Luckin Coffee wanted to become the Starbucks of China. The company was incorporated in 2017 and opened their first stores in 2018. Within 2 years of incorporation, they went for IPO in 2019. And by Jan 2020, it manages around 4,507 (Jan. 2020) stores and has exceeded the number of Starbucks stores in China.
Sounds impressive until the cover up was exposed and the share price tanked by 81% in one day.
Luckin ran out of luck and I was lucky not to invest in Luckin.
Some principles helped me. First, I don’t buy IPOs because insiders have very big advantages over retail investors. We don’t know what we don’t know and they tend to IPO during bull markets to get higher valuations. Second, I take short sellers’ reports very seriously.
I came across an anonymous research damning Luckin Coffee in early 2020. Muddy Waters published it and took a short position. I shared it in our Ask Dr Wealth Facebook Group on 2 Feb 2020.
We believe that Chinese companies will be the future MNCs of the world and we can find them listed on the stock exchanges in Shanghai, Shenzhen, Hong Kong and the U.S.
However, we are skeptical at the same time because Chinese companies have high incidence of frauds (watch The China Hustle).
Hence we have a 3-step fraud prevention approach when investing in Chinese companies. But today I just want to focus on one of the steps in this article, that is, to follow short sellers. Be sure to sign up for their email alerts to help you keep ahead of others in investing.
#1 – Muddy Waters
Muddy Waters first came to fame in Singapore when they shorted Olam. The short seller was taking on our sovereign wealth fund, Temasek, whom the latter was a Olam shareholder. Eventually Temasek made an offer to buy more stake that it didn’t already own and Olam was saved as a result.
Let’s go back to the Luckin Coffee case. The report was prepared by an anonymous party but published under Muddy Waters’s name.
The investigative effort to uncover this case was massive. A total of 11,260 hours of store traffic video were recorded. The collection was carried out by 92 full-time and 1,418 part-time staff employed by the anonymous short-seller. They also gathered 25,843 customer receipts.
This is something that a retail investor has no means and resources to carry out and hence we leverage on their findings to help sharpen our investment research.
They compared the reported financial results with the data collected on the ground and here are some of their findings:
- the number of items per store per day was inflated by at least 69% in 2019 3Q and 88% in 2019 4Q
- inflated its net selling price per item by at least RMB 1.23 or 12.3%
- Luckin’s revenue contribution from “other products” was only about 6% in 2019 3Q, representing nearly 400% inflation
Below are samples of the receipts they collected for their investigative work:
They also dug the background of the insiders:
- Luckin’s Chairman Charles Zhengyao Lu and the same group of closely-connected private equity investors walked away with USD 1.6 billion from CAR while minority shareholders took heavy losses.
- Luckin’s independent board member, Sean Shao, is/was on the board of some very questionable Chinese companies listed in the US that have incurred significant losses on their public investors.
- Luckin’s co-founder & Chief Marketing Officer, Fei Yang, was once sentenced to 18 months’ imprisonment for crime of illegal business operations when he was the co-founder and general manager of Beijing Koubei Interactive Marketing & Planning Co.,Ltd. (“iWOM”).
Besides Luckin Coffee and Olam, they have attacked Anta Sports, Sino-Forest, China Huishan Dairy, American Tower, St Jude Medical and more.
You can subscribe to their email update here.
#2 – Blue Orca (previously Glaucus Research)
Just the beginning of 2020, we had a heart attack when Blue Orca Capital attacked one of our stocks, China Medical System (HKEX:0867).
We documented the episode in a previous article. In short, it was a fantastic growth stock with double digit growth rates, and rising earnings, free cash flow and dividends over several years. Drug distribution in China has a strong long term prospect due to a large ageing population. But Blue Orca accused them of inflating revenue and claiming non-existent tax savings from a shell company in Malaysia.
I heed short seller reports seriously and decided to err on the safe side. Settled for a 34% gain eventually. The share price is still hovering around where I have sold but we don’t know what may happen next.
Blue Orca shorted companies such as Samsonite, Pinduoduo and a handful others.
The track record for Blue Orca, including Glaucus Research (Blue Orca and Bonitas Research were formed after the partners at Glaucus Research part ways), was excellent at 82% success rate with an average return of 51% as of end Feb 2020.
You can subscribe to their email updates via the website.
#3 – Bonitas Research (previously known as Glaucus Research)
Bonitas Research got more well-known in Singapore when they attacked Best World (SGX:CGN), which was a darling small cap among investors. Simply because it had an exceptional performance in an otherwise meek Singapore stock market – Best World’s share price had gone up by 140% in less than a year.
Bonitas Research wasn’t the first to sound the alarm bell. Marissa Lee of Business Times raised her doubts when she couldn’t verify Best World’s claims through her ground work. Bonitas Research published their report two months after the Business Times article, one of the key accusations was that Best World overstated its 2017 net profits by at least 130%.
Best World has been suspended from trading since 9 May 2019.
Bonitas Research has attacked Hengxindai and Bosideng among others. Follow them here.
#4 – Iceberg Research
Iceberg Research was famous for the whistle blowing efforts against Noble Group, then an STI component and a giant in the commodities business.
The mysterious outfit claimed that Noble had over-inflated the value of an Australian investment for years. The battle ensued and it took 3 years to prove Iceberg Research was more right than wrong. Noble was suspended in Nov 2018 and had to do major debt restructuring subsequently.
Now they set their sights on Trafigura and Nyrstar, both are in the commodities business.
Follow Iceberg Research here.
Trust, but Verify
Investing in stocks is not only about picking good stocks, but also to avoid bad ones. It takes a lot of time to dig and investigate in depth. Hence, we should leverage on short sellers to help us avoid frauds. We should thank them and not hate them.
