Tiger Woman on Wall Stree (31 page)

I can attribute much of my achievement to an intense focus on and discipline in my work. My father’s quintessential tiger parenting ultimately resulted in an American success story built with Chinese strengths. Unfortunately, my single-minded focus on succeeding in my career has also come with some painful personal lessons. From these, I have learned that unbalanced growth is never sustainable. When I analyze China and its economy today, I often remind myself of this life lesson.

I am in the equity research business because I firmly believe that the equity market is
not
efficient. The efficient market hypothesis asserts that financial asset prices fully reflect all available information at all times and that therefore no one can systematically outperform the market by using an informational advantage. The efficient market hypothesis says that you can beat the market only through luck. The spectacular and repeated failure of the efficient market hypothesis has barely dented its popularity, even following the financial crisis that erupted at the end of 2007.

Market inefficiency exists when any of the following four forms of knowledge is missing or misunderstood:

1. Raw data

2. Gleaned information

3. Tested understanding

4. Creative intelligence

Investors derive information by making connections and finding patterns in data. They form an understanding by testing these patterns in the light of hypotheses and theories. They then make the leap from analysis using established facts and theories to new, original insights or creative intelligence to form investment decisions. Investors can and will outperform the market if and when they identify and explore inefficiencies from any of the four levels of knowledge. The best way to do this is to thoroughly research and ferret out what the Wall Street consensus has not yet taken into consideration.

If you want to invest in a consumer products company, try to get on-the-ground information firsthand. As I have done on many weekends, spend time at Best Buy, lululemon, and Apple stores; touch and try out the products; talk to people on the floor; and read customer reviews online. If you want to invest in an aesthetic laser company, book an appointment at a local med spa and ask the doctors questions about its efficacy and safety as if you were going to be operated on yourself. If you want to invest in an online travel agency, register yourself as a user not only on its site but also its competitors’ sites and experience firsthand how the agency’s services differ from each other and what drives the decision to pick one over the other.

For most investment ideas, you can find many creative ways to research a company. Only lazy minds refuse to see and explore them.

If you can’t do firsthand research on a company, do not invest in it. For example, banks are very hard to research because of the complexity and opacity of their on- and off-balance sheet activities. Many people think that U.S. banks are still cheap on a book-value
basis. But it is difficult to ascertain the accuracy of the market value of bank balance sheets, including the number, extent, and characteristics of nonperforming loans and other toxic assets. This is true when thinking of investing in American and European banks—it is essential for Chinese banks.

Bank stocks are among the hardest to dissect. They are also largely influenced by policy, politics, regulation, and macroeconomic factors, all of which are beyond the control of the management. Company-specific research might not be sufficient to tackle this group of stocks. You may well need the advice of a political scientist specializing in the impact of populism and popular reactions on legislators and regulators before considering investing in the financial sector.

The globalization of the capital markets has meant a surge of new and unfamiliar investment candidates for analysts and portfolio managers. Foreign issuers—regardless of their listing destinations—provide analysts and portfolio managers with access to investment opportunities outside the United States. These are likely to be beyond the knowledge base of most investors (including the professional money managers). Some opportunities that sound compelling initially may offer poor risk-adjusted returns.

Understanding risks is at least as important as understanding opportunities, if not more so. Market valuation tends to be particularly inefficient for stocks that are less followed, poorly covered, misunderstood, and traded on illiquid exchanges. Generally these are small-cap stocks and the stocks of companies in emerging markets such as China.

One reason that small-cap stocks have more alpha (the risk-adjusted return above the market) is that they are often too small for the large funds to invest in. Small caps tend to be less liquid, as defined by daily trading volume. Large funds cannot get in and out of a position in a small-cap stock without influencing its price
significantly, and it may take investors days to build or exit a position. The absence of big players in the game eliminates competition in due diligence, furthering market inefficiency and creating a sweet spot for smaller investors.

The most commonly made mistake by investors is confusing stocks with actual companies. People tend to have a positive bias about the stocks of companies that make products and offer services that they know and use, such as Facebook, Apple, Netflix, Starbucks, Ford, McDonald’s, and GE. It’s important to remember that stocks and companies are distinctively different: stocks literally have lives of their own. Companies do not change every day; stock prices do. Good companies—companies making good products and offering good services—can be bad stocks. Apple’s stock, which fell from $800 to $400 in mid-2013, is an excellent example. Poorly managed or financially distressed companies, including near-insolvent banks, can sometimes make good trades: Citigroup’s stock, for example, ripped from around $9 in March 2009 to almost $47 in May 2013.

The reason for this is that companies are evaluated based on business performance, but stock prices are driven by investor expectations. For stocks with lofty expectations that are already factored into the price, a small execution hiccup can trigger a sharp sell-off. Seeking out the humble stocks that are overlooked and underestimated is a better strategy than chasing the hyped-up ones.

Sometimes the stock price of a company will move in a direction against the wisdom of its business management. What’s good for the long-term growth of the company may be bad for the short-term performance of the stock price. For example, stocks typically do not perform well when companies are in a heavy investment mode, even though this helps to ensure future growth. Investors
typically want to wait and see the return on the investment before they put their money in the stock. It is a prove-it-to-me-first mentality.

Generally speaking, stocks move the most during earnings season. This is especially true when there are earnings surprises followed by revisions in the projections of future earnings, which usually happens concurrently with sell-side upgrades or downgrades on a stock.

Public companies are required to file quarterly reports with the SEC within 40 days of the end of a fiscal quarter, and most listed companies announce earnings within one month of the end of the quarter. Investors—both institutional and private—and analysts play this earnings game once every three months. What investors like me live for are surprises.

To capture the potential big swing in a stock due to a surprise, you have to be in the stock ahead of time. You need to buy a stock before a positive surprise sends the price soaring, and you need to short a stock before a negative surprise triggers a sell-off. By definition, surprises are not predicted by the market, except by contrarians. To catch the surprise, you need to have done sufficient homework to hold a conviction on a stock’s future earnings that is different from the Street consensus.

My research philosophy applies to investing anywhere in the world, including China. To be a successful investor in any stock, you must do your homework: perform due diligence and unearth misunderstood information. The nature of business in China means that you must take your game up one notch and be even
more exhaustive when performing due diligence on the company’s business and on its executives, including their professional track record, character, and integrity.

In addition, investors need to be mindful of the China-specific risks arising from the weak rule of law and the discretionary power of state bureaucrats, which can result in corruption, predatory behavior, and other abuses by state entities and their functionaries.

In global equity markets, premium valuations are rewarded to companies with predictable earnings streams and good governance, including a track record of respecting and protecting the rights of minority shareholders. This is why a subscription-based software company with recurring revenues typically receives a higher multiple than a hardware company with lumpy sales that swing unpredictably from quarter to quarter.

When the China craze that I call the Red Party was in full swing, investors ignored these factors, and undesired consequences followed.

Because of the unpredictable commercial, policy, and political environments, the revenues of both Chinese companies and multinationals in China can be at risk from time to time. Past crackdowns on medical ads, for example, have shown that Baidu’s advertising revenue can be volatile. Yum, the parent company of KFC, saw sharp sales declines in late 2012 and early 2013 after the Chinese FDA expressed concerns about its food hygiene. These sudden changes in the enforcement of government regulation had dramatic consequences for Yum.

Few investors like companies with dramatic swings in earnings. And when these swings are caused by factors beyond management’s control, they compromise earnings predictability.

Every publicly listed company faces what economists call a principal-agent problem between the managers (often the majority owners in China) and the minority shareholders. The problem: How does a shareholder (the principal) ensure that a manager
(the agent) acts to advance the principal’s interests, rather than merely empowering and enriching himself or herself? This universal problem deserves more attention from Americans considering investing in China; they would be separated from their investments by 12 hours in time, thousands of miles in distance, and vast differences in languages and cultural and legal norms. Unless investors can find ways to overcome those challenges by collaborating with or developing their own local expertise, they are unlikely to generate alpha in a sustainable way.

What makes China even harder to invest in is a tradition of lousy corporate governance, rampant corruption, and the consequent economic distortion and waste, often as the result of local and regional governments being partial owners of the business. Because of these irregularities, the future earnings of Chinese companies can be difficult to predict. Under normal circumstances, that should warrant a substantial valuation discount.

During the Red Party, investors dismissed these risk factors, and in some cases actually rewarded companies with a valuation premium based on the idea that Chinese companies would experience rapid revenue growth because of the size and rising prosperity of the country. A company’s rate of growth alone, however, does not reveal the quality of growth, and revenue growth does not equate to distributable earnings growth. Distributable earnings inside China to Chinese shareholders are not the same as the actual distributed dividends to American shareholders, because of different taxes imposed on foreign recipients of dividends and exchange rate and currency convertibility risks. Dividends due to foreign shareholders can also be at risk as a result of poor corporate governance and the absence of the rule of law, as we discussed before.

Assuming that past growth is indicative of future growth is yet another common mistake—one with grave consequences. Luxury Swiss watch sales in China have grown by 20 to 30 percent per year
since 2008. But a substantial portion of that growth comes from purchases for bribery aimed at corrupt officials, business owners, and mistresses, and it is therefore vulnerable to a government crackdown on corruption, as we saw in China in 2013.

Consider another example: KFC China had a nice run in China since the 1980s. This does not mean that future expansion into less populated and less wealthy small cities will garner the same rate of return that we have seen elsewhere.

Another issue for investors is the difficulty of properly assessing the long-term value of a business in China. Most value investors depend on what’s called a mid-cycle analysis to normalize a company’s earnings power before ascribing a value to a business. Normalized earnings are earnings adjusted for cyclical variations. To get that estimate, analysts look at the successive peaks and troughs in a company’s earnings and adjust them to a moving average.

But in China, for most businesses, mid-cycle references do not exist. The Chinese economy has only gone in one direction—up—since the Reform and Opening Up movement of the 1980s. Whenever the economy showed growth fatigue, the government stepped in with stimuli and pumped the growth to double digits. We simply do not know how the Chinese market will act in a down cycle, as the government has not yet allowed it to happen.

In the absence of a full cycle of growth, all projections of a stock’s intrinsic value become guesses at best. The tools commonly used on Wall Street to assess the intrinsic value of a company, such as discounted cash flow analysis, are compromised.

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There is only one sustainable winning strategy for all investors, whether in the United States, China, or anywhere else. Do your homework, explore market inefficiency, and exploit it. When and
only when the inefficiency is identified and verified by meticulous research can you invest with conviction. Conviction allows you to tolerate market volatility and to maintain a sound mind when the stock behaves differently from your expectation. Only a sound mind can exercise intellectual and emotional discipline, without which rational investment is not possible.