A Big Bear Thesis for Ali Baba Stock
“China is more prosperous than before. The people have better lives but they are not happy and confident because the scars are still there.” Those are the words of Jung Chang, an amazing human being who wrote one of the best books you’ll ever read – Wild Swans: Three Daughters of China. In her book, Mrs. Chang tells the riveting story of what happened in China since the beginning of the 20th century. Given that one in five people on this planet is Chinese, we should better understand them, or at the very least, try and make some money off of them.
The Chinese are a superstitious lot, and with that comes an affinity for gambling. If it’s not the horse races in Hong Kong, it’s the baccarat in Macau, a place that produces nearly 5X as much in gaming revenues as Las Vegas. This inclination to gamble has taken foreign financial firms by surprise. When MSCI Barra first started selling risk management products in Asia, they ran into a fundamental problem. Chinese investors didn’t care about risk. If anything, they cared about taking on even more risk. Hero or zero.
Chinese Finance Gone Wild
If you think it’s just Chinese retail investors gone wild, there’s a whole lot more crazy stuff happening in the China financial sector. There’s a shadow banking system – underground financial activity – where more than 40% of Chinese loans are said to be underwritten. Similar to Enron, Chinese companies have been known to implode spectacularly, or even just disappear. When that happens, don’t expect the Chinese courts to drop what they’re doing and sort you out. If a boisterous group of Chinese mainlanders can’t get their money back, what makes you, a gweilo, think you’ll fare any better?
As a foreigner investing in China, there are certain rules you have to play by. The easiest way to get Chinese exposure is by picking up an ETF, preferably one that tracks Chinese large caps, so that you’re taking on as little risk as possible. Never mind the fact you’re investing in many state-owned enterprises, at least you’re not down in the small-cap fracas. For more adventurous investors, you may be tempted to take a punt on one of China’s greatest tech success stories – or so they say.
The Ali Baba Bull Thesis
In our recent article on How to Invest in The Amazon of China, we talked about how Jack Ma’s company – Ali Baba (BABA) – is not only the Amazon and eBay of China, but a whole lot more. They happen to own 33% of Ant Financial, a unicorn you can read more about in our piece on The Biggest Fintech Company in The World. As with many companies, the bullish thesis is easy to tease out.
We’ve been longtime shareholders in BABA, if only because we believe Jack Ma might be one of the most inspiring entrepreneurs out there. When he recently stepped down, it raised some eyebrows. Our boots on the ground began hearing murmurings about how he was forced out. Given the history of the country he operates in, we’re concerned about our investment. When that happens, we go find the biggest bears out there and see what they have to say.
The Ali Baba Bear Thesis
The biggest bear thesis for Ali Baba is what we’ve already told you about the Chinese financial system. Things behave differently in China. There’s the notion of guanxi, where you can often curry favors depending on who you know. There are legal, regulatory, cultural, and political risks that even Chinese locals can’t quantify. The biggest risk is in what we don’t know. For example, why is it that Ali Baba employees are 20X more productive than Amazon employees? A simple measure of productivity is to divide the gross merchandise value (GMV) for a company by the number of employees. Here are those numbers for 2019:
- Amazon GMV per employee – $419,799
($335,000,000,000.00 / 798,000)
- Ali Baba GMV per employee – $8,366,190
($853,000,000,000 / 101,958)
That’s just one of the questions raised by an anonymous Ali Baba bear who has been following their financials since the BABA IPO in 2014. At least that’s what he claims, along with an assurance that he has no skin in the game. He publishes on a blog called Deep Throat IPO, and provides some pretty elaborate theories on how China is messing with the Americans.
It’s an easy yarn to spin, especially given the general distrust towards China these days because of “the Rona.” It’s also no secret that some U.S. firms we’ve come across before have colluded to help sell some real garbage on American stock exchanges – pump and dumps driven by the Chinese growth story.
You don’t need to look very far to find Chinese firms being traded here in America with accounting irregularities, like Luckin Coffee (LK), which was recently convicted of fraud along with “dozens of companies that helped the coffee chain inflate its sales and expenses.” As a punishment for lying to investors, “The Starbucks of China” was fined a whopping $9 million, something the WSJ reported yesterday.
One man who made some money when Luckin Coffee crashed and burned was Jim Chanos, a man who covered his short position after LK dropped more than -70% on news that “it revealed in a government filing that its chief operating officer fabricated 2019 sales.”
Mr. Chanos is also extremely bearish on BABA, and says to avoid Chinese companies like the plague:
How many times do investors have to be burned in these companies that are just too good to be true? Growing 40% to 50% a year, with all kinds of odd transactions with affiliates. Variable-interest entities based in the Cayman Islands …” he added.
He mentions something called “variable interest entities” (VIEs), and he’s not the only one warning about these complex structures that are nearly impossible to understand.
Variable Interest Entities
The Council of Institutional Investors (CII) is a nonprofit that promotes the interests of institutional investors in the United States. They issued a paper, back in 2017, titled BUYER BEWARE: CHINESE COMPANIES AND THE VIE STRUCTURE warning against Chinese firms listing in the United States that use the VIE structure. It all boils down to the following:
As shareholders without equity ownership, foreign investors possess no meaningful right to participate in the profits or control over the operating company.
Dozens of large Chinese tech companies are using the VIE structure to list on U.S. equity markets, names like NetEase (NTES), Weibo (WB), Baidu (BIDU), JD.com (JD), and of course the biggest of the lot – Ali Baba.
One thing that’s always a red flag for any stock is when there’s some convoluted corporate structure which takes a two-page org chart to explain. Mr. Deep Throat points to Ali Baba’s 2018 annual report which lists some 920 separate operating entities within their ecosystem. In the 2020 annual report, Ali Baba lists only their major entities along with the below diagram which shows how they are “in the process of enhancing the structure we use to hold our variable interest entities.”
If we stick with Warren Buffet’s advice and invest only in what we know, diagrams like the one seen above are a red flag. We’re now starting to understand what Mr. Deep Throat means when he says Ali Baba is “the goofiest, most convoluted, opaque, mismanaged accounting mess and business structure in history.”
There are a whole lot more accounting irregularities detailed in Mr. Deep Throat’s most recent post on Ali Baba which is worth reading if only for the hilarious commentary. Some of his points of contention include the below :
- Why BABA spent $16.711 Billion (roughly 10 Burj Khalifa’s) on Property Plant & Equipment since the IPO (3/31/14)
- Why BABA needed to provide $4.483 Billion (3 Burj Khalifa’s) in Share Based Compensation (SBC) in the current fiscal year and $21.820 Billion (15 Burj Khalifa’s) since the IPO in 2014?
- Why write-ups of “Questionable Assets” this year were $10.303 Billion and a whopping $32.610 Billion since the IPO?
And the list goes on. It’s an entire can of worms that we don’t have the desire to open because we’ve already reached a conclusion based on the first red flag that came across our radar.
Mr. Ma’s Departure
As longtime shareholders in Ali Baba, we’re future bag holders if this house of cards comes tumbling down. Being the set-it-and-forget-it investors that we are, we didn’t feel the need to check in on BABA because we were sure Mr. Ma had things under control. When we saw the news of his departure, along with his sale of shares, our thesis suddenly lost its punch. Why would someone who relentlessly fought to build one of the greatest companies in China suddenly feel the need to retire?
It was a question many mainstream pundits were asking. The only people who seemed to have an answer were the Chinese business people we rub elbows with in hopes of getting some guanxi. They say Mr. Ma was pushed out by the Chinese government. Of course, baijiu-fueled conversations about Jack Ma and 20 yuan won’t get you a cup of coffee at Luckin Coffee – unless you know someone.
Mr. Ma’s departure raised the alarm, so we first laid out our easy-to-understand bull thesis based on numbers that we assume are true. Today, we’ve laid out the bear thesis which argues that everything is being masked by a convoluted financial structure that we can’t even begin to understand. Given the ongoing and recent problems with Chinese companies fudging the numbers, we’re viewing Mr. Ma’s recent departure as a huge red flag. We’ve also noted the larger problem with Chinese tech companies that use VIEs in The Nanalyze Disruptive Tech Investing Methodology.
Jung Chang’s literary masterpiece grabs the reader because it relays some events that took place within the CCP that are simply unimaginable. Consequently, the book was banned from China because it didn’t paint the government in the best light. So was Winnie the Pooh, because the country’s great leader bears a slight resemblance to that cuddly bear. Ironically, it’s this leader’s government that’s probably the biggest bear case for not owning Ali Baba.
Is the Amazon of China an attractive investment opportunity, even after Jack Ma’s departure? Find out in the “Nanalyze Disruptive Tech Portfolio Report,” a complete list of disruptive tech stocks and ETFs we’re holding. Now available for all Nanalyze Premium annual subscribers.