Gaining by betting against flimsy Chinese firms

(Jennifer S. Altman/ FOR THE WASHINGTON POST ) - Sahm Adrangi, principal at Kerrisdale Capital Management, is seen in offices on July 18 in Manhattan, N.Y. Adrangi runs a fund that roots out fraud at Chinese companies then shorts the stocks.

(Jennifer S. Altman/ FOR THE WASHINGTON POST ) - Sahm Adrangi, principal at Kerrisdale Capital Management, is seen in offices on July 18 in Manhattan, N.Y. Adrangi runs a fund that roots out fraud at Chinese companies then shorts the stocks.

Sahm Adrangi works with six other people in a small room on Madison Avenue with a view of an adjacent brick building. He doesn’t speak Chinese. He’s never set foot in China. At 30, he claims no special insight into the sources or durability of the Chinese economic miracle.

Yet he has managed to dig up enough information to wreck the fortunes of several Chinese companies — while building up his own.

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Two years ago, Adrangi, a 2003 Yale graduate, left an investment banking job and set up a small hedge fund, largely with money from himself and his parents, as well as a few other supporters. Since then, his red-hot fund has increased sixfold, partly a fortuitous accident of market timing but mostly a product of his ability to spot flimsy Chinese companies listed on U.S. markets — which he bets against by short-selling them.

The firm is tiny by hedge fund standards, with $20 million under management. But Adrangi has promoted his bets through newsletters and online postings that savage U.S.-listed Chinese companies he views as “scams.” In doing so and doing well, he has grabbed the attention of eager U.S. investors and fearful Chinese executives — not to mention U.S. regulators who are trying to keep track of about $20 billion worth of small- to medium-size Chinese companies listed on U.S. exchanges.

Here are a few samples of Adrangi’s scathing assessments:

China Education Alliance “is mostly a hoax,” he wrote of a Chinese for-profit education firm, which then had a $150 million market value on the New York Stock Exchange and is now worth less than $25 million. The company’s Harbin “training center” — which CEA said had “17 modern classrooms” for 1,200 students — had no desks and was all but empty, Adrangi said. It boasted of online revenue, but its Web site didn’t work.

China Biotics claimed to have more than 100 outlets for its nutritional supplements; Adrangi said he hired researchers who checked all the company’s business addresses and found only four outlets. Later, on June 22, the company’s auditors resigned, citing “irregularities” that might “constitute illegal acts” and for which the board had “not taken timely and appropriate remedial actions.” The company is contesting a shareholder suit in Washington that makes the same allegations.

China Marine, a maker of snacks and an algae drink, reported revenue to China’s State Administration of Industry and Commerce that was 85 percent lower than what it reported in U.S. filings, Adrangi said. The company reaffirmed its U.S. reporting, but on Aug. 8 (considered an auspicious day in China), it announced just $1 million in quarterly profits, down 85 percent from a year earlier.

Noting extremely high profit margins claimed by one of China’s battery manufacturers, Adrangi wrote that he believed the firm was “fabricating its SEC financial statements.” He added that the company’s battery plant “is either the world’s most spectacular battery manufacturing facility or the company’s financial statements are fiction. We believe it’s the latter.”

The companies have disputed Adrangi’s assessments, insisting that they are not misleading U.S. investors or regulators. CEA, for example, called Adrangi’s darts “unfounded allegations.” Its chief financial officer, Alice Lee Rogers, whose predecessor left the company March 1 for what the company said were “health reasons,” said that Adrangi was “not tell[ing] people the true story” and that CEA was a “legitimate business.”

“Most of these companies are making something,” Adrangi replies, “but they’re just overstating their numbers.”

One in a chorus

Adrangi is just one of a growing number of investors who are openly publishing their skepticism about small Chinese firms while betting on a steep fall in their stock prices. They include Carson Block, a former Jones Day lawyer and head of a Shanghai storage company; he writes for muddywaters­research.com, which is named for the Chinese proverb “muddy waters makes it easy to catch fish.” John Hempton, a one-time civil servant, trades from his beachside home in Australia. The dean of the group is retired Texas real estate developer John Bird, who helped blaze a trail for the rest of them in 2009 when he picked apart the financial statements of China Sky One Medical, a maker of diet patches and hemorrhoid ointments.

All of their targets are drawn from the more than 300 Chinese companies that since 2004 have taken advantage of a technique known as the reverse merger. It is a sort of backdoor way into the prized U.S. capital markets. It works like this: A Chinese company seeking access to U.S. capital markets swaps its shares with the shares of a U.S.-listed company that has fallen on hard times and has been reduced to nothing more than a shell.

Usually the U.S.-listed company takes on a new name, appoints new directors, reports glowing results from its new Chinese operations and raises millions of dollars by issuing stock and luring new investors. And it does this without having to go through the regulatory steps that would be required for a newly listed company, especially one based in China.

But Adrangi and others have alleged that often the numbers don’t add up. They have hired researchers who have visited the companies’ facilities and found that they often bear little resemblance to what was described in statements made to investors or the Securities and Exchange Commission. Moreover, the companies often submit wildly different — and much worse — financial data to Chinese authorities than they do to U.S. investors.

John Mattio, who handles investor relations for China Marine, says Chinese microcaps are no more troubled than U.S. microcap stocks. He also says short sellers attach too much importance to information the Chinese firms give to provincial offices of the State Administration for Industry and Commerce. These are organizations that issue permits, Mattio said, not disclosure or tax agencies where the figures matter more. Nonetheless, China Marine quickly hired a new auditor and corrected its reports in China, asserting that its U.S. disclosures were truthful.

The dispute has piqued the interest of the SEC, which created a “cross border working group” in 2010. Between March and May this year, more than two dozen Chinese firms lost their U.S. listings, said John Nester, an SEC spokesman. Although mergers are a matter of state law, the SEC can look for fraud and question auditors.

There is a whole infrastructure for the reverse merger industry. Pieter Bottelier, former head of the World Bank’s Beijing office, said that in 2009 he was an invited speaker at a high-powered conference at a fancy hotel in Shanghai’s Pudong district. But, he said, the economic overviews weren’t the main events. He said it was “essentially a promotion” for a U.S. firm wooing Chinese companies interested in reverse mergers, and hundreds of Chinese executives came to listen.

Sometimes sophisticated investors are taken in. Hedge fund star John Paulson and former AIG chief executive Maurice “Hank” Greenberg have both suffered sizable losses in Chinese firms listed here. And some Americans who are directors of these companies have sought legal counsel about their exposure.

Activist roots

Adrangi has taken an accidental route to the China investment field. Born in Iran, his parents moved to California when he was 5 and then to Vancouver. His father, an engineer in Iran, bought a fencing company. Adrangi attended a prestigious boys’ school and then went to Yale.

When he arrived, he was an activist. As he wrote in an article in the Yale Daily News, he wanted to “stick it to the man and topple the evil capitalist empire.” Six months after the chaotic trade talks in Seattle in 1999, he traveled to Washington to protest trade policies at the World Bank and International Monetary Fund meetings.

But, he says, he grew disaffected with protest groups, which expected him to agree with a wide range of positions, only some of which he shared. He majored in economics, grew more conservative and, like many undergraduates, fell into a routine of schoolwork and beer pong, while becoming an editor and a columnist at the Yale Daily News.

Initially he sought a career in journalism. He had internships at the National Post and then the Globe and Mail in Canada. He read “Barbarians at the Gate” and Roger Lowenstein’s book about Warren Buffett. He wrote earnings stories and features, including one about a pair of Canadian mining experts who were for the third time building a mining company that they would eventually sell to a bigger firm for healthy profits.

But he wasn’t able to turn those internships into a full-time job. So he moved to New York and went to work for Deutsche Bank. He applied to law schools and deferred three of them. He never went. Instead, he moved to Long­acre Management, selling distressed assets of bankrupt companies. Then he went out on his own.

Attack mode

Initially the fund wasn’t focused on Chinese companies. Even today it has invested in about 100 non-Chinese companies, including wireless companies in Africa, a Costco-like retailer in central America and an Internet bank in the United States.

But then Adrangi read about Bird and called him for advice. Bird told him that looking at the books of Chinese reverse merger firms was like listening to someone claim they drove 300 mph to arrive on time for dinner. “The sales were outstanding, but it didn’t make sense,” Adrangi said.

Adrangi’s first forays into attack mode were anonymous because he feared retaliation or lawsuits. He created a Web site and posted brief items pointing to companies he believed to be hyped. The SEC forbids hedge funds from soliciting customers on the Web, so Adrangi made no mention of his firm, Kerrisdale Capital, or his fund.

Then he read signed reports about Chinese reverse merger companies and he began to do the same.

He took aim at China Education Alliance. The company went public in 2004 through a reverse merger. The company says its revenue has grown from $3.1 million in 2005 to $37 million in 2009, and net income from $1.7 million to $15.2 million.

The company said it distributed educational materials online, but Adrangi found through researchers that the Web sites didn’t work, payment mechanisms didn’t function and traffic on the company sites was slow. He then compared the company’s financial results with other companies in the online education business and found that CEA claimed similar revenue despite having “a tiny fraction” of their traffic. In one case, CEA reported 50 percent more revenue than a competitor with one one-hundredth the Web traffic.

Meanwhile, he sent researchers to the company’s training center. They took photos and video of the virtually empty building, which he posted. CEA said it had more than $12 million of revenue from the center.

Since Adrangi first posted his attack on CEA, the company’s stock has plunged from $4.50 a share on Nov. 26, 2010, to 76 cents on Aug. 22 — even though the CEA chairman has bought $1 million in shares to bolster the price, chief financial officer Rogers says.

Adrangi also made money shorting China MediaExpress, a firm that operates television advertising on inter-city express buses. A darling of China investors, the company’s auditors resigned, the stock price collapsed and in time trading in the shares was halted. And Adrangi profited from the collapse of Rino, a Dalian-based maker of industrial pollution control equipment. The stock, which once traded as high as $35 a share, has since been taken off the exchange.

Now, ferreting out hyped Chinese companies has become a cottage industry for hedge fund managers and investors — all of them with big financial stakes. As short sellers, they profit when other investors come around to their view and the prices of the stocks tumble. But finding overpriced Chinese companies has become more difficult.

For Adrangi, it has been in­cred­ibly lucrative. In 2010, its 81.5 percent return (before fees) crushed the Standard & Poor’s 500-stock index’s 15.1 percent gain. Aside from its bets on a few U.S.-listed Chinese companies, its portfolio “roughly tracked the market,” Adrangi said in a letter to investors, warning that “we do not have a magic formula” for “generating outsized returns.”

Three months later, more Chinese reverse merger companies “imploded,” Adrangi told investors, and his firm Kerrisdale Capital rang up more big gains. Its top five investments were all shorts of U.S.-listed Chinese firms. The run continued in the second quarter, when the fund returned 54 percent (before fees) against 0.1 percent for the S&P 500.

‘Shining sunlight’

Are the short sellers being unfair? Or libelous?

The SEC’s Nester said “there have always been shorts who take dim views of companies and then the objects of the lack of their affections complain that they are bad-mouthing them to make money.” He said the commission has no view on this. “You have to look at the entire scope of behavior,” Nester said. “Markets have people whose interests do not coincide.”

Another SEC official, who would not speak for attribution, said that “the federal securities laws are based on shining sunlight and then letting people make their own decisions.”

Adrangi said he has received complaints but has never been sued.

Although Adrangi has skewered many Chinese companies listed in the United States, he has little sympathy for investors who lose money on them.

“The responsibility belongs with investors who make these investments,” he said. “No one should be relying on the SEC or underwriters to protect them.” He said that if investors “end up holding the bag, that’s just the way capital markets work.”

But he conceded it can be hard to see through the stories the companies spin. “Historically, stock scams are promoters promoting stories. The actual numbers will tell a more truthful story,” he said. “If it’s a mining company and there is nothing in ground . . . the numbers don’t lie. The people do. The trick here is that the numbers are made up.”

 
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