The reputation of the equity research industry reached crisis point in late 2001 when almost all of the 15 sell-side analysts covering Enron rated the energy firm a “buy” or “strong buy”, right up to the brink of its bankruptcy.
The scandal prompted tighter oversight from the US Securities and Exchange Commission, with rule changes that prohibited equity analysts from being supervised by investment banking staff. Today, employees from the two departments aren’t allowed to discuss research reports prior to their distribution. Nonetheless, “sell” or “strong sell” recommendations are a relative rarity at many banks.
The discrepancy has inspired a different breed of research analysts. Describing themselves as independents, the new research groups aren’t looking for deals and fees from the listed firms they cover. Instead they thrive on short-selling the stocks that they research, and publishing damaging reports on their targets.
Previously the short-sellers had largely focused on Chinese firms listed in New York (see WiC111). However, over the course of this year – and especially in the past month – they seem to have shifted most of their attention to Hong Kong, stoking debate on whether their activities might be detrimental to the broader market.
What has been happening?
An influx of Chinese capital through the Shanghai Connect and Shenzhen Connect has propelled Hong Kong shares to a two-year high. The two trading channels allow investors in mainland China and Hong Kong to invest in each other’s stock markets – and some of the companies that were previously off-limits to mainland investors have registered astonishing gains.
As fears of a correction in the Hong Kong market have grown, the shorters have got more active. According to Caixin Weekly, seven Chinese firms were attacked by short-sellers in 2015 and there were eight cases in 2016. Over the last three months there have been nine raids and this time the prime targets are high-flying Chinese firms eligible for the Stock Connect schemes, especially mid-caps with less-than-impeccable records in corporate governance.
The shares of China Hongqiao have been suspended from trading since March as the Shandong-based aluminium smelter sought to defend itself against a damaging report by Emerson Analytics (see WiC358). Real estate developer Fullshare Holdings has been fighting allegations from Glaucus Investments, which accuses it of manipulating its share price (Glaucus was later joined in its attack by another short-seller FG Alpha).
And Gotham City Research, named after the hometown of Batman, has just picked its first target in Asia: AAC Technologies. AAC is a key supplier for Apple’s iPhones and it is the first time that a Hong Kong blue-chip has been targeted by the short-sellers (see WiC366).
How do the short-sellers operate?
Increasingly, they have been favouring more dramatic announcements about the companies they regard as overvalued. There was consternation earlier this month as Carson Block, the founder of Muddy Waters, perhaps the most high-profile of the short-sellers, told Bloomberg that he had identified a new target, and that he would name and shame the company at the Sohn Hong Kong Conference two days later. (The conference was founded in 1995 in memory of a Wall Street professional who died of cancer.) The tactic worked perfectly, Hong Kong Economic Journal notes, and stoked a “mini panic sell-off “ among a number of Hong Kong-listed Chinese firms, with some plunging more than 10% in price.
Block’s actual target – the furniture maker Man Wah – also dropped nearly 10% before applying to have trading in its shares suspended.
Wolves hunt in packs, and Daniel David, chief investment officer at FG Alpha, revealed another short position at the Sohn Conference, this time against Dali Foods.
“The Sohn Conference in Hong Kong has effectively become a lavish short-selling feast for the likes of Muddy Waters,” Caixin Weekly observed.
More conventional research reports are often deemed less trustworthy if their authors own shares in the company in question. Conflicts of interest aren’t a problem for short-sellers, however, who thrive on taking profit when share prices fall after the publication of their findings.
According to China Securities Journal, some of the short-sellers also sell their research to hedge funds before making the accusations public. “By cooperating with hedge funds, the short-selling force is magnified,” the Xinhua-run newspaper notes. “This has become a new risk factor for fund managers.”
The short-selling sultans have established a reputation for picking up on particular themes. Some of the recurring gripes: gross margins that are unusually high compared to peers; large numbers of connected transactions; mounting debts or bloated receivables; handsome profits but no dividends; and controlling shareholders that have been collateralising their shares for loans (more on this later).
“All of these problems are becoming more widespread and that’s why short-sellers are becoming more active [in Hong Kong],” Daniel David of FG Alpha tells China Securities Journal.
How do companies defend themselves?
The destructive potential of some of the short-seller claims puts bosses at the targeted firms in an unfavourable position. Simply being mentioned can be disastrous. Damage is done even if the allegations are inaccurate or exaggerated.
The opening move is furious denial. The next defensive option is to request a suspension of trading in the shares of the targeted company. This protects the shares from selloffs in the short term, while its management prepares to rebut the allegations. A lengthy suspension can also hurt the raiders (who typically need to borrow a company’s shares before short-selling it) as it increases their trading costs and prevents them from exiting swiftly at a profit. Timber firm Superb Summit has been suspended from trading since 2014 after a Muddy Waters report questioned the accuracy of its accounts. Of course, suspensions like these also deprive longer-term shareholders of the freedom to divest.
Another way to fight off the short-sellers is to look for allies. Since last month, research teams at some of the investment banks have reiterated their “buy” recommendations on AAC Technologies, for instance, and Citic Bank went further in extending Rmb10 billion in credit lines to Fullshare and AAC. Fullshare is an important contributor to the local economy in Nanjing, Bloomberg News has noted, while Citic spoke up directly for AAC, saying that the credit line proved the bank’s commitment to supporting the real economy.
Anonymous Analytics, a short-seller itself, then weighed into AAC’s battle with Gotham City, and unexpectedly published a report of its own that took a bullish line. “The entirety of Gotham’s short thesis alleging undisclosed related parties appears not only false, but it doesn’t even make sense from a valuation perspective,” it suggested. (AAC’s stock went up around 10% after it was freed to trade again.)
To bolster confidence further, AAC’s controlling shareholders have been raising their stakes. Other companies have launched buybacks to prevent their share prices from falling too far. Bruised by its battle with the short-sellers, a senior executive at Fullshare even told China Securities Journal that it has been working to set up an “anti short-selling alliance fund” to help Chinese firms defend themselves.
Another tactic from the targets of the raids is to threaten legal action. Many don’t follow through with the threat and few have prevailed in court, however. A notable exception was China Evergrande, which saw its shares dive nearly 20% in a single session after a damning report from Citron Research (see WiC158). The Guangdong-based developer claimed vindication last year when Hong Kong’s Market Misconduct Tribunal found Citron guilty of presenting a “false and misleading” case. Citron’s founder Andrew Left was fined and banned from trading in Hong Kong for five years.
Should regulators step in?
Hong Kong’s share brokers are particularly unhappy about Gotham City’s attack on AAC, a member of the benchmark Hang Seng Index. “Short-sellers’ reports have become a weapon of massive destruction,” Hong Kong Commercial Daily notes. “The price volatility and trading suspension of a blue-chip has a much broader impact on other market activities such as index futures trading.”
Other short-sellers are embroiled in legal challenges and the outcomes of these cases could have a far-reaching impact on short-seller activity in the territory.
When regulators around the world banned short-selling during the financial crisis, Hong Kong’s market bosses declined to join them. But the irony is that Hong Kong’s share market is fertile territory for bearish investors, with more than a sprinkling of companies whose accounting practices aren’t always as reliable as they should be.
Company executives lament that – having been attacked – they need to spend most of their time preparing materials or meeting with investors to make their case. The extra workload then diverts them from the day-to-day running of their businesses. Then again, the reputations of some of the short-sellers have been boosted by cases in which their criticism hasn’t been far from the truth. Take Huishan Dairy, whose dire financial condition has now been confirmed, just months after a critical report by Muddy Waters (see WiC360).
In fact, one study of the 31 cases since 2011 in which publicly-traded firms have been targeted in Hong Kong suggests that the shorts have been victorious 80% of the time (with a win being defined as a delisting, a long-term trading suspension, or a significant drop in share price). In this regard, the short-sellers can even be seen as providing a service to investors by punishing the poorest performers.
That seems to be the case in the US. “Thanks to the raids by short-sellers, the Chinese firms which have ‘survived’ and remain listed in New York are largely better companies with strong investor confidence, including internet giants Alibaba and Netease,” Caixin Weekly notes. Charles Li, the chief executive of the Hong Kong bourse, seemed to be saying something similar last week when he told reporters that short-sellers could help regulators to identify “cracked eggs” in the market.
How about the A-share market?
For the time being, mainland Chinese investors need not worry about the likes of Carson Block and Dan David. Regulators there have imposed strict restrictions on short-selling. Holding a short position in a company while publishing a bearish report on it, Caixin Weekly notes, is classed as market manipulation.
However, many vulnerable companies can be exploited by the short-sellers when they target mainland stocks in Hong Kong. One particular weak spot: where company bosses have been collateralising their shareholdings so as to borrow money. According to Economic Observer, as of May 24, nearly Rmb4 trillion ($588 billion) worth of shares from more than 1,000 firms had been collateralised against loans, or 7.2% of the total market value of Chinese stocks (compared with less than Rmb1 trillion as collateral before 2013).
Huishan Dairy’s chairman Yang Kai had pledged as much as a quarter of his shares in the company for a loan from Ping An Insurance. Other Chinese firms listed in Hong Kong have got involved in similar shadow banking activity. Once share prices start to fall, there is immediate pressure to sell down some of the collateral, pushing prices lower. So the chances are that the short-sellers have been nosing around this pool of borrowers to identify their next targets.
Another factor in favour of the short-sellers is the herd-like mentality of China’s retail investors, many of whom like to trade on a momentum basis. Prices climb quickly when sentiment is bullish, but they can drop just as fast when investors start to panic.
Of course, the Chinese investors in Hong Kong – utilising the Stock Connect schemes – have little experience of short-selling behaviour. Gelonghui, an internet and WeChat platform for financial bloggers, has become a popular channel in explaining it and some mainland investors have patriotically rallied behind some of the firms in question. Hong Kong’s Apple Daily notes that the share price of Great Wall Motors spiked more than 20% on Tuesday after a bullish report was published on the platform (a major investment bank made the same call on the same day). According to the article, the sudden spike was partly a result of covering of positions, as the carmaker had been one of the most short-sold stocks due to problems with the launch of its new SUV model (see WiC238). Gelonghui predicted Great Wall’s experience may now mimic that of Evergrande, a long-time target for short sellers which has seen its share price more than double in the past three months.
The Economic Observer’s article on the dangers of the collateralised loans also warns that much of the collateral has plunged in value (due to the poor performance of the A-share market in recent months). However, after warning of the disasters that might lie ahead, the author ends by saying that the risks can be managed. The closing advice is likely the result of diktats that the media shouldn’t publish commentary that triggers market alarm. By concluding with a ‘don’t worry, everything is going to be fine’ disclaimer, the Economic Observer has flagged the risk but can say it did not contravene official policy. And in a way this also explains why short-sellers have been so successful with some of their China calls. When so much has to be read between the lines, there is more room for doubt, and more opportunity for uncertainty to be exploited.
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