I still enjoy my daily Luckin cuppa for about 10 yuan (S$2) — almost three times cheaper than a Starbucks latte. But as the froth parts in the signature blue cup, the murky liquid beneath is a reminder of the dense fog the company now finds itself in.

The dubious acts of the Xiamen-based behemoth are no storm in a tea cup. I noted a year ago that it could challenge its American counterpart if it kept its feet on solid ground, but Luckin’s hollow foundations have since been exposed.

On May 12, the Nasdaq-listed coffee chain fired its chief executive and chief operating officers, after the company said in April that much of its 2019 sales of about 2.2 billion yuan may have been fabricated. 

The China Securities Regulatory Commission has “strongly condemned” Luckin’s accounting fraud and at least three Chinese agencies are investigating the company.

The embattled firm was shown up by the pandemic as it heaved under the pressure of temporarily closing about 200 outlets in Wuhan and other cities, resulting in a tumbling share price.

Like a sieve, the resulting economic downturn will likely separate the wheat from the fraudulent chaff in the stock market. The devastating wave started by the pandemic will rip through the global markets and bring to shore book-cooking companies.

After all, it was none other than Warren Buffett who said: “You only find out who is swimming naked when the tide goes out.”

EXPOSED BY LOW TIDES

Once short sellers sniffed a rat in Luckin’s numbers late last year, they launched an investigative process that was nothing short of astounding.

More than a thousand interns fanned out across 600 outlets in 53 Chinese cities and logged some 11,260 hours of store traffic footage on mobile phones and collected 25,843 customer receipts. From these, the amount of revenue for Luckin was projected and it was found that the amount fell far short of published figures.

This investigative work was rumoured to be funded by hedge funds and was sent anonymously to short-seller Muddy Waters Capital. 

When Muddy Waters published the information collected in January, it marked the start of what must be the end for Luckin. The company’s stock plunged 90 per cent through March, wiping out US$11 billion in value.

Luckin has not been the only one making the news for the wrong reasons. More recently, investors were taught a lesson by GSX Techedu, an online education company worth almost US$8 billion.

Online investment newsletter Citron Research — run by activist short seller Andrew Edward Left — first accused the New York-listed GSX of inflating last year’s sales, which the Chinese company refuted outright.

On May 18, Muddy Waters jumped in the fray, claiming that most GSX users were in fact bots and that up to 90 per cent of reported revenue was likely to be fake.

Its stocks dropped more than 7 per cent overnight. To date, it is not known if the regulators are probing GSX Techedu as they have done with Luckin Coffee.

To be sure, while prominent short sellers claim that they do thorough research and keep companies honest, targeted companies and critics of short selling argue that a number of short activist campaigns amount to spreading inaccurate and misleading information to drive down stocks prices so that they can cash out quickly. 

For retail investors who are on the other side of the trade or planning to jump on the short selling train, this means that before you act, you have read the short sell report in detail to qualify the veracity of claims before dumping your shares or short selling the stock. 

Obviously, the impact of Covid-19 will expose suspect companies not only in China and across the globe.

Singapore-based Hin Leong, for years one of the biggest and most powerful names in oil trading, was found to have hidden more than US$800 million in losses.

More are likely to follow. In a recession, the pretenders have nowhere to hide.

In normal times, it could be easier to get away with things like overstating revenue, aggressive accounting and understating liabilities that would not surface on the prospectus or accounting books.

But in a downturn, these red flags are easy to be picked up by investors if they look close enough.

Why is a company suddenly raising cash, which drastically dilutes the founder’s shareholding, when on paper it has an extremely healthy cash balance?

Why is this hotel chain boss selling all his properties? Such hearsay will swirl in the next few months as short sellers go to work.

There is historical precedent on how recessions undo frauds, the largest of which was perhaps when Bernie Madoff owned up to a US$65 billion Ponzi scheme in 2008.

Unfortunately, each disgraced Chinese firm merely adds to the disrepute of the Asian giant. No sector seems to be immune to such misbehaviour, from food and beverage (China Huishan Dairy for one) to sports apparel. 

A whopping nine out of 16 Chinese sportswear companies listed since 2005 — in the Hong Kong, London and Frankfurt stock exchanges — turned out to be frauds with threadbare fundamentals, and all were from Fujian province in China.

It leaves one wondering if China really is to stock fraud what Silicon Valley is to technology — famous words by Carson Block, founder of Muddy Waters.

WHAT COULD HAVE BEEN, AND WHAT STILL CAN BE

The sad thing about companies such as Luckin is that it is actually one that has a shout at being an attractive equity story if it was clean from day one.

While revenues were overstated by almost 60 per cent, even with the actual numbers, investors would still have liked it.

There was an exciting product that was unique with an online-to-offline concept. It was a good equity story (David vs the Goliath of Starbucks) that attracted big global investment names. A good story does not need to be embellished with a gold cover.

Fraud should be exposed, but unfortunately, cases like Luckin have consequences.

There has been a huge loss of investor confidence in US-listed Chinese stocks. Companies that harboured hopes of being listed have cancelled their plans — among them a fintech giant with billions in revenue that we know of.

The Chinese regulators have been clamping down on fraud in recent years, and they plan to do more. But to really weed out the fraudsters, China needs to open up its capital markets more, and allow more players to come in for natural checks and balances.

For investors — do your homework. There remain many good Chinese-listed firms that deserve their high valuation. Still, check them inside out, listen to management calls and ask around.

If it’s something too good to be true, it’s always safer to keep the cash or exit while you still can.

ABOUT THE AUTHOR:

Josh Lim is a co-founder and Executive Director of IJK Capital Partners, a cross-border investment and advisory company with a China focus. IJK has offices in Shanghai, Hong Kong and Singapore.