Tiger Woman on Wall Stree (24 page)

“Data like that is immensely powerful,” Yifeng said proudly. “We collect this real time, sometimes even faster than the company itself.” He said his company’s algorithm was reliable and robust, and the company had invested heavily in infrastructure. “The team is ready to go,” he told me.

Yifeng’s greatest asset was his team of talented programmers, whom he had hired and trained over the years to code algorithms to collect and analyze information available online. Over time, Goldpebble had also built a due diligence team, including a call center and a survey team that covered even remote locations across China such as villages in Xinjiang, Inner Mongolia, and Tibet.

By the time we finished our coffee, Yifeng and I had begun strategizing about a mutually beneficial partnership. With his high-powered data processing system and my rigorous analytics and expertise in Chinese businesses, we could identify and arbitrage market inefficiencies faster and more accurately than most.

One kind of inefficiency—valuation inefficiency—refers to a situation in which the value of a stock does not fully reflect timely and accurate information. This is far too common with Chinese
ADRs. With investors and the underlying businesses they are investing in separated by thousands of miles, an 11- or 12-hour time difference, and wildly different languages, cultural norms, and business standards, valuation inefficiencies prevail.

Inefficiencies in two groups of companies have the potential to be particularly advantageous for American investors: Chinese ADR companies and multinational corporations (MNCs) with exposure to China. For MNCs with significant exposure to China, more often than not the China segment of their business drives the price movement in the stock. I consider companies such as Yum! Brands, Mead Johnson Nutrition, Prada, Swatch Group, Richemont, BMW, and Caterpillar, which derive much of their revenue, earnings, and growth from China, to essentially be “Chinese” stocks—though they have the benefit of mostly hewing to Western standards of corporate governance.

These inefficiencies create opportunities for arbitrage based on disconnects in information and understanding. Most investors in both ADRs and MNCs are based in North America and Europe, physically disconnected from their investments in China. That means most portfolio managers acquire information about their investments predominantly from media and analysts’ reports. Both sources are often inaccurate, biased (if not completely false), and delayed. Accurate information eventually reaches investors, but it takes time, sometimes months or quarters. In the case of hard-core frauds like Sino-Forest and Longtop, the truth didn’t emerge for years.

Those with access to better information have a better chance of making profitable trades. But information alone isn’t sufficient. The lack of or an incomplete understanding of China creates another source for arbitrage, what I term knowledge or analysis arbitrage. The knowledge includes proficiency with the Chinese language, familiarity with the Chinese culture and its nuances, and a realistic view of the commercial environment in China. China is
a difficult place for outsiders to penetrate, it having been walled off from the rest of the world for decades by Maoist policies. If I gave one set of data or information to two analysts, one with local expertise and the other without, their interpretations would likely be drastically different or even opposite.

That first meeting with Yifeng piqued my interest. I realized that together we could yield perhaps the best results in the equity research world—especially given the worsening quality of sell-side research as Wall Street firms tightened their belts.

One month later, I flew to Shanghai to conduct my due diligence on Goldpebble. I spent a few days with Yifeng, checking out his IT infrastructure and meeting the rest of the team. I made sure that I met up with his compliance counsel, investigated the company’s compliance methodology, and ensured everything was in line with U.S. procedures and standards. At the end of my visit, I had met my new partner.

Our business is extremely humbling. No one is right all the time. Even reputable analysts can make very wrong calls. As Muddy Waters’ reputation and influence in the market grew around 2012, the firm’s impact started to outpace the quality of its research. The research firm issued a few unjustified “strong-sell” recommendations that sparked market panic and did lasting damage to those unlucky stocks and their shareholders. But for ready minds, those occasions also created special investment opportunities.

“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 report 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.