I do not normally comment on what is happening unless through my podcast, but the demise of Luckin Coffee two weeks ago forced me to write this.
I have to say that precisely two weeks ago I felt incredibly proud of the short-selling community.
Luckin Coffee, previously a multi-billion-dollar coffee chain that should have been the Chinese answer to Starbucks, the high growth machine, plunged 80% due to the management’s admission of alleged fabrication of sales, over $300 million of these.
You had many of the world’s largest investors involved with Luckin betting on the perceived skyrocket growth only to find that they really do own a chain of coffee stores which is losing money hand over fist.
I felt extremely proud of short-sellers for two reasons.
The first reason is obviously tied to the work the community can produce. The reports targeting Luckin showcase just how great it can get.
Both the anonymous report reposted by Muddy Waters and the work done by Ash Illuminations are done well. Especially because the idea of the thesis was actually quite simple. They went and sat in Luckin stores to see whether the sales make sense and whether the reporting of Luckin is honest.
Now simple does not mean easy. They went into several hundred stores to track this. They carefully sampled stores from all Tiers of Chinese cities, they aggregated online orders from smartphone receipts, they looked at which products are being sold, which are not. The breadth and depth of the research are astonishing.
In short, they did the job to be statistically significant and the reports did become significant two weeks ago.
The second reason why I felt so proud of the short-selling community is that it again proved that somebody knew.
I saw one tweet which was saying that nobody knows anything anymore when you can dupe some of the world’s largest investors who should be doing the most sophisticated due diligence.
But someone knew and for many people reading this it is of little surprise that it was short-sellers. However, in my view, the work of Ash, Muddy and many others is still wholly underappreciated. They are underappreciated by society because I believe not many people look at short-selling as a function of the market with the best motivation to uncover wrongdoing or fraud.
If you ever want to start an interesting discussion start with the question; who do you think is best motivated to find fraud in the public markets?
For some readers, this might even include a bonus amusement as I have sometimes encountered answers such as the auditors of course! Yeah right.
For me, it is clearly short-sellers. Short sellers do the job when the government does not want to or can’t do the job. Short-sellers will do the due-diligence when nobody wants to. They will discover conflicts of interests, they will find the accounting gimmicks.
Why? Because they can get paid for it.
Now, I do not want to lighten anything that the government and the SEC are doing, but we have seen time and time again that many of the responsible agencies are just not doing enough. In the case of Europe even doing the reverse such as in the case of Wirecard.
Luckin Coffee is a Chinese company listed in the US which turned out to discover serious wrongdoing. It is not the first one, just watch China Hustle. I am sure it is not going to be the last one, and technically that is also already the case as TAL Education had to admit their own wrongdoing.
Apart from short-sellers and the government you might have the investigative journalist who might be focused on finding fraud. However, their position is incredibly hard. They have zero certainty and I can imagine that many times people do not get paid even a tenth of what they should for the work they did.
Marc Cohodes likes to say that short selling is an activity pursued by people with brain damage. That it is just too crazy to do. Well, I’d say a study of brains of investigative journalists is in order.
Due to all this, I see the activist short-seller as an investor who is best wired to expose fraud and will continue to do it.
Many of the market participants certainly understand that short-sellers are in it for the money (besides whatever other motivations they might have). I mean this is a popular catchphrase! Shorts only want the profit and want to see the stock down, they do not care about anything else.
But many people understand it in the wrong context. I think the motive of making money is extremely underappreciated in terms of the context that they are the only one to have that motivation in this specific way.
I am sure someone made their retirement money shorting LK. This is why it works.
This is why the short-sellers have such a rich history of successfully pointing out fraudulent practices with the same excellent work we have seen at Luckin.
Due to all this, I am and was extremely proud of the community.
And of course, my whole point is not something new for many readers, but I would say that it has to be repeated. Short-sellers themselves should keep on repeating this. Many people I encounter still do not understand what is short-selling and why it is extremely important to preserve it.
In the end, I just want to ensure that people will think of short selling as a vital mechanism which exposes fraud in the market.
Mind you, I am not saying short-selling is some sort of holy grail that only deals with exposing fraud, but this part is extremely crucial.
Finally, I would like to just quickly talk about Citron as some people say; oh how could I navigate the situation if even short-sellers among themselves are not sure about LK. However, I would argue that one could understand the situation even without some sort of privileged access.
After Citron came out with the famous tweet, which Muddy now retweeted (a fair play on their part), you had JCap coming out with their own assessment of the situation around Luckin. What was important in that report was that JCap did an assessment of the consultancy report that Citron used to go long LK.
Basically, one consultancy was hired to do a check of the reports written by short-sellers to verify whether they are on to something or not. The consultancy firm did the same thing as the short-sellers, they went in and counted the people and all that. The conclusion of the report was that the short reports are wrong.
JCap publicly refuted the consultancy report in a way where people who did not have first-hand knowledge of the situation could easily see that consultancy report was not entirely credible.
The most striking thing was the datasets. The shorts presented data for several hundred stores. The consultancy did so for ten stores. Such a small dataset can be hardly convincing. Furthermore, JCap discussed how the methodology of selecting stores was also flawed. It almost seemed as the classic auditor stuff, don’t dig too deep because you could find something.
In any case, this just shows that people outside the inner circles could actually understand what is going on and form an opinion. Investors should not forget that this is possible. You could have double-checked the information, make up your mind and actually enter a position. It is fair to point out that I am doing this with hindsight bias, but let’s not forget that the possibility was there.
I would end by repeating that nobody should fall into the state of ‘nobody knows anything these days’, ‘why bother’ etc. Even though you can see obscenities such as TAL Education actually not dropping much after ‘discovering wrongdoing’.
This kind of mood is exactly the state where fraudsters will thrive. Do not think that China is somehow exceptional when it comes to fraud. They might not be as adept at hiding it, but lies, obfuscation and fraud have been with humanity forever and everywhere.
Jan Svenda 