorly managed company in a commodity business that was shifting to a lower-margin product to fend off decelerating sales growth. Against common sense, it was making customers pay sooner, likely driving them away in the process. On top of it all, the CFO was the kind of guy who would take a conference call at a nightclub. “But it’s a retail stock,” I wrote. “How do you think this will play out if I’m right?”
In less than 30 minutes I had my response. Most people in my business are CrackBerry addicts (we still use the BlackBerry for its heightened security features). Jason had gathered all the basic information on the stock. As I read his e-mail, I was filled with the restless excitement that comes from uncovering a great play.
Jason w
rote forcefully: “It sounds like a great short. This is how you short a retail stock. You short it, and every time it lifts its head, you hit it again. You have to save your firepower. Pace yourself. And if your thesis is right, the stock goes to zero.”
That made perfect sense, so I took his advice. I started with a small position. Then, during the weeks leading up to the company’s earnings report in November, I nibbled on it or added onto it each time the stock went higher.
The morning of the company’s earnings release, I woke up one hour before the alarm. I went into the office at 6 a.m. to wait for the earnings release. At 7 a.m., the news flashed across my Bloomberg terminal. CLF’s sales and profits had both come in at a fraction of analyst estimates, sending the stock tumbling 16 percent in premarket trading. I had nailed it. While I was pleased, I was in no rush to cover the short position. I told myself, “The movie has just started.”
The company’s stock deflated further over the next few months. Then in February, a research firm issued a report alleging that CLF had falsified its 2009 revenue and earnings. The report featured detailed data and pictures demonstrating that the business was effectively a sham. In May, the Nasdaq hearings panel ruled to delist and suspend trading in its shares. Today, the stock trades not on an exchange but over the counter, where companies do not need to meet minimum requirements or file with the SEC, for a measly $0.16 a share. Just like that, in just six months, I had doubled my investment.
* * *
Normally I love New York in December: festive holiday parties, the Christmas tree in Rockefeller Center, ice skating in Central Park followed by hot chocolate. But this year was different. I felt like I was standing alone in the cold, with a thick pane of glass separating me from the happiness and excitement of New York’s Christmas festivities.
Those who are single and working on Wall Street and who don’t want to spend the holidays alone have two standard choices: going to glamorous beach parties at St. Barth’s in the Caribbean or skiing in Aspen, Colorado. It had not taken long for word to get out that I was single again, but as I watched my e-mail inbox fill up with invitations to these two predictable destinations, I wasn’t even motivated enough to open the messages and respond.
Rather, I wanted to be close to my family. Strangely enough, I needed to be with my father, to absorb a little of his strength.
I called Peter, my old friend from the education industry, to tell him that I was considering returning to Shanghai for the holidays. “Why don’t we schedule a bunch of meetings for you around the holidays?” was his reply. “That way you can get some research done.” I thought it was a great idea. I hung up and booked a last-minute trip to the place of my birth.
I wanted to see with my own eyes what was lying beneath all that fog and, I hoped, allay my doubts about the corporate governance and integrity of Chinese companies. Exploring a new investment frontier—and being among the people who knew me best—would almost certainly be preferable to facing the holidays as a newly divorced woman in New York City.
Shanghai
Stepping into the lobby of the Four Seasons, not long after I deplaned from my 15-hour flight to China, I was flooded with a sense of familiarity. The decor was just as luxurious as the hotel’s Manhattan branch, with its silken table settings and crystal chandeliers. But the quiet New York sophistication was absent; the vast marble space was a hive of activity. At every table, a transaction was taking place. The crackling energy of the space evoked a sense of excitement and growing prosperity that was lacking on Wall Street.
There could be no doubt that this was China. The raucous hustle and bustle of businesspeople cutting deals was wreathed with the pungent odor of stale cigarette smoke. The coal bosses from the provinces and the flush local financiers yelled out to one another, oblivious to all the refinement around them, their jarring countryside accents drowning out their neighbors’ conversations. An army of waitstaff stood ready to respond to the shouts of “fuwuyuan!” (“waiter!”) from customers across the dining area. This was a new frontier, the Wild East, a place where rags-to-riches stories were unfolding before my eyes.
I was there to meet a friend, Robert, who had moved to Shanghai from New York a few years ago to join the private equity gold rush. I surveyed the room while I waited for him, and then I spotted a familiar face: Nick, a former investment banker and Ivy League graduate, now one of millions of unemployed casualties of the 2008 financial crisis.
“Nick! What are you doing here?” I asked after a quick embrace.
He was on his way to discuss one of the deals that was gestating around me. He briefed me on his latest venture: a boutique advisory shop targeting rural private businesses that needed cash to expand.
Nick’s business model was to hire local analysts to scout out private enterprises far from China’s booming coastal areas. These local hires, who work at one-tenth the salary of a comparable Wall Street position, would find private businesses operating in obscure locations, most of which had limited operating histories, no earnings, and no hard assets for collateral. Nick’s trick was to convince these provincial company managers, many of whom didn’t even need financing, that he could merge their businesses into an already publicly listed shell, therefore bypassing the usual stringent IPO regulations.
This was the model for the now-infamous reverse-merger deal, a loophole that gave companies a back door onto America’s normally well-guarded stock exchanges. An advisory firm like Nick’s would match a company seeking to list with a defunct shell company that still retained its ticker symbol. The first company would merge with the second, effectively going public while bypassing the SEC’s strict auditing and disclosure requirements for IPOs.
Some legitimate companies did go public this way, such as Blockbuster Entertainment and Berkshire Hathaway. But many of the entities that listed through a reverse merger were evading SEC oversight for a reason. These firms were often too immature or poorly performing to attract investors—otherwise they would have chosen the standard listing route. Reverse mergers helped sneak hundreds of sketchy companies onto U.S. exchanges, including many Chinese firms that would not have passed muster for a traditional IPO. Between January 2007 and April 2010, a total of 159 Chinese companies took this back door onto U.S. securities markets—nearly three times the number of Chinese companies that conducted traditional IPOs.
It didn’t take companies like Nick’s long to exhaust the low-hanging fruit. As the China gold rush continued, banks began hunting down companies—IPO ready or not, with real earnings or not—to conduct reverse mergers. A few boutique investment banks in New York and California handled many of the reverse-merger deals. They sent employees to China’s hinterlands to seek out new candidates, packaged them with promotional materials, and sent them down the assembly line to investors. Bankers weren’t picky—there was too little meat and many mouths to feed. Likewise, many investors didn’t know or care about the real quality of China-based companies.
They should have been more concerned. Some of these banks courted their Chinese clients by promising to use a light touch when doing due diligence. Investment banks are charged with verifying a company’s financials before an IPO. But some American bankers sold Chinese executives by pledging not to contact their banks to check their cash positions—in other words, giving them a green light for fraud.
Reverse-merger production lines boomed, and Nick, ever the stellar salesman, became quite popular in China’s business arena. Maybe even a little too popular—in less than six months after our encounter in Shanghai, both he and some of his clients would become targets of an ongoing investigation by the SEC.
By the end of 2010, fraud and serious accounting issues were being uncovered everywhere at Chinese firms, with the help of a group of independent research firms that began digging up dirt on fraudulent Chinese companies for their hedge fund clients.
Chief among these research firms was Muddy Waters, an outfit led by a former lawyer named Carson Block. Block drew the name of
his company from an old Chinese proverb: “Muddy waters make it easy to catch fish.” According to Block, the opacity of China’s business environment had made it a breeding ground for committing fraud, cutting corners, and gaming the system. Block and his counterparts plunged into these murky waters and started catching fish.
His methods were simple and effective: Block would identify a target and dig in. His researchers spent months tracking down and interviewing insiders and delving into corporate structures. They would even travel to remote locations in China to videotape empty factories or count acres of farmland. Block’s reports did not just tell their reader about fraud; they demonstrated it step-by-step with pictures, data, and insider information.
By September 2012, exposés by Muddy Waters and other firms had forced the auditors of 67 Chinese companies to resign. And 126 Chinese companies had either been delisted or had “gone dark,” meaning they were no longer filing with the SEC.
Those results shouldn’t have been that surprising. Many of these reverse-merger companies were low-end manufacturers or commodity companies in China’s hinterlands. The management at these companies left a lot to be desired; many had built their businesses off local connections, as opposed to management or finance skills. It’s unlikely that many knew enough English to say “Nasdaq” instead of “Na-si-da-ke,” the Chinese transliteration—let alone understood and respected the mechanisms of first-world capital markets and their legal requirements.
Nick hurried off to his next meeting as I continued to scan the lobby for my friend Robert, who appeared a few minutes later, apologizing profusely for his tardiness.
“You must be really busy with all those listings,” I said, as we sat down in a more discreet corner of the lobby, screened by a clump of potted bamboo.
“We had to push them out of the pipe because their four- to five-year shelf life was up,” he explained. “Some of these guys are too hickish to go public. Their businesses don’t make money, and they’re burning cash. Banks won’t lend to them because they’re not connected with the Communist Party. So we have to push them out while the market is still hot.”
