‘Corruption is incentive plus stupidity,’ says J Capital's Anne Stevenson-Yang
Anne Stevenson-Yang is a director and co-founder of J Capital Research, a New York firm and short seller that specialises in Chinese companies, as well as international companies looking to grow their business in China. GlobalCapital spoke to Stevenson-Yang about the dangers of trusting financial reporting from China, and steps stock exchanges could take to stifle the likelihood of fraud.
Stevenson-Yang told GlobalCapital that she never feels starved for opportunities, when it comes to finding targets to short. She said that far from the number of cases of fraud out of China diminishing, companies are just becoming more sophisticated at hiding it.
Stevenson-Yang lived in China for 25 years, initially starting out as a journalist there. She told GlobalCapital her move to China was prompted by two things: it was hard to get ahead in journalism in the US and a China job gave her the opportunity to learn another language. She set up J Capital along with her co-founder Tim Murray in 2010, having returned to New York and begun a career in finance.
The firm started as a subscription service, with up to 20 hedge funds paying fees for the firm’s reports. But now J Capital publishes several reports on companies publicly, and has developed a reputation for its exhaustive primary research. Famous targets, both of which have subsequently collapsed, include Luckin Coffee and Wirecard.
J Capital's expertise lies in particular in uncovering details via primary research of Chinese companies listed in North America or Europe, or alternatively international companies that are growing rapidly in China.
On Wednesday, at the Contrarian Investor conference, Stevenson-Yang announced a new short idea: Staar Surgical, a company that makes implantable contact lenses. It is listed on the Nasdaq, headquartered in California and reports a growing business in China.
GlobalCapital has contacted Staar Surgical for comment.
GlobalCapital: Accounting irregularities have plagued Chinese companies listing in Europe and North America for years. But are blatant frauds becoming less frequent?
Anne Stevenson-Yang: I would say it's actually quite a bit worse now than it was five or 10 years ago. The US market as well as any market has always been seen by Chinese companies as just a bucket of gold. The aim is to be the company that catches it.
10 years ago, the frauds were small and super obvious because nobody was paying any attention. For example, I visited a company in China back in 2010 or something like that, looking to learn about the agriculture sector. The company, which is actually still listed by the way, is called China Green Agriculture. I go to the desk and it's got a different name and I say, where's China Green Agriculture and she says ‘What's that?’ I said, ‘Well it's your listing company’. To which she replied, ‘Oh, we have a listed company?’.
Back then you had all these brokers running around China that would say, ‘Hey, I'll find you a shell company to reverse this into and give me a chunk of shares and I'll get you a bunch of money’.
There's a whole industry in New York of snakeheads [Chinese people smuggling gangs] who will put together a team of illegal immigrants from China to staff your restaurant or your store or whatever. All I have to say is ‘I want two cooks, five waiters and two busboys’ and then they'll send them over. I think it's kind of the same thing.
You had these packagers who put together a CFO and an IR team and all these people you need on a little plate, and say ‘give me shares in return and we'll make sure that your shares go up at least 50%’.
There were brokers that were just flat out corrupt and would send people in to create financial statements for these companies out of whole cloth and [who] knew exactly what they were doing and then there were brokers that just kind of didn't know.
I always feel like corruption is incentive plus stupidity. In sentiment terms it was based on the idea the Chinese economy was growing like mad and the Chinese consumer was going to be internationally dominant. You have massive amounts of money to be made by brokers and promoters, and then you have a lot of people in that industry who are really not that swift. Yeah, so those two things together, to create corruption.
This sort of simple fraud became clearer, though. By 2012 or 2013 people started to get wise to it and Chinese companies couldn’t do that anymore.
But it's not like Chinese companies became more and more honest, they just became more and more savvy. Now you get much larger companies which have financials that are much harder to figure out. The Chinese government has colluded in hiding their information by making it unavailable to auditors, no longer disclosing customs statistics, no longer providing tax data, you know, all that sort of thing. And these companies just grow and grow and grow and God knows what's under the cover.
GlobalCapital: Many short sellers, like Carson Block for example, think that if certain Chinese companies post a year of less-than-good numbers it’s because they want to ‘appear human’. Is that your view too?
You don't get the same level of innocence now. I remember there was a company listed out here called Rino, and it was a flat out fraud for a whole bunch of reasons. But I rang [someone there] because they'd just announced all these new contracts that were really big. I said, ‘Hey, what about these contracts’, and he said, ‘Oh, those aren't real – I just said that’. I actually couldn't use that because it was inside information. That kind of like flat out innocence, you don't find that a whole lot anymore.
Instead, you get companies that are really professional at creating numbers that you simply can't figure out. Take Alibaba, my poster child, it's always spending a billion dollars here, a billion there, making acquisitions and then the next quarter it'll report how the acquisition does and it will just disappear. So suddenly you just have no idea how this company that they spent $2bn to acquire is doing, and then hey presto, they write up their fair value based on all of these acquisitions.
What companies really need these days is a source of cash, so that you can push money through the accounts and sort of pull the wool over the eyes of the auditors. There's a lot of competition to list in China, and that winnows out a bunch of the companies so what happens is you get these companies that have access to cash flows one way or another, usually by owning a payments tool. And with that payments tool they can push money through their accounts and so they're the ones that look like they're really, really growing.
GlobalCapital: In terms of scale, in your judgement, how many Chinese companies listed in North America would be committing some level of fraud.
I would challenge anybody to name a company, whether Chinese domiciled or foreign domiciled that gets more than 30% of its revenue from China that does not have [some level of] corruption in that 30%. It'd be kind of a fun little exercise to just name a company at random and see what I could find. Sadly, I think I could find a lot.
GlobalCapital: Is there something about China specifically that makes it more fertile ground for people like you to uncover cases of fraud?
The Chinese state just views companies listing overseas as not [within] its purview. As [it affects] American investors, it doesn’t see it as their business. In any case there's just a ton of fraud on the Shanghai and Shenzhen markets. So, if they were to start saying, ‘you US-listed companies have to be more honest about your accounting that would really show up some others. I don't think it's something specifically cultural to China. It's a combination of very neat markets — in other words, a lot of foreign and domestic cash — and the excellent job the Chinese government does at persuading the world that it’s just a growth machine.
GlobalCapital: How do you start researching companies?
It’s probably more art than science. You have to look at the liquidity, the short interest, whether people know about this company or not.
You have to look at who covers it and who owns it too. If you know a big chunk is owned by Warren Buffett then you don't want to touch it, and the same is true of some other investors. You just look for companies really that are outliers — you know, why should this company be growing 25% when its peers are all growing by 5%.
And then you look at outline margins. For its industry, is it really reasonable for an auto parts company to be making 50% gross margins.
Then you look at the proportion of revenue in cash in China. The proportion of cash held in China tends to be a red flag, particularly as the renminbi is not convertible. There's no good reason to be holding your cash overseas. If you're not reporting it back to the US, and using it to issue dividends or to invest in something, you kind of have to wonder why.
GlobalCapital: A high profile case you were involved in recently was Luckin Coffee. What were the red flags for you there?
First of all, it's ironic, don't you think, that everybody’s talking about the online, offline business model, the asset-light business model and how great that is? Then all of a sudden it's greater to have assets.
With retail chains you always worry about central control, gross versus net reporting, and particularly about capex.
Luckin was just a kind of logical thing. Living in China, I often met people in their neighbourhoods at coffee shops. I've met a lot of people at a lot of Luckins, and I can't tell you how many free coffees I’ve gotten.
You can just use a different number or email address to register and they give you a free coffee, and it just started me thinking – what are all these coupons they're issuing for the free coffee. Is this growth they're reporting reasonable?
I started looking into Luckin for that reason, and the more you look, the more you found.
GlobalCapital: How often can you not find adequate information to make a call one way or the other?
Oh, frequently there'll be a lot of red flags but we just can't figure out what it's about, or you can't tie the ends together so you just have to leave it alone.
A lot of companies that report really high cash balances and keep, say, 85%-95% of their cash in Asia. You think, that's kind of weird; why would they do that?
But you have no way of checking the cash balance or maybe you know they've got $500m, and they reported net interest income of $20,000 so that's a little wrong, but you can't prove this, because they don't have the money.
For the most part it's because there are little clues but you just don't have any information.
GlobalCapital: But I don’t get the impression you’re starved of opportunity.
There are plenty of fraudulent companies and plenty of shorts to go around. The question is [about] which ones will the market believe you, and which ones you really have a case for.
I never worry about running out of targets, I only worry about things like the market going vertical for no good reason.
GlobalCapital: What about international businesses looking to grow into China? A lot has been made of Chinese companies listed in the US being fraudulent but international companies developing in China can fall into difficulty too.
That's very common. What happens is the stock market really wants companies that will grow in China, and maybe your company just isn't doing enough there and the shareholders are saying, ‘You know what, you just don't have enough international experience, find somebody who understands China and get in there’.
Eventually management may just throw up its hands and say fine, and buy a company in China, or set up a joint venture that you control, or hire a chairman of China, who then hires a bunch of staff. And management may say go figure out growth to that chairman, and provide them with a whole bunch of share options and a big payment for reaching a certain amount of turnover.
So then the share price keeps going up and the US team may wonder about it and be sceptical about why the shares are rising.
This happens often. I’m thinking of a particular company which I won’t name but the China chairman is looking at a huge pay-off for reaching a certain amount in revenue, so they’re going to reach it one way or the other.
I think it's actually awkward for the few companies that have local Chinese teams that just want to report what's actually happening. Their peers are all talking about 16% growth and so it's really awkward on the calls if they’re reporting like 5% growth or whatever. They’d get dumped and the US will hire a more aggressive team. You’re kind of damned if you do and damned if you don’t.
GlobalCapital: What could regulators or stock exchanges do if they took this stuff more seriously. There are, I suppose, very obvious things.
The first steps to take, as you say, are quite obvious. The first one is the PCAOB [Public Company Accounting Oversight Board] needs to be able to access audit records, and if China says these are state secrets, then they should not be able to list on US exchanges. Don't give them a three year period to comply, just delist them.
The second thing is to demand data. Chinese data is always going to be problematic as long as the Communist Party is in charge of deciding what the government data is, but nevertheless, they haven't provided detailed customs statistics to the foreign platforms. Lately, the SEC just needs to be more activist. When you have these cases of companies flagrantly not complying with the rules, the SEC needs to move more quickly into an investigation and delisting.
But there’s a kind of unholy conflict of interest, right? The SEC, the companies that run the exchanges, the brokerages and so forth — everybody is basically doing a sales job, rather than a regulatory job.
GlobalCapital: Do you think this will happen or do you think your role and other short sellers’ roles will remain similar to what it is now for the foreseeable future?
This business has been around for a long time. I don’t worry that the model will just disappear. And if it does, it won’t be because of the regulators.
Alibaba did not wish to comment for this article. China Green Agriculture did not respond to requests for comment.