Tiger Woman on Wall Stree (15 page)

While I had decided not to invest in GET, it turned out to be a successful IPO. But soon after, the stock started to retreat as the husband and wife team missed its revenue targets over and over again.

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Scenes like the one at the St. Regis had become common in New York by that time. China’s seemingly unstoppable economic growth through the global financial crisis impressed many American investors, and Chinese companies were eager to cash in on this sentiment. In 2010, as many as 41 Chinese companies floated their shares on U.S. exchanges—making up more than a quarter of the year’s IPOs, up from 18 percent in 2009 and 13 percent
in 2008
. China-based IPOs posted an average return of nearly 30 percent, compared with approximately 19 percent among all IPOs over the
same period
.

Investors hurried to lunches like the one at the St. Regis not just to learn about the company that was being touted, but also to test the waters to see how hot an IPO would be. A big crowd indicated that the IPO was likely to be oversubscribed—meaning that investors wanted more shares than were available to buy—and therefore that the stock would “pop,” or soar up from the IPO price. Investors could then offload their shares for an “instant alpha,” a quick effortless profit for the lucky bunch who managed to get a piece of the deal.

The lunch also gave investors face time with the key underwriters, the banks that would sell the company’s shares to the public during an IPO. To get a piece of a white-hot offering, small funds and individual investors had to be sure they were at the lunches. And if the temperature was really hot, as almost all Chinese IPOs were at that time, merely showing up at the road show wasn’t enough. Desperate would-be investors had to write thoughtful
thank you notes afterward and persistently call their brokers at the underwriting banks, providing their feedback on the lunch and reiterating their interest.

Altogether, this was some serious bowing and scraping. But the investors had to do it. Otherwise, unless they worked at a multibillion dollar fund, they wouldn’t get a piece of that instant alpha.

All this hype created a lot of converts, drunk with blind faith in the China growth story. But one peculiar character stood out the most. In my mind I nicknamed him “Knucklehead.”

Knucklehead was an ancient guy who came to all the IPO lunches, rain or shine. He was born and raised in New York and had lived there all his life. He had never been to China and didn’t speak a word of Chinese, but he had a passion for everything about the country. He raved about Chinese paintings, slurped soup dumplings with relish, and had an obvious appreciation for Chinese women. But above all, he loved Chinese stocks—especially the pops.

Knucklehead caught the China bug from Baidu, the homegrown search engine that now dominates the Chinese market. Baidu’s stock popped 354 percent on its IPO debut in August 2005, the kind of instant alpha not seen since the dot-com boom 15 years before. From that day on, Knucklehead made sure that his butt was in a chair at every China IPO lunch.

I first met him at the lunch for Youku, a video site that was being billed as China’s YouTube. I was surprised to see him attending the road show for an Internet company, a sector that usually appeals to a younger crowd. It wasn’t until later that I learned that he didn’t use e-mail and could barely find his way online.

At one point during the lunch, he leaned over to tell me that he owned Baidu. “What a great stock,” he said loudly. “I bought it at $27.5. It’s a five-bagger,” he told me, using an insider term that meant he had quintupled his initial investment. “It’s one of the largest positions I have in my portfolio.”

I sensed he was fishing for a compliment, so I congratulated him.

“Do you own it, too?” he asked.

When I said no, he looked disappointed, even offended. He asked me why.

“I’m concerned about their overmonetization problem,” I said.

“What?” he yelled back at me.

“It’s kind of complicated to explain,” I told him. “But have you been to their website? People think it’s a search engine, but that’s not exactly true.”

“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 wrote 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.

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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.