“The China Hustle,” a documentary from a few years back, depicts a special type of stock market fraud. Obscure Chinese high-tech manufacturers, agricultural producers, and mining companies would list on overseas stock exchanges. Investor conferences, investment funds, and stockbrokers played up each company’s connection to China’s growth miracle, stimulating investor demand and precipitating share price spikes.
Trouble is, many companies were cooking the books, with eye-watering revenue growth stemming from a web of fraud. As the real value of these huckster companies came to light, stock prices tumbled, and naïve investors were left holding the bag. All up, over 200 Chinese companies were found to have engaged in some kind of China hustle, resulting in $50 billion in securities fraud.
Some years later, Luckin Coffee’s multi-billion-dollar collapse alerted investors to the prospect of a new kind of hustle. A recent string of short reports, fraud admissions, and lawsuits have reinforced these fears. In fact, I’d go as far as to say Luckin’s the tip of the iceberg. We face a “New China Hustle” of falsified growth and management acting in bad faith.
Let’s unpack what it is, and what to be on the lookout for.
Michael Norris is a TechNode Contributor and Research and Strategy Manager at AgencyChina. He has the financial sense not to hold or short stocks of any of the companies mentioned in this article.
“New China Hustles” don’t involve manufacturers, agricultural producers, or mining companies engaged in the physical economy. Instead, these hustlers involve digital economy actors like digital advertisers, online education providers, and consumer commerce companies.
Take the recent fraud admissions from Luckin Coffee and TAL Education Group, respectively a digital-first coffee vendor and an education provider with a swag of online-only sub-brands. In both instances, fessed-up fraud involves inflated online purchases. Mobile gaming company Cheetah Mobile and online tuition provider GSX are staring down the barrel of shareholder lawsuits about inflated user numbers and sham revenues.
Why the sudden tech angle?
Investors know technology and internet stocks have outperformed the market. That breeds comfort with these stocks’ high-risk, high-reward growth profiles—scale first, profits later. This leeway suits hustlers well.
But even in tech, eventually you have to come up with some numbers. When predicted growth falls short, falsified revenue and user growth keep stock prices on an upward trend and can help evade questions around sketchy business models, elusive profitability, and evaporating cash reserves.
When it comes to growth, digital hustlers have grey areas they can exploit. In the case of Luckin Coffee and TAL Education Group, we’re looking at fake users and inflated revenues. With bad intentions, it’s pretty straightforward to perpetuate digital fraud—a couple of clicks here, a few numbers into a dashboard there, and you’ve got an additional 20% extra app users this month!
Indeed, digital companies with management acting in bad faith can be equivalent to a black box. You can use satellite images to cross-check an obscure cobalt mine’s stated output. However, there’s limited scope to do the same for an obscure gaming company’s user revenue. It takes the continued effort of well-resourced skeptics and short sellers to yank away the façade.
When digital actors define their own growth metrics, monitor their own performance, and report against that performance, they are simultaneously their own referee and cheerleader. That’s dangerous, particularly when sophisticated hustlers know what metrics move markets and aren’t afraid to use that to their advantage.
Luckin Coffee is perhaps the most brazen example. As the now-famed anonymous short report hauntingly suggested months before Luckin admitted to sales fraud, “Luckin knows exactly what investors are looking for, how to position itself as a growth stock with a fantastic story, and what key metrics to manipulate to maximize investor confidence.” Armed with that knowledge, Luckin Coffee fooled institutional and retail investors. It would be reckless to assume other hustlers didn’t have the same level of situational awareness and the willingness to exploit that for financial gain.
Indeed, I fully expect the next crop of Chinese companies to fall from grace to be cunning PR operators—unafraid to grease the wheels with analysts, press, and commentators to head-off accusations of manipulated metrics and insulate multi-billion dollar market capitalizations.
Fast and fraudulent
Victims of securities fraud are not exclusively “Bitcoin Bros” or “Youtube Day Traders.” Victims include a mix of ill-considered, ill-informed, and innocent pension funds, investment banks, and individual investors.
Scandal-ridden Wirecard also shows securities fraud isn’t something that just emanates from China. Low-tech and high-tech companies with lackluster, incompetent, or downright deceitful management are listed on exchanges worldwide. Perverse incentives that obscure poor management and bad companies exist across venture capital and public markets.
However, there’s a reason why it’s called a “China Hustle.” The feverish desire for above-average returns, information asymmetry, lack of oversight, and loose corporate governance notions, all make China suited to unchecked financial manipulation.
Luckin and TAL have admitted to user fraud. But I’m sure they’re not alone. There are credible short-seller reports on Uxin, Iqiyi, and GSX, and I reckon that most of these will eventually be vindicated.
So, what do you need to be on the lookout for?
First, there’s digital manipulation, like fake users, bogus sales, and inflated transaction volumes. Next, there’s accounting wizardry that results in flexible (or non-existent) definitions of revenues, costs and cash, related-party transactions, and frequently revised or inconsistent reporting formats.
If you’re seeing user growth that dramatically exceeds third-party data or costs are defined differently each time you open an earnings release, it may be time to take profits and abandon ship.