Tiger Woman on Wall Stree (13 page)

Over time, I started to realize that this was the reason for China’s notorious lack of innovation. The culture of lawlessness
meant many companies feared having their products reverse-engineered and copycatted. So Chinese companies spent much less on R&D than their American peers, stifling industries where innovation drives revenue growth and market share, such as technology and healthcare.

During the same meeting, I learned of a fascinating development—something that no American portfolio manager sitting in a fancy office on Fifth Avenue would have ever imagined. Active Chip had just acquired a team of engineers from Taiwan with the goal to develop a new chip for video players. But the merger went badly. The two groups of engineers—the mainlanders and the Taiwanese—clashed for cultural reasons, the CFO told me. I could guess why: in Taiwan, Chinese mainlanders are despised for having no manners or sophistication; in the mainland, Taiwanese are looked down on for being harsh bosses and cultural elitists. The Taiwanese see themselves as the more professional Chinese, more civilized and in sync with the modern world. They have little patience for Chinese mainlanders, who, having grown up in a post-Communist, not-quite-modernized country, are often perceived as crude and unprofessional. Add in nationalist sentiment—the fact that Chinese mainlanders are taught from childhood that Taiwan is a Chinese province—and little room is left between the two sides for cooperation. Regardless, the merger didn’t generate the intended synergy but instead compromised morale and productivity.

When I left the meeting, I immediately arranged a call with a small private semiconductor company in Shenzhen that was rumored to have snuck into the market by selling chips similar to the ones Active Chips made but at a 30 percent discount. During the call I confirmed that the small company was willing to sacrifice short-term profitability in order to win a piece of the market—a death knell for Active Chip’s profitability.

A fierce price war did indeed follow. Starting in September 2006, Active Chip reported four consecutive weak quarters. The
company missed analyst earnings estimates and revised its revenue guidance downward for three consecutive quarters. Two years after its IPO, the stock dipped from its peak of $16 to below $3, around its cash balance per share.

Ferocious competition was a recurring theme for many of companies I visited, whether they made semiconductor chips, medical devices, or solar panels. Every market has examples of small companies delivering superb growth and profit margins in their early stages. But once they get to a certain size, their success attracts competition. Since few Chinese companies have defensible intellectual property, their products are often commoditized before they have the chance to scale up and establish their brand equity and franchises.

This combination of low barriers to entry and ferocious competition means Chinese companies are typically not buy-and-hold investments because their profits are not sustainable. However, some of them can be compelling trades in the early stage of their product cycle. For investors in Chinese companies, it is critical to figure out early on how far a company has progressed in its product cycle and monitor its developments and competitive landscape closely. This trend holds true for all “commodity companies”—businesses that make goods or services that are hardly differentiable from each other and compete on pricing rather than features—in emerging and developed markets. That’s why I frequented Best Buy to track price changes among GPS gadgets week by week and why other American semiconductor analysts spent more time in the evening calling Chinese companies to check their prices rather than creating financial models. Even the best financial model instantly becomes inaccurate if competitive dynamics change.

My trip dispelled another myth, that of China’s green-tech innovation. Many investors in the United States heard the awesome data on how many solar panels and wind turbines China was
producing and believed that the country was leading the green-tech revolution. I thought so too until I started researching the sector firsthand.

I visited several solar facilities, nestled in the industrial landscape that stretches for hundreds of miles west of Shanghai. The companies tried their best to show off their labs and “proprietary technologies,” but it soon became obvious to me that they were following the same low-cost manufacturing model as any Chinese button or sock manufacturer.

These companies took advantage of hefty amounts of government stimulus, cheap labor, and lax environmental regulations to pump out “clean-tech” products and ship them overseas. They were rushing to grab market share by offering cheap prices, just as with any other low-value-added Chinese factory story. Few of the turbines and panels I saw were actually installed in China; when they were, they often didn’t work or were never attached to the electrical grid.

Years ago, when polysilicon, the raw ingredient for solar panels, cost 10 times what it does now, some Chinese companies boasted about their ability to use large amounts of recycled polysilicon in their cells and thus lower their costs. My contacts told me that they actually had droves of laborers sifting through the floor sweepings at polysilicon factories and hand-picking out all the leftover material. This manual process was hardly a defensible innovation worthy of being labeled high-tech. Instead, it was just another example of a Chinese company relying on cheap local labor to boost its production yield—tactics that its competitors could easily adopt as well.

China’s green-tech companies became known not just for lacking intellectual property but also for stealing it. One famous case was American Superconductor Corporation (AMSC), a Massachusetts-based company that makes operating systems for wind turbines. The company had a profitable partnership supplying
operating systems for wind turbines to one Chinese wind turbine manufacturer, Sinovel. But then one day, some AMSC employees visiting China saw a Sinovel wind farm operating a version of their software with an expired code. The American company had encrypted its software to stop working if its clients didn’t pay a renewal fee. Clearly, Sinovel had breached these defenses.

One of AMSC’s employees who had access to the software code was ultimately tried and convicted for selling company trade secrets to Sinovel. The Chinese company had given the employee a six-year employment contract worth $1.7 million in return for
the codes
. AMSC lost far more than that. The U.S. company was so heavily dependent on its relationship with Sinovel that its revenues dropped 90 percent. Its stock price also plummeted, falling from $44 in January 2010 to less than $5 in September 2011.

After Chinese solar and wind turbine companies bankrupted almost all their competitors globally, they finally took a dive themselves in 2011. Just like any other sector the Chinese government had supported or intervened in, the clean-tech industry faced severe manufacturing overcapacity that ultimately triggered the collapse of solar product prices and made the businesses unprofitable. Suntech Power, one of the world’s largest solar companies, dissolved into bankruptcy in early 2013. Senior creditors took over the company, and equity holders saw the value of their shares fall from roughly $50 in 2008 to only $0.50 as Suntech filed for bankruptcy.

Ironically, this was all made possible by China’s hefty government subsidies. On the one hand, the subsidies lowered costs for domestic manufacturers and allowed them to win market share. But ultimately they damaged their businesses by creating excess capacity in the market. The situation worsened in 2012 as the United States and the European Union passed antidumping actions to protect their markets from low-priced Chinese products. In December 2012, the Chinese government finally decided
to withdraw subsidies to solar companies that were not yet profitable. The industry is now undergoing a massive restructuring, and many Chinese manufacturers
have filed for bankruptcy
.

I met with more than 30 companies during the two weeks I spent in China, a typically exhausting schedule that hedge fund analysts call “speed dating.” What I learned did not inspire confidence. After doing exhaustive research, I had to confess to Jason that I couldn’t find a single company to fit into Aurarian’s long book. Our fund only bet long on companies with sustainable business models and proprietary technology, which ensured that competitors faced a high barrier to entry and the company could maintain a stable or rising profit margin.

Of the Chinese companies I saw, larger companies in big cities with proven operating track records were clearly the lesser of two evils for U.S. investors. The small ventures in rural areas had a hard time recruiting and retaining talented employees, and many of their executives were amateurs. Still, there was nothing I liked enough to invest our clients’ money in. China lacked the commercial infrastructure needed to conduct business efficiently, and average labor productivity and management talent lagged behind the West as well. Instead, I found dozens of companies that had succeeded based on mass production and cheap labor, with their products well on their way to being commoditized. Many of them were perfect short candidates, and I convinced Jason to trade some of them.

I saw an interesting dilemma. No country in the history of human civilization had progressed as fast as China over the past 30 years. The country had transformed from dirt poor in 1980 to what was today effectively a middle-income country. But in some ways, China had become the victim of its own success. Chinese
people at all levels of society had grown used to this rapid pace of transformation and come to see it as a goal in itself. Everyone from corporate managers to local government officials was racing to build empires.

Despite this rapid growth, the nature of economic activity had not evolved. China’s success was almost entirely driven by mass production in low-end industrial manufacturing sectors and by economies of scale. Modern China was stalled in that model, wanting but unable to move up the value chain from its cheap-labor production model. Moving up that chain would require a serious and difficult effort to establish the rule of law (not to be confused with the rule of lawyers, which is sometimes the case in the United States) and political and regulatory transparency.

When I asked Chinese managers about their goal for their companies, more often than not their answer was that they wanted to grow as fast as possible. In comparison, most executives at American public companies would say they were working to generate quality and sustainable profits for their shareholders. To do so, American companies invest in research and development as well as human capital, including training their staff and cultivating a corporate culture. Chinese companies, on the other hand, often seem eager to see their growth outpace their ability to manage the company, even though this might hasten the company’s demise.

This mentality of building an empire in one day seems to be deeply rooted in Chinese society, from government to individual business owners. Perhaps China changed too fast—after all, the country experienced a magnitude of economic growth in 30-plus years that had taken the Western world from the eighteenth to the twenty-first century to complete. China’s institutional growth, including the rule of law and checks and balances on the single-party central government, has not kept up with the economic gains. That incompatibility continues to hinder China’s progress up the global value chain. Meanwhile, other emerging economies
are catching up, eroding China’s position as the world’s factory by offering even lower labor costs.

The year 2007 was a good one both professionally and personally. Jason and I were a winning team, and all our hard work began to pay off. In 2007, our fund delivered a more than 60 percent return to our investors—an achievement that led
Institutional Investor
magazine to call Jason one of most promising emerging managers in the business.

The next year led us into much choppier waters. As did many other people on Wall Street, Jason and I foresaw the crash of 2008, but we weren’t prepared for the magnitude of it.

Jason had seen the signs of an imminent housing crisis firsthand in 2007, as he traveled to Los Angeles and Florida to visit companies we had invested in. While driving his rental car up the coasts, Jason noticed just how many unfinished real estate projects and rows of McMansions stood empty on newly cleared plots far from city centers. This scene clashed with the public perception that both demand and prices in the housing market had nowhere to go but up.

As we know all too well now, housing purchases were fueled by widely available bank credit. Appreciating property prices and easy money sparked a gold rush, and many Americans bought properties that they couldn’t afford, just because the banks were willing to lend them the money. The banks then repackaged the mortgages into their latest white-hot financial innovations and sold them to investors who bet on the continuous appreciation of the housing market. Major U.S. financial institutions created complex, often deliberately misleading financial instruments, such as mortgage-backed securities and other derivatives, which Moody’s and Standard & Poor’s then minted with inflated credit ratings.

During the peak of this housing bubble in 2006 and 2007, the Wall Street firms were so hungry for mortgages to securitize that they started accepting mortgages without any documentation about the borrower’s creditworthiness. These subprime loans were often called “liar loans,” because the borrower didn’t have to verify his or her income through W-2s, income tax returns, or other records.

The proliferation of mortgage-backed securities backed by liar loans planted the seeds for the financial meltdown that began in 2008. These financial instruments, while seeming to decrease the risk financial institutions faced, actually complicated their balance sheets and ultimately served to burst America’s inflated housing bubble, creating unforeseen risks to the broader economy.

In financial terms, an asset bubble forms when the market value deviates from the underlying intrinsic value. Every bubble must burst; it’s a matter of when, not if. Jason and I believed that when the housing crisis occurred, the contagion would hurt all sectors of the economy, and consumer discretionary spending would be one of the first things to fall. We began building short positions around the thesis that the housing bubble had inflated consumer purchases of appliances and electronics and that once the housing bubble popped, those consumer stocks would crumble.