Tiger Woman on Wall Stree

by Junheng Li

  “Special situation investment” refers to an investment strategy that capitalizes on major movements in a stock. The special situation could be a major corporate initiative—such as a spin-off, a merger or acquisition, or bankruptcy proceedings. It could also be a shift in market perception—rather than the underlying fundamentals of business—due to the release of a media or research report.

  Such a shift in market perception can be triggered when a prominent short seller takes a position against a stock—as in the case of Herbalife, when Bill Ackman, the activist investor in charge of the hedge fund Pershing Square, pushed down the value of the stock from $70 to $42 by labeling the company a pyramid scheme. A shift in market perception can also be caused by the announcement of unexpectedly positive earnings for a heavily shorted company, as in the case of First Solar. The U.S.-based solar company, which had nearly 30 percent of its float sold short, saw its stock climb from $27 to almost $40 when it surprised investors with its strong expectations for its performance in 2013. As well, a shift can be caused by the failure of a planned merger or acquisition, which forces arbitrage desks to dump their positions in target companies. This was the case with the unsuccessful attempt by Charles River, the U.S.-based drug developer, to buy WuXi PharmaTech, a China-based clinical research outsourcing company. The failed bid resulted in the collapse of WuXi’s stock from more than $17 to around $11.

  Like any other investment strategy, special situation investment requires solid, on-the-ground knowledge. Chasing ambulances or “catching falling knives,” as investors say, can easily do more harm than good. For example, consider investors who bought Bear Stearns after its shares collapsed from more than $80 to $30 on Friday, only to find out the next Monday that J.P. Morgan had bought the company at a massive discount of $2 per share.

  One such special situation in which I carried out a profitable long play was with New Oriental Education & Technology Group, the largest private after-school test preparation service provider in China. On July 18, 2012, Muddy Waters released a 96-page report alleging fraud at New Oriental and recommending a “strong sell” rating. Muddy Waters had apparently released its research to clients after the market closed on July 16, as investors woke up to a 32 percent overnight drop in the stock.

  I had followed stocks in the education space for a few years by then. In fact, education was one of the top two sectors I always kept an eye on out of personal interest, the other one being healthcare. I believed both sectors would enjoy secular growth in the foreseeable future, regardless of China’s economic performance. I instinctively valued the two industries: one enlightened a country’s labor force; the other improved people’s quality of life.

  I became familiar with the for-profit education business model when I was a student in Shanghai, taking English test preparation classes back in the mid-1990s. Students and their parents pay these companies tuition up front in cash for courses that last for a few months on average, and so the company’s revenue model is relatively transparent and difficult to manipulate.

  Some critics complain that New Oriental is structured as a VIE. As noted in an earlier chapter, a VIE is a legal structure that gives foreign investors de facto control of a Chinese operation but not direct equity ownership. In a VIE, the company sets up a web of contracts between entities in China and investors abroad to bypass Chinese regulations that limit direct foreign ownership in strategic industries, like education and publishing. Investors are rightfully suspicious of VIE structures because the investors have no claim on assets in the case of corporate restructurings. However, since New Oriental books most of its tuition and income to the overseas entity that investors have a direct claim on, I consider it a clean VIE.

  I learned about the favorable macroeconomic trends at work in the education sector from my close friend Peter Winn, who had built one of the strongest for-profit language education franchise businesses in China. Over the previous decade, growth in the education sector has been consistently strong, with little dependence on macroeconomic conditions such as increasing inflation, unemployment, or falling industrial production.

  The industry has also benefited from China’s one-child policy, which ensures that the only child has the priority claim on the family’s resources. As Chinese citizens become richer, more and more parents can afford the high price tag to send their children overseas to study. As of 2011, one out of every seven students studying abroad was Chinese—a figure that was up 17 times from a decade earlier, according to the Chinese Academy of Social Sciences.

  Despite China’s fast-growing economy, an increasing number of Chinese young people want to pursue a Western education abroad. North America, Europe, Australia, and New Zealand are the top destinations. The running joke is that the United States absorbs the smartest kids, while the rich but dimmer ones go to Europe. Australia and New Zealand have to deal with the leftovers.

  Competition for spots in overseas schools is tough, and in order to win one, the students first have to learn English and achieve near-perfect scores on standardized tests such as the TOEFL, GRE, IELTS, and GMAT. So before sending their children abroad, most Chinese parents invest heavily in preparation courses, including online, after-school, and weekend classes.

  As the largest and most established company in the for-profit education space, New Oriental Education benefits greatly from these trends. It is the most respected brand name in the sector. New Oriental is known for having a long operating history and high-quality teachers, and the high average test scores of the students who have taken its classes give it a strong reputation. This all allows it to charge higher prices than the numerous other private educational chains in China and still fill its classrooms. Although the competition in test preparation is heating up, New Oriental still enjoys a fair amount of pricing power as the industry leader. Chinese parents equate the New Oriental brand name with a fast-track visa and brighter future for their children.

  The business is also highly scalable: New Oriental can sign up as many as 400 students per class for some of its most popular overseas test prep classes in Beijing and Shanghai. It packs hundreds of students into a large auditorium with television screens to broadcast the teacher’s lesson to the back of the room; for each of these courses, it also records hundreds of sales of its proprietary textbooks. These classes can be very large because they are not aimed at teaching English as a method of communication, but rather as a specialized skill set to decode and conquer standardized tests.

  Just like me when I first arrived at Middlebury, many graduates from test preparation classes don’t really speak or understand much conversational English. However, they have learned the necessary techniques to unlock near-perfect scores on their TOEFL. Since the company’s overhead, including the teachers’ hourly salary and classroom rental cost, is largely fixed, high student enrollment per class directly translates into increasing profit margins.

  I had met New Oriental’s CFO, Louis Hseih, a few times at various conferences in New York and traded around the name a few times. I thought Hsieh was a bit arrogant but competent. Many investors were put off by his overly “promotional” air, but he struck me as highly intelligent and very familiar with his business. I considered Louis to be one of the most talented CFOs among the Chinese ADR companies.

  Because of this background knowledge, I quickly realized as I read the Muddy Waters report on New Oriental that it was analytically sloppy. Unlike the firm’s previous work, it was rich in conclusions and allegations but short on facts and evidence. At best, some of the allegations simply indicated a lack of understanding of China’s commercial realities. At worst, the claims seemed exaggerated in order to intentionally trigger panic selling that would profit the firm’s short-seller clients.

  One claim in particular showed a lack of understanding of the commercial reality in China: the allegation that New Oriental had understated its auditing fees and that its declining auditing expenses per school over the years indicated accounting irregularities. The repo
rt pointed out that New Oriental’s 2011 audit fee was lower than it was four years before, despite an increase in its number of schools. In Muddy Waters’ thinking, that indicated either that the company was hiring a lower-quality auditor or that there were fewer stores to audit, despite what New Oriental claimed about its growing store numbers.

  I have half a dozen former classmates working at various auditing firms, and after checking with them, I realized that this specific allegation was a shot in the dark. Operational scale, as indicated by the number of schools and learning facilities, is merely one of the factors and not likely the principal factor in determining auditing fees. An auditor decides what fees to charge a corporate client based on a combination of the complexity of a firm’s business model and corporate structure, its strategic relationships with the client, and the potential for cross-selling different services to the same organization. I also learned that after the 2008 financial crisis, most Chinese auditing firms cut their fees by as much as 20 percent to retain customers in a slow business environment. These reductions may have been even deeper for large accounts, where auditors wished to cultivate long-term business relationships. With its annual revenue of $770 million in 2012, New Oriental is a large account by all considerations.

  Even so, these realities didn’t stop the Muddy Waters report from triggering a sharp decline in New Oriental’s stock. Sell-side analysts were as clueless as the scared investors and jumped ship as quickly as they could, lowering their target prices for the stock and downgrading the company from buy to sell.

  The other allegation that contradicted common sense, at least for a Chinese person, was Muddy Waters’ suspicion about the fact that Michael Yu, the CEO, had transferred 26.4 million shares to his mother. In fact, gifting stock to immediate family is fairly common among Chinese managers. It’s also often used as means to protect wealth in case of divorce, because a Chinese wife has no claim on assets that are in her mother-in-law’s name. The experience of Tudou, a Chinese video site, demonstrates this point nicely: its 2011 IPO was delayed for almost a year because the founder’s wife claimed a large portion of his equity interest in the company during divorce proceedings. If only Tudou CEO Gary Wang had transferred more shares to his mother! In addition, a mother would be considered a safer parent with whom to entrust such an interest than a father. In the case of a split between parents, the probability of an elderly woman getting remarried (thus giving the new partner a claim on the assets) is far lower in China’s patriarchal society than for an elderly man.

  The Power of Data

  But the allegation that was most damaging and hardest to rebut was that many of the schools in New Oriental’s network were franchises, rather than directly owned. Muddy Waters claimed that New Oriental had misrepresented certain franchise schools as fully owned businesses. In the view of Carson Block, Muddy Waters’s founder, that allowed the company to maximize its store base growth, helping it to justify its fast revenue and profit growth, as well as counting its franchise fees as company cash.

  To investigate this claim, Goldpebble developed a proprietary algorithm to sift through 107,517 of New Oriental’s class records and 14,468 opening course records from its online enrollment website. To examine the potential for financial reporting fraud, Yifeng’s team checked this database with schools and learning centers in China’s major cities. The survey team also interviewed senior management of other nonlisted private schools, compared New Oriental’s financials with those of other listed private schools, and performed on-site visits to private school associations, the Ministry of Education, and the tax bureau to identify potential frauds in the corporate structure.

  To ascertain the scale of its franchise network, Goldpebble conducted comprehensive surveys of 48 schools and 680 learning centers to verify the stated revenue and issued invoices. All 48 of the schools invoiced their revenues to New Oriental subsidiaries, indicating that they were directly owned. Thirty-five supplied bank details or postal remittances to prove that the funds went directly to New Oriental. Goldpebble received survey responses from 564 out of 680 learning centers, and those that answered all issued invoices to their local New Oriental branch. In addition, none of the 564 schools said they were aware of any franchise operations in their cities. Based on these data, we estimated that less than 1 percent of New Oriental’s income was franchised and was therefore insignificant for New Oriental’s operating and financial reporting purposes.

  After completing this extensive investigation, we concluded that Muddy Waters’ allegations were groundless. There was no trace of fraud, and all the issues Muddy Waters raised—from New Oriental’s franchises to its accounting practices and corporate structure—appeared to be false. We urged our clients to buy the stock at less than $10 per share in July 2012. By November, it had bounced back to $20, a more than 100 percent gain in less than four months, our biggest win in 2012.

  Our experience with New Oriental showcased the power of investigative research—in the words of Ayn Rand, “not to trust, but to know.” This was the only way to invest in China, not through the “he said, she said” of analyst reports, unverified news, and rumors, but through exhaustive bottom-up research. Only with this rigorous methodology could an investor develop a level of conviction that would allow him or her to withstand market volatility and pursue profit-making opportunities by betting against the crowd. Of course, this type of research is beyond the reach of most retail investors due to resource constraints.

  This is one of the main reasons that I suggest retail investors stay away from individual Chinese stocks. Again, losing money is a lot worse than not making money.

  China’s X Factors

  On May 30, 2012, I sat down with a reporter from Bloomberg TV in the China World Hotel, a historic landmark on the western side of Beijing, for a televised interview on how to invest in China. I told him that I thought highly of Muddy Waters’ work. Carson Block had shown, not just told, people how to conduct exhaustive and meticulous research, and in the process he had helped to combat opacity and generally poor Chinese corporate governance. Every serious investor should invest and build a research infrastructure capable of conducting this level of due diligence, but even so, there is no guarantee of getting it right 100 percent of time.

  The interviewer asked how investors could capture Chinese growth. The best solution, I told him, was to invest in multinationals with defensible models and significant exposure to China. Multinationals give foreign investors a way to benefit from Chinese growth without investing in Chinese stocks directly, thereby circumventing Chinese corporate governance issues.

  One of the multinationals I mentioned was Yum! Brands, an American quick-service restaurant (QSR) chain that operates 39,000 restaurants in 110 countries. Its brands include KFC, Pizza Hut, and Taco Bell, but its crown jewel is KFC China. With approximately 5,700 stores, Yum! China generated more than 50 percent of Yum! Brands’ operating profits, and KFC China generated approximately 85 percent of Yum! China’s profit. For this reason, the stock attracted the interest of global money managers and investors seeking a proxy for the booming growth in the disposable income of the Chinese middle class.

  Since its first store opening in Beijing in 1987, KFC China achieved great success in branding itself to appeal to the swelling ranks of middle-class Chinese consumers. KFC in China managed to localize its menu but still have its customers think of it as a quintessentially American brand. The Chinese middle class was fascinated with American fast food, and unlike in the United States, the restaurant was considered an appropriate place to have a birthday party or even take a first date.

  I was no different. I indulged in KFC in the mid-1990s, before I learned how unhealthy it was. The price tag, almost 20 RMB for a sandwich, was not exactly cheap, but I savored every bite of the delicious (and at the time unusual) combination of a fried chicken fillet, mayonnaise, and uncooked lettuce.

  I have never bought Yum’s stock. The valuation was above what I was willing to pay for a fast
-food chain restaurant business. But it had been a darling for many global fund managers who wanted China exposure without China risks such as corporate governance and accounting issues. The stock took off from a level of $50 in October 2011 and ripped all the way to $70 in early 2012, as the company planned hundreds of new store openings in China. By late 2012, the stock traded at more than 20 times forward earnings, a huge valuation for a company that sells fried chicken.

  I have been cautious of the stock for several reasons. The QSR industry is highly competitive. It has what analysts describe as a low switching cost for the customer: many consumers go to KFC one day, McDonald’s the next, and Chipotle the day after, unlike other retail segments where consumers stay relatively faithful to one brand. That should ultimately spell volatile profits and leave the company vulnerable to competition in the long run. For such a segment, Yum had an extremely high valuation. In comparison, the stock of Swiss luxury watchmakers, another category in the retail space including Richemont and Swatch Group, is valued at around 12 to 15 times forward earnings—even though the luxury industry in theory provides a similar China growth story and even though the barrier to entry for companies, including brand equity and customer service, is much higher than in the fast-food segment. Even Apple, a great China discretionary spending story, typically trades at a multiple between the high single digits and the low teens.

  By then, Yum had been hit by a string of events that prompted me to pay close attention to this “Chinese” company. It all started with the “45-day chicken.”

  On November 23, the Chinese media reported that one of KFC China’s chicken suppliers, known as the Su Hai Group, had fed toxic chemicals to its chickens to accelerate their growth cycle from 100 days to a mere 45. On the same day, KFC China responded, denying the allegations and stating that a 45-day growth cycle was the industry standard.