Here’s what to watch out for in China, says shortselling activist


Carson Block has long been an outspoken skeptic of Chinese equities. The activist short seller has raised red flags regarding corporate malfeasance, accounting irregularities and outright fraud in the Luckin Coffee case last year, and called on regulators to delist Chinese companies from U.S. stock exchanges. Regulators pay more attention: Securities and Exchange Commission published rules earlier this month for delisting Chinese companies that will not comply with US auditing standards, allowing a three-year transition for now.

Block moved to China in 1998, shortly after college, with the intention of starting an equity research firm focused on A-listed listed companies. But New Jersey-born Block, who grew up helping his father report on U.S. micro-capitalizations, says he’s struggled to get Chinese companies to answer even the most basic financial questions, while Stock manipulators he encountered were all only too happy to brag about their methods. . He moved to law, working on mergers and acquisitions and foreign direct investment with the international law firm Jones Day. He also made a foray into starting a self-service storage business in China before founding Muddy Waters in 2010, an investment research firm that researches fraud and fundamental issues in China and beyond.

From the start, Block warned of reverse mergers, which gave Chinese companies access to US government markets, and allegations of fraud at Sino-Forest; Canadian regulators later discovered the company had committed fraud. Today, he is particularly concerned with a corporate structure known as a variable interest entity, or VIE. These are offshore shell companies that Chinese companies use to access US markets – investors do not directly own the underlying Chinese company. Block’s warnings found a receptive audience among policymakers; President of the SEC Gary Gensler echoed his concerns.

Barron spoke with Block over the phone from his new Austin, TX office about why U.S. investors should rethink investing in China, how he sees the write-off push playing out, and why passive funds are making difficult life for short sellers. A modified version of our conversation follows.

Barron: Chinese companies are now subject to more scrutiny. Are regulators finally listening to you?

To block: It’s hard to talk about today in isolation and ignore the arc of how we got here. We published the first successful Chinese company fraud exposure with Orient Paper, and from 2010 to 2012, short sellers exposed more. Many companies have gone bankrupt and have been written off. But what China did was smart: they used [their] banks to take some companies that were heinous frauds private, betting that if you put real money in the pockets of American investors who have long been doing this obvious frauds, it would help erase their memories.

Carson Block.

Photograph by Josh Huskin

Between 2013 and 2014, the SEC basically said [investigating this sort of fraud] produces black holes with time and effort. And since China has cleaned up the mess somewhat, the zeitgeist has moved on. Everyone’s memory had been erased, and by 2014 everyone wanted a piece of the


Alibaba Group

[BABA] IPO, so we were off to the races.

Last year you published a report on the Chinese version of


Starbucks

[SBUX], Luckin Coffee, saying he exaggerated his results. Around the same time, sentiment about China started to deteriorate. What changed ?

Covid was sweeping the United States and [former President Donald] Trump was doing badly in the polls until his re-election, so he went into “blame China” mode massively. Luckin played in there. While Senator Marco Rubio has been advocating the Holding Foreign Companies Responsible Act since 2018, he suddenly found a very receptive audience in the White House.

This paved the way for the SEC to delist Chinese stocks that do not comply with audit disclosures.

It could be unprecedented, so I’m not sure the SEC feels very comfortable taking this down. [delisting] way, but they’re going to have to, in the end. The question is how many companies will be voluntarily delisted before the SEC.

Large companies like Alibaba have already secured secondary listings in Hong Kong. Will others follow?

China wants to avoid making it look like Chinese companies are being kicked out of America, so they’re going to make it look like they’re leaving. The problem is, Hong Kong doesn’t have the cash to absorb all of these companies.


Have I got
‘s
[DIDI] The United States’ proposed delisting portends similar actions by many other Chinese companies listed in the US Tier 1. Tier 1 companies can re-register. But they’re going to have to organize a number of Level 2 company acquisitions to avoid too many Hong Kong listings and draining cash.

How will American investors fare?

Investors are excited that poor Chinese ADRs are going to be acquired and could make money. The first time [about five years ago, when the Chinese government facilitated taking several Chinese companies private], there was a motivation to keep the US markets open for Chinese companies in the future, so [Beijing] paid a premium. This time around, it’s more likely that no one wants to pay that much. Companies will have to design misfires or bad neighborhoods and send the stock to the toilets, with [Beijing promising it] will make sure someone buys them. You have to believe that the numbers reported by these companies are what they want to be — and I believe they are.

How widespread is this?

We believe that the more “real” Chinese companies generally represent around 20-30% of their turnover, and we have seen many Chinese companies represent around 90% of their turnover. For example, we worked with Wolfpack Research on their 2019 short film by


iQiyi

[IQ], which came out of


Baidu

[BIDU] and we have publicly declared that it is a fraud. [In August 2020,


iQiyi

said it had engaged advisers to conduct an internal review of the allegations.]

I find it remarkable how people rationalize equity investing in China and try to dismiss what I say as bad apples. This is what we supposedly learned from the financial crisis: When you give the finance people this choice – face you win and face you don’t lose – it leads to bad results. This is clearly the situation with China. In its colonies with [U.S. regulators over accounting fraud], Luckin only returned a minority of the money they collected through fraud in the United States, and it was the most successful resolution ever to a confirmed fraud in China!

Asset managers don’t seem to be deterred by this and are enthusiastically developing business in China. What should investors remember?

I never thought that China was investable. The thing that China did in a great strategic way that never crossed the mind of the Soviet Union was for China to co-opt the American elite, be they Hollywood or financial, by giving the most important people real economic stakes in China. By doing this, they make it more difficult for the United States to politically muster the will to confront China. Should you participate in this co-opting of our elite and further corruption of our system? It should be a moral choice, but I realize that the vast majority of investors will laugh at this statement outside the room. If you think the future of the world is in totalitarian regimes and you don’t mind, then of course take charge of China.

Beijing is making major policy changes, emphasizing social good over profitability and seeking to become more self-reliant. How does this affect the investment outlook?

A lot of [institutional] investors had convinced themselves that they were so indispensable to the Chinese Communist Party that they would never be caught off guard by sudden changes in policy. It is clearly proven to be wrong. China will only treat foreign investors well for as long as it needs to. If you aim at China for long, you are submitting to the whims of a dictatorship and a US-China relationship going in the wrong direction. Expect to be caught off guard again.

Considering your point of view, why aren’t you shorter in China now?

We are not publishing a long / short book based on a macro thesis. We are there maybe five times a year with a new candidate. Gathering evidence is difficult, especially when the environment on the ground is very hostile. We published a report on GSX, and it locked [the data] so people couldn’t recreate the methodology. [


GSX Techedu

is now


Gaotu Techedu

(GOTU). The company declined to comment.] These companies are much more resilient than they should be.

In China fraud 1.0, you could monitor empty factories and offices. In China fraud 2.0, you see [it] of the tax treatment because when you have false profits it is difficult to get the correct taxes. But we never could [make an activist short case] on the basis of taxes. We have to bring such strong evidence of fraud to get people to say there is a problem.

The bull market has not been easy for short sellers. What does the opportunity look like more broadly?

It’s harder. The range of opportunities is growing every day in terms of speculative companies, but the markets are increasingly driven by the flow of funds. The big change here is passive investing. Passive [funds] will not sell unless there are exits, and they must buy at any price when there are entries. So the floats effectively get smaller, even though the percentage of public ownership on the screen doesn’t change. This can make stock prices parabolic.

With fewer investors active in the market, when the flows reverse, there will be no one to catch the knives as they fall. The market is on a relentless bullish march, especially with companies in popular indices, but it is increasingly fragile. I have no idea when, but when it breaks, it breaks really hard and really fast.

Thanks Carson.

Write to Reshma Kapadia at reshma.kapadia@barrons.com


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