Tiger Woman on Wall Stree

by Junheng Li

  I’ve seen corruption in practice since I was in school, when I witnessed families bribing teachers so that their children would get better grades. It’s hard to blame the well connected for taking advantage of their positions, given that cronyism is now so rampant in China. An individual makes a principled stand against this corrupt system at his own political, social, and economic risk. Therefore, few do.

  While corruption is innate to all emerging markets, including Africa, Latin America, Eastern Europe, and the former Soviet Union, China is uniquely handicapped by its double status as an emerging and centrally planned economy. Many Chinese have observed that the spread of corruption is closely linked with China’s massive infrastructure build-out, which was fueled by the 4 trillion RMB ($586 billion) stimulus plan in 2009. The stimulus triggered huge investments in megaprojects that temporarily staved off a recession in China, but also spurred a vibrant economy of corruption.

  From an economic perspective, corruption is a form of rent seeking in which privileged parties in a system extract value from their political or social position. The Chinese government takes money from the population in the form of taxes and fees, as well as through less obvious channels, such as providing artificially low returns on deposits at state-owned banks. Much of this revenue is then channeled into government-led investments. But along the way, wealthy and connected politicians and businesspeople siphon off much of the money.

  I believe that a big portion of government-led infrastructure spending in 2008 trickled out in the form of bribery, embezzlement, and kickbacks, all of which went to the connected and enfranchised. Interestingly, shortly after Beijing released its massive stimulus package, Macau casino stocks began to soar, led by those companies with the most exposure to VIP gamblers from the mainland. Between the start of the recession and the end of 2012, Galaxy Entertainment Group, Sands China, Melco Crown Entertainment, SJM Holdings, and Wynn Macau all saw their stocks appreciate 3,000 percent, 300 percent, 530 percent, 1,000 percent, and 100 percent, respectively. The observed correlation between infrastructure spending and Macau casino business supports my hypothesis that a big portion of the stimulus was wasted as corruption rent.

  This government-led spending has not only wasted money; it has also embedded corruption from allocating contracts and approving bank loans into the engine of the state-driven growth plan. As a result, the party’s economic objectives are deeply intertwined with the profiteering of its affiliates. Chinese people joke about why the government prefers fiscal measures to stimulate the economy: monetary expansion or tax cuts just don’t offer the same kickback opportunities.

  In developed economies, the private sector tends to attract talent, because it tends to be more entrepreneurial and efficient and therefore offers better financial rewards and more exciting career opportunities than jobs in state-owned enterprises (SOEs). In China, however, the SOEs have the upper hand in attracting and retaining employees, due to hidden perks associated with corruption. Especially in recent years, China has seen a surge in the number of college graduates both taking the civil service exam necessary to get government jobs and applying to work at SOEs.

  The government has thrown in with the crony class and has cut the many millions of hardworking people with fewer connections out of the profits of China’s economic growth. This has worsened the already-wide income gap between the rich and poor in China and furthered social anxiety, causing the Chinese people to lose confidence in their government.

  It is hardly a coincidence that as corruption blossomed with Beijing’s stimulus package, the global fashion houses saw Chinese demand for Western luxury goods surge. Luxury sales in the mainland expanded an impressive 30 percent in 2011, making it one of the world’s fastest-growing markets. High-end stores sprang up. Shin Kong Place, a luxury shopping mall that opened in Beijing in 2007, recorded store sales growth—a matrix measuring retail store performance—of 30 to 50 percent annually.

  The hunger for luxury goods also spilled beyond the Chinese borders, as many Chinese went abroad to buy luxury goods to avoid high domestic taxes. Stores catering to the wealthy in major shopping destinations such as Tokyo, London, and New York began employing Mandarin-speaking salespeople and stocking Chinese teas. Chinese shoppers had become the world’s preferred customers; by 2012, they consumed one-quarter of the world’s luxury products.

  Well-known luxury brands—such as Swiss watchmaker Richemont, the owner of Cartier; Swatch Group, the owner of Omega; LVMH, the owner of LV brands; and PPR, the owner of Gucci and Bottega Veneta—benefited handsomely from the stimulus, witnessing 20 to 30 percent sales growth year over year in Greater China (including Hong Kong and Macau) between 2009 and 2013. CEOs of high-end companies came to view their brand’s China momentum as the defining source of their future success.

  But events in 2012 and 2013 called that assumption into question. After occupying Nanjing Road in Shanghai and the trendy neighborhoods of Guomao and Chaoyang in Beijing, these brands couldn’t wait to invade China’s small cities, only to realize that few people in China’s less populated cities could afford diamond watches or luxury handbags. At roughly the same time, global luxury brands discovered that their revenue was vulnerable to policy changes.

  The reason had to do with the source of Chinese demand. It is impossible to get an accurate number of how many luxury items are bought for personal consumption as opposed to being given as gifts—often as bribes. JL Warren, my research firm, estimates that for high-end Swiss watches with price tags of more than 50,000 RMB (roughly $8,000), 40 to 60 percent of purchases are for gifting. Although most analysts attribute the surging demand for luxury products to the rise of China’s middle class, these figures clearly imply that currying business favors is a powerful driving force in the market.

  Another powerful source of demand for luxury items comes from what I call China’s “mistress economy.” A slew of sex scandals in China at the beginning of 2013 showed just how much power and sex go hand in hand in China. One Guangdong deputy chief was sacked after evidence emerged online that he had 47 mistresses, while sex tapes made by a property developer led to the firing of 11 officials in Chongqing.

  In China’s male-dominated culture, many officials keep a beautiful, refined mistress draped in Prada—or keep dozens of them if they can afford it. Infidelity is rife among all class levels in China, but among officials mistresses have become a de rigueur status symbol similar to flashy Cartier watches and luxury cars.

  Chinese mistresses are unique in that they have far more material demands than their counterparts elsewhere. These young Chinese women are in a search not for love, but for cash, high-end apartments, expensive cars, and logo-emblazoned luxury products. They know that their affairs almost certainly have expiration dates; like everyone else in China, they are trying to amass as much wealth as possible before their luck—or their country’s—runs out.

  One company that benefited from both these trends was the high-end Swiss watchmaker Compagnie Financière Richemont SA (already mentioned above). After entering China around the onset of the global financial crisis in 2008, Richemont saw its sales grow 20 to 30 percent per year. The company owns many global leading luxury brands, including Cartier, IWC, Jaeger-LeCoultre, and Vacheron-Constantin. Due to its sky-high prices, almost all Richemont’s brands were sought after as gifts to grease palms in Chinese business relationships. Richemont saw a surge in demand from Chinese consumers both in and out of the mainland that pushed the company’s stock up 230 percent between 2009 and 2013.

  But good things usually don’t last, especially in China. Judging by consumer behavior—such as how many watches were purchased in bulk and how many watches were bought without adjusting the band size to the buyer’s wrist—store managers and their distributors estimated that roughly 40 to 50 percent of purchases were intended as gifts. This high percentage of gift-driven purchases left the company’s business vulnerable to changes in the political environment and policies. Richemont’s revenue was w
hat stock analysts call high risk, meaning it could dissipate unpredictably.

  That is exactly what happened in 2012. The Swiss company experienced a slowdown in business around the time of the once-in-a-decade leadership transition in November. After realizing how much popular resentment their old bosses had caused, China’s new leaders, led by Xi Jinping, the country’s president, launched an anticorruption movement. The government restricted or banned the giving of many extravagant traditional gift items, ranging from the ill-tasting Chinese liquor Mao Tai and the famous Longjing green tea to Hermès bags and Swiss watches with price tags of more than 50,000 RMB (roughly $8,000 at the time). To convince the masses that Beijing was serious about this new policy, Xi also required all senior officials to liquidate their real estate assets overseas or else risk being removed from the party.

  Today, with nearly 50 percent of its revenue coming from China, Richemont is effectively a China story, a company whose sustainability relies largely on Chinese consumer demand. In a recent conference call to investors, CEO Johann Rupert was asked about the prospects of the company’s growth globally. He answered, “I feel like I’m having a black tie party on the top of a volcano. . . . That volcano is China. . . . the food’s better, and the wine’s better, and the weather is great, but let’s not kid ourselves. There is a volcano somewhere, whether it’s this year, in 10 years’ time, or in 20 years’ time.”

  Richemont has felt the pinch of the anticorruption measures, but it is far from alone in that. Gucci’s parent company, PPR, revised its China strategy and decided to hold back new store openings in 2013. LVMH, another popular luxury brand in China (largely because of its conspicuous logo, which appeals to a Chinese pack mentality), was also caught off guard by the unexpected slowdown and decided to call off its expansion into smaller cities.

  Many analysts failed to foresee the slump because they didn’t realize that the growth of these stocks came in large part from free-riding the corruption boom. Many sell-side firms ascribed these luxury names a high earnings multiple under the assumption that the demand came from the ever-rising Chinese middle class.

  In reality, the demand came from a tiny portion of the population with concentrated power and privilege and therefore wealth. But since this power and privilege shift with the change of bosses in Beijing and the policies they create, this demand should be considered risky. On Wall Street, risks should translate into a valuation discount. Analysts ought to assign this group of stocks a China discount, not a China premium.

  * * *

  Before I left China that summer, I had a conversation with an old friend, a former CFO of a few publicly listed companies. It drove home the point that the country was gripped by a crisis of confidence. I had stopped in Beijing for a few days, and he insisted on picking me up in the latest addition to his fleet of Porsches—a sleek black SUV. Given that our lunch destination was only a few blocks away, sitting in the snarl of Beijing’s notorious traffic for far longer than it would have taken to walk was a bit over the top.

  Over the phone, he had said he had some business to discuss with me. I was looking forward to hearing what he had in mind. After some idle chitchat over dim sum, my CFO friend cut to the chase so fast that he didn’t even bother to remove the chicken foot he was gnawing on from his mouth. “Can you recommend some good hedge funds offshore for us to invest in?” he asked.

  Even someone as connected and successful as my friend didn’t feel safe leaving his wealth, mostly garnered from pre-IPO stock options, within China’s borders.

  At the same time that many American investors were trying to get their money into China to benefit from its economic growth, Chinese investors were trying to get their money out—even if they had to break the law to do so. A survey by Global Financial Integrity, a nonprofit research organization in Washington, D.C., showed that China was the source of nearly half of the world’s $5.9 trillion in illicit capital flows, or money that leaves its home country illegally, between 2001 and 2010.

  There is a gaping disconnect between the American perception of modern China’s economic miracle and its reality. China’s economy is buzzing, but it hinges on an institutional environment in which the rule of law and transparency have not kept up with its growth and success. Despite the vast wealth generated in China over the past 30 plus years, the country has begun to stall. Fear, uncertainty, and a sense of injustice and resentment toward the government are prominent, including among those who work for it and benefit from the unequal opportunity. This disconnect might take a while to travel to the Western world and reach U.S. investors, but ultimately it is sure to get there. It is just a matter of when.

  CHAPTER 13

  Muddying the Waters

  February 2011

  MY SIX-WEEK TRIP TO CHINA WAS PRODUCTIVE FOR WORK AND for healing on a personal level. Being close to my family provided much-needed strength and confidence to start a new chapter in my life in New York. At the same time, everything I saw in China convinced me that both Wall Street and the rest of the world had gotten the China growth story wrong.

  On the 14-hour flight from Shanghai to New York, my mind was buzzing with new ideas. The conversation with Nick and my private equity friend, enhanced by Johnnie Walker and green tea in the lobby of the Four Seasons; the visit to my childhood home and Nanjing Road, so transformed with its neon lights and luxury brand stores; the milk scandals, the high-speed rail crash, the rampant growth of Macau casino business, and the burgeoning corruption economy—all swam around in my mind.

  The China miracle had happened all too fast, at the cost of the quality of the transformation. Those who have spotted the disconnect between the quality and quantity of China’s growth are still ahead of the curve and stand to profit handsomely from this observation—or at least not crash and burn when the illusion crumbles.

  * * *

  My plane came to a halt outside the gate at JFK airport. I collected my luggage and wheeled it outside to wait in the taxi line. The New York air felt pristine and fresh compared with the thick Shanghai smog I had breathed in just hours before. I inhaled deeply. Then the ping of my BlackBerry brought me back to earth.

  Skimming through the dozens of e-mails I had received during the flight, one caught my eye. An independent research firm had issued a report alleging that CLF was a fraud and detailing its dubious corporate governance and financial reporting. The report alleged that the company’s managers pocketed most of the proceeds they raised from shareholders for personal use, rather than buying equipment to grow the business as promised. The report backed up its claims with photos of idle factories, empty store shelves, and interviews with purported clients who claimed they actually had no affiliation with CLF.

  In the following months, CLF failed to file its annual report for 2010 and fired its auditor, Ernst & Young, one of the Big Four accounting firms. As a result, Nasdaq halted trading in the company’s stock in May 2011.

  The banker buddy I bumped into at the Four Seasons did not fare any better. Shortly after I returned, I read in the news that the SEC was investigating Nick’s advisory firm regarding its activities in China, although I never heard any definitive results.

  As in many other SEC investigations of U.S.-listed Chinese companies, no one was ultimately held responsible for these frauds. CLF’s managers are still at large and living well on the money they stole from investors, just like many other Chinese executives who were involved in fraudulent dealings. The company’s stock is still drifting on the Pink Sheets, an over-the-counter market with fewer restrictions than the Nasdaq.

  CLF’s downfall held an important lesson for investors: stick to sizable companies with proven operating records in major cities. The longer a company is around, the more historical information its investors have to base their analyses on. The company’s location can also affect its performance. Small companies in obscure locales have a hard time accessing and retaining talent; therefore the quality of their employees and their management is often compromised.
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  Unearthing Fraud

  CLF was just one of the many Chinese frauds that floated to the surface in 2010 and 2011. Several independent research firms had begun making names for themselves by uncovering suspicious practices at Chinese companies in a broad range of industries. These research outfits were mostly small or even one-person firms, staffed by forensic accounting nerds and former investment bankers who operated out of homes and coffee shops. They worked like a pack of lions, circling the herd and separating the weakest companies for the kill.

  Muddy Waters, the China-focused research firm, emerged as the most influential of these outfits. Carson Block, its Harvard-educated American founder, had possibly been burned a few times doing business in China. Muddy Waters’ business model is to uncover fraudulent business practices.

  Block issues only one rating on the companies he covers: strong sell. Judging from stock price movements around the time he publishes his reports, most of Muddy Waters’ clients are fast-moving hedge funds equipped with short-selling instruments—as well as perhaps some mutual funds, which subscribe to his research to avoid any stock in his radar screen. Here’s how I believe the model works: Block typically sells his latest findings about a specific target to his inner circle of clients first, allowing them time to build a short position (or unload a long position) on a stock. Then he hands the evidence he has gathered to regulators such as the SEC, sometimes prompting an investigation and therefore investor panic. Finally, he releases a report, filled with data, pictures from on-site visits, interviews with related parties, and other supporting evidence, detailing how the target of his allegations has committed misconduct or fraud.

  As Block built up his credibility, his attacks became self-fulfilling prophecies. Just by issuing a report, Muddy Waters would trigger panic selling and a sharp decline in the value of the stock, enabling his clients to make a handsome profit or avoid a deep loss. Although it has never been publicly stated, I suspect that this is his business model.