by Junheng Li
Out of curiosity, I called up one analyst who had issued a strong buy rating on the stock.
“What’s there to love about this stock?” I asked him. “It seems like terminal cancer to me.”
“Well, you know, they are working on the pipeline . . . a bad quarter doesn’t mean something good won’t happen in the future,” was his lame answer.
“Why don’t you upgrade it when good things indeed happen?” I tried to be polite. “For now, it’s a crapshoot. And you are recommending a crapshoot to the Street?”
“Yeah, but . . .”
Over time, I learned that “Yeah, but” is a typical defense when an analyst can’t downgrade a stock he or she knows is bad. Sell-side analysts are often caught in a tricky position: they run the risk of sabotaging the bank’s relationship with powerful companies if they express negative opinions about a stock. Because of this conflict of interest, their ratings always have a positive bias.
“Know your enemies and know yourself and you will not be imperiled in a hundred battles,” Sun Tzu wrote in The Art of War. The conversation with the analyst gave me extra comfort that I was way ahead of the crowd in my due diligence, and I added on to my position. In the following three quarters, Sunlight missed its estimates again and again. Eventually the Street’s sell-side analysts were all forced to downgrade the stock, and its price collapsed to about $3. Since I borrowed the shares at $12, I made a respectable 80 percent profit in less than a year.
Short selling is not hard. It just takes independent thinking and a lot of groundwork to analyze any difference between the company’s underlying business and its perception in the market—as well as the guts to bet against the market. After that, it is all about having the patience to watch as the movie plays out on its own.
CHAPTER 8
Learning, Burning, and Crashing
ONE SUNDAY IN THE SUMMER OF 2007, I WENT TO BEST BUY TO perform “channel checks”—analyst-speak for a third-party investigation of distribution channels to verify how well a product sells. This time, I bought my research partner and boyfriend, Andrew, to join me in playing the role of a married couple shopping for a GPS gadget—to help us navigate from Manhattan to our weekend house in Vermont, no doubt.
I had met Andrew, an Irish-born American from North Dakota, at a colleague’s party. Tall, fit, and blue-eyed, Andrew was a senior investment professional at a multibillion dollar hedge fund founded by two former Goldman traders in the summer of 2003.
I remember our first conversation at a cocktail party at a mutual friend’s apartment in Manhattan. We didn’t get along too well: Andrew took the opposite view on a medical device company that I liked, claiming that its heart monitoring technology was ineffective in predicting heart failure. The disagreement led to a dinner at which we planned to exchange research notes on the company. The dinner went very well. We realized that despite our drastically different conclusion on that particular investment, we had a lot in common. After the non-date date, we quickly became best friends and close colleagues. In 2008, we got married, just about a year after we met.
Most of the dates Andrew and I went on did not take place in restaurants or theaters. Instead, he would accompany me on field trips and to my office over the weekend to brainstorm investment ideas or help me build financial models. Andrew knew how to entertain me—not with flowers and lavish gifts, but with endless intellectual stimulation. For us, a trip to Best Buy to analyze and discuss new tech products was not unusual.
We were there that day to investigate Garmin, a U.S.-based tech company that made only one type of product, portable navigation devices, including the global positioning system (GPS) devices that people kept in their cars at the time. The company was at the top of my short list. To help it keep its shelf space at stores like Best Buy, the company relied heavily on spinning out new models for its navigation devices, with various features or in different colors. Garmin had a strong brand name that allowed it to charge high prices, but my suspicion was that competition would soon push into the segment, bringing prices down. That could trigger a collapse in Garmin’s stock.
By now, I was a seasoned technology investor, enthusiastic about all gadgets and technological devices. I would often go to this Best Buy store in Noho (a neighborhood in New York City north of Houston Street) to check out the latest technology gadgets. On the corner of Houston and Broadway, it sat on prime real estate in one of the priciest shopping neighborhoods in New York. The Noho store was buzzing on the weekends, which provided plenty of material for real-time field research. To get an idea of what consumers thought of a product, I would chat with the shop assistants; compare features, reliability, and prices among different models; and eavesdrop as other customers discussed what they wanted to purchase. Sometimes I would even jump into their conversations, asking whether they favored certain models over others. This was harder to do by myself than with Andrew. My all-American boyfriend—with his nonthreatening, midwestern manner—always put strangers at ease.
After an hour of this research on Garmin, I decided to conclude my field trip before someone caught on to me and realized my true intention. One salesperson became suspicious when I was grilling him on different models of wireless routers. He thought the product company had sent me to monitor sales in the store. Since then, I only went to that Best Buy on Sunday, his day off.
“Did you learn anything new?” Andrew asked.
I pulled him aside to be discreet. “I’m afraid that the competition is getting tough for Garmin. TomTom and Sony are coming after it aggressively.”
“How do you know?” he said.
I told him that Sony’s latest model cost $200—one-third of Garmin’s—and offered very similar features. The sales guy had also told me that TomTom, Garmin’s European competitor, and Sony in Japan would both introduce more affordable models with virtually the same features in just a few weeks. I believed this competition would be the catalyst for a profitable short play.
Andrew was intrigued by my passion for gadgets like GPS devices. Once out of the store, he told me that my eyes had been shining as I shared my analysis. I told him it was because I had spotted something that the Wall Street analysts glued to their financial models had not yet noticed: Garmin’s sales cycle had peaked. Garmin’s stock also had a price/earnings ratio of 20, far more than that of most technology companies with only one successful device. That’s why I was excited.
“But their latest models look really cool,” Andrew said, reminding me of the slim pink model I had picked up.
“Do you really expect consumers to pay $400 more for a pink device they leave in their car?” I asked him. One tip that Jason had drilled into me was that, in the fast-evolving technology business, hardware companies that depend on spinning out different versions of a single product always get crushed. Dell, Palm, and Nokia had all suffered this same fate: they created products that captivated consumers, but eventually new market entrants created enormous pricing pressure, which in turn killed their profit margins. One could go long on these stocks for a limited window of time, when they were growing their market share. Eventually, however, they all became credible shorts.
Later that year, Garmin marked the entrance of a competitor that would prove even tougher than TomTom or Sony. Google launched the second version of its mobile maps application in November, a technology that quickly made even the sleekest and cheapest GPS clunky and obsolete. People began pulling out their smartphones to look for directions, and demand for stand-alone GPS devices sank.
* * *
For four years at Aurarian, as I said, I worked like a maniac without realizing it. I became a CrackBerry addict—slang for someone attached to his or her BlackBerry at all times. I had to be ready to answer e-mails at any time of the day or night. Jason would message me with random questions on everything ranging from the newest laws on Internet gambling to changes in the tax credit status for geothermal companies. These requests disrupted many dinners and workout sessions, not to mention
my sleep. But I loved the constant intellectual stimulation of covering so many industries and the challenge of zipping through these requests. I got into the habit of typing out my thoughts (fearful that I might forget them) as they came to me. More than once, a truck almost hit me when I was crossing a street and typing notes to myself or to Jason.
My typical day started at 5:30 a.m., when I would head to the gym. I would get in four miles on the treadmill while simultaneously watching CNBC and reading that day’s Wall Street Journal. By 7:30 a.m., I was in front of my four computer screens, glancing through the news headlines for the companies in our portfolio. I would then spend most of my day talking to companies—ones we were invested in, ones we were interested in investing in, and everything else in between, including competitors, customers, and suppliers. I never really ate lunch, but rather snacked on nuts and fruit throughout the day to ensure my energy level remained high and steady at work. My brain usually crashed around 6:30 p.m., so I’d go back to the gym for a short workout to recharge.
If I didn’t have a business dinner, I would do more work from home. I would either work on my financial models on my laptop (it was hard to model during the day in a busy office), comparing the assumptions and earnings estimates in my own model with those of the Street analysts, or speak with contacts in China before calling it a day.
I also spent countless hours on the road. When it comes to researching companies, seeing is believing, and I traveled extensively to company headquarters to meet investment targets on their own turf. Unlike broker-sponsored investor conferences, which usually take place at posh locations, some of the industrial companies our fund was interested in were based in places in the United States so remote that many Americans had never been to them.
These memorable trips included a visit to North Dakota to see a company that claimed to have a technology to convert animal waste into ethanol. I remember standing in an animal waste processing facility in February, half of the building open to the air despite the subzero temperatures. I toured the facility and chatted with the company’s site engineers for a few hours to understand the technology and its commercial applications. I was underdressed in my New York fur coat, freezing my butt off. Many of the workers—clearly entertained to see my fur coat among their usual sea of Carhartt overalls and work boots—asked to take a picture with me.
Another time I traveled to a frigid Duluth, Minnesota, to check out an iron ore company’s on-site exploration firsthand. I spent several days on various sites hanging out with the construction workers. At the end of the trip, I developed a nasty skin rash. I’m still not sure whether it was from the hard hat, the rubbery turkey sandwiches I ate for lunch and dinner a few days in a row, or the sheets from my aging motel.
My obsession with work came at a sacrifice: I wasn’t exactly living the lifestyle of an average young professional woman in Manhattan. That didn’t bother me, though. At Aurarian, I was obsessed with learning about stocks and the market, and I put in insane hours, with my signature intensity. As a result, I had established a reputation as a winner—a stock picker with good eyes for home runs. I was run down physically but very satisfied with my career.
I was beginning to understand why this business belongs to the young and hungry. To succeed in this business, one has to operate at peak condition 24 hours a day, 7 days a week, for a simple reason: globalization means that the investment universe is in action 24/7. Asian markets open just a few hours after the U.S. stock market closes at 4 p.m., and in between investors can trade the European markets. There was never any time for boredom or idle reflection, as the work never ended. There was always another stock to nail, another company to visit, another analyst to call. The intellectual stimulation never stopped, and neither did I.
Investing in China
By 2006, it was hard for anyone on Wall Street to dismiss the surge that was going on in Chinese IPOs. Being a prudent investor who had never been to China, Jason initially avoided Chinese stocks. “It’s still a Communist country, after all,” he would say. “I don’t want to wake up one morning and find the company I invested in being nationalized.” He knew there were good momentum plays among Chinese companies, but he didn’t have the stomach for the risks that went with investing in an emerging market. This view was not uncommon among more conservative investors at the time.
At a certain point, however, dealing with China became unavoidable. Aurarian was a small-cap fund focused on innovation of all sorts—high technology, medical devices, and green technology were our specialties. China was becoming well known as the world’s factory, making everything from MP3 portable music players to solar panels and wind turbines. Production of all kinds of critical goods was shifting to China, especially in the two sectors I followed closely, semiconductors and green technology. With cheap labor and low costs, Chinese companies seemed destined to put their American competitors out of business.
At the time, the third wave of Chinese companies was invading U.S. capital markets. The first wave of Chinese IPOs began coming to U.S. markets in the 1990s. These companies were state-built empires in strategic industries such as insurance, energy, and telecommunications, monopolies constructed with generous government funding and protection. They had gone public not of their own volition but as part of Beijing’s “go-out” initiative to list state-run businesses overseas. The idea was that the IPOs would bring improved business practices to the companies while also building China’s image abroad as an economic superpower.
The second wave of Chinese companies hit U.S. exchanges in the early to mid-2000s. These firms were sexier than their predecessors because they operated in hot industries such as technology, consumer products, and media. These companies sought out American markets to raise capital and obtain the prestige of a U.S. stock ticker symbol. Many went to the United States because they were as-yet-unprofitable high-tech start-ups and therefore couldn’t satisfy the listing criteria of the Chinese exchanges, such as having three years’ minimum profitable operating history. For those companies, Nasdaq was a suitable listing destination, as it brought together high-risk, high-growth companies and offered an investor base that was experienced and willing to bet on innovative business models for a potentially big upside.
Names like Baidu, Ctrip.com, and New Oriental Education & Technology quickly became Wall Street darlings due to their industry-leading positions and the familiarity of their business models. During their IPO road shows, these companies were pitched as “the Chinese Google” or “the Chinese Expedia”—except, given the size of the Chinese market, they were expected to soon dwarf their U.S. equivalents. These were terms every U.S. investor could understand and was all too willing to pay a premium for. Most of these Chinese IPOs debuted successfully, and their managers returned home as heroes armed with handsome market capitalizations.
Many companies in this second wave of IPOs were in certain restricted sectors, such as technology, media, education, and healthcare, in which Beijing limited or prohibited direct investments from foreigners. The Chinese companies used something called the variable interest entity (VIE) structure to circumvent that rule and gain access to international capital markets.
The structure is essentially a series of contract agreements that give foreign investors control but not technical ownership over companies operating in China. Since equity holders do not actually have a claim on the company’s underlying assets, the structure is inherently risky. The risk is often compounded by worries of China’s opaque legal system and weak law enforcement.
One incident in early 2011 shook investor confidence in these structures, which some estimate apply to nearly half the Chinese companies now listed in the United States. Alibaba, the largest e-commerce company in China, transferred ownership of its online payment system Alipay to a Chinese domestic company held by Jack Ma, the founder and CEO of Alibaba. Yahoo, which owned more than 40 percent of Alibaba shares via a VIE structure, claimed that it was blindsided by Ma’s move, which was done without
the approval of Alibaba’s board. The incident alarmed foreign investors because it set a high-profile example of the inherent risks in investing a company while its underlying assets are at the discretion of management and the Chinese state. Prominent investors such as David Einhorn at Greenlight Capital sold their shares in Yahoo immediately after the dispute broke out.
* * *
The third wave of Chinese IPOs, which rushed to join the party on the American exchanges around 2006, presented problems of its own for investors. At the time, China’s private sector was gathering momentum, and a slew of some 400 smaller companies, so-called piggybackers, rode in on the high tide of U.S. investor optimism toward China. Among this group were many small Chinese companies that snuck into U.S. exchanges through backdoor listings, in which a company injected its assets into a listed but defunct shell company, thereby getting listed with less regulatory scrutiny from the SEC than it would have experienced in a standard IPO. This group was dominated by mom-and-pop businesses that often dealt in commodities, such as agriculture or resources. Many were located in rural areas, making it hard for investors to do due diligence. Today, many of these companies have been delisted—some voluntarily, after being taken private by management or private equity funds, and some involuntarily, after failing to comply with SEC requirements.
Getting listed in the United States is a pricey undertaking, and the application process requires jumping through a lot of hoops. But for many Chinese companies, it was worth the effort. Smaller Chinese firms typically sought out an American exchange listing, and especially a coveted Nasdaq ticker symbol, for the prestige. Getting listed on an American exchange was glorious, to modify Deng’s phrase—it was a sign these companies had made it. Once listed, they could also use their stock as a currency to compensate their employees and to acquire other assets and businesses.