Technically Teton Capital Partners is down -5% year to date as of June, according to  investor letters reviewed by ValueWalk. This is a relative oddity for the billion dollar  long / short fund. Since 2001 the hedge fund with an 18.8% compounded annual return, run by Kleinheinz Capital “cub” Quincy Lee, has only experienced one negative year. But don’t let looks deceive. Short exposure in the fund where trading was halted could impact performance in a positive way when shares trade again on an open market.

Teton Capital Performance
Teton Capital

Teton Capital not hooked by China Ocean’s fish that got away story

When Teton took a look at the stock of China Ocean, little did they know it would be a “rollercoaster ride” that would “secure a place in the Teton short hall of fame.”

Like most hedge fund research hero stories, the analysis is probing for holes in the consensus thinking.  What first stood out was a profit anomaly.  Teton conducted a relative value analysis that is known to work for stocks as well as in evaluating hedge fund investments. Find the “beta,” used loosely in this instance, and then compare revenues both over and under the given market environment.

In the case of China Ocean, the owner of fishing boats located along the Chinese coast was exhibiting significantly higher profitability per boat than the Chinese fishing boat average. “We found that China Ocean’s vessels had 9x the sales vs. comps, and China Ocean claimed high profits while the comps were losing money or break even at best.”

Can a stock or a hedge fund significantly beat its market “beta?” Lee didn’t think so and shorted the company in the Korean market.

Initially, the trade worked beautifully, as the stock fell 50% in value over the first year. But as Lee was figuring out how to play the 2014 tax gain, a positive company press release and a short squeeze occurred pushing share prices up nine-fold. At the top of the squeeze, Samsung Securities, Teton’sprime broker in South Korea, issued the dreaded margin call on 40% of the stock’s short borrow. Undeterred, Teton scrambled to maintain as large a short as it could and the stock quickly retraced lower.

But something was amiss.

Teton Capital China Ocean
Teton Capital

Something didn’t smell right to Teton and regional regulators

Traders and analysts with a deep knowledge of market structure and a sound trading logic typically have a sense when something is fishy. Correlations are illogical, momentum indicators are “unnatural,” or there is sometimes just a rancid smell of fraud in the air. In the case of China Ocean, Lee detected a stench he thought was stock market manipulation.

Lee pointed to China Ocean’s CEO purchasing stock options at low prices and then the company releasing “ridiculous press releases to pump up the price,” at which point the CEO would sell his options. The official excuse for public consumption was that the CEO used the bounty from the stock options to pay off high-cost company debt, Lee noted, but he wasn’t buying. And neither were regional regulators.

In 2016 the firm caught the attention of the Financial Services Commission, Korea’s version of the US Securities and Exchange Commission, which began a formal investigation. Several months after the investigation the FSC halted trading in China Ocean.

Regulators, seeing a dichotomy and perhaps looking for incriminating on the record statements, requested public comment on charges that recent filings contained false information.  Making the comments public allows aggressive analysts and the press the ability to take apart the company’s story –defacto working alongside regulators to help identify and deter fraud. Smart work by regulators getting industry experts to work on a straight commission basis.

What resulted was trading in the stock was halted at a point the pre-halt market cap valued the firm at nearly $200 million.  This is the value Teton has on its books, but it expects that value to move lower. “Thus, it is our hope and expectation that the trading halt will be lifted in the next few months and we will realize the remaining 20bps of position size as profit,” Teton wrote, pointing to the potential for unreported short exposure potential.

Specifically, the hedge fund stated in its Q2 letter:

We found that China Ocean’s vessels had 9x the sales vs. comps, and China Ocean claimed high profits while the comps were losing money or breakeven at best. We then dug further and found significant discrepancies in the company’s reported financial statements to investors versus the locally filed Chinese financial statements. Combined with the extremely suspicious financial statements was a confounding set of actions by the CEO. There were numerous odd related party funding transactions and odd explanations as to why there was a perpetual need for cash when the reported income numbers looked so attractive.

Our initial short entry proved well timed as the stock fell 50% over the first year from entry. We were attempting to defer tax recognition on our gain into the new-year in late 2014 when we were caught in a vicious short squeeze. In the span of 5 weeks the stock went up nine-fold. We wrote about this episode in our 2014 Year End Letter (2014 Letter). Luckily, before the squeeze, the position was roughly a 20 bps position. However, near the top of the squeeze, 40% of our borrow was called in by Samsung Securities, our Korean prime broker. We maintained as large a position as we could borrow and the stock rapidly retraced most of the gain.

During 2015, it became even clearer that this was a classic stock manipulation fraud. The CEO would be granted options at short term stock price lows, then would put out ridiculous press releases to pump up the price only to then exercise and sell all his personal options. Often the excuse for selling was that the CEO was using the sale proceeds to lend money to the company in order to pay off high cost debt. Early in 2016, the Korean SEC finally began to question the circus that is China Ocean and in late April, the Korean SEC halted trading in China Ocean stock in order to request the company to comment publicly on rumors that recent filings contained false information. The stock remains halted and is marked on Teton’s books at a pre-halt market cap of roughly $200 million. Unlike the Hong Kong SEC, the Korean SEC has a history of relatively short trading halt periods. Thus, it is our hope and expectation that the trading halt will be lifted in the next few months and we will realize the remaining 20bps of position size as profit. While quite a rollercoaster ride, China Ocean has now secured its place in the Teton short hall of fame.

In the hedge fund’s 2014 letter the short in China Ocean was described as follows:

This short is a Chinese headquartered stock which trades on a non-Chinese exchange. The detail behind this fraud is fascinating and worthy of a great chapter in a new short-selling book. However, as we are still short the name and weary of future squeezes we will not discuss those details here. We initiated our short around th e $30 level and successfully rode it down to sub $10. We were all patting ourselves on the back in October saying job well done. I personally decided to hold off covering until early 2015 for tax-related reasons. That was a huge mistake. Beginning in mid-November, after a relatively silly press release about the CEO being granted a new stock award, the stock started gapping up daily. In what can only be accurately described as an orchestrated short squeeze by day traders, the stock managed to go up more than 10x in the span of one month. Luckily for us, it started as only a 20bps position, but at the peak in December was more than a 2% position. Unfortunately, along the way we were forced to cover approximately 46% of our original position near the peaks due to a partial recall of our borrowed shares.

While our confidence that this company is worthless is very high, it was clearly a mistake to maintain the position at what was a sub-$100 million market cap. We will classify this mistake as picking up pennies in front of a steam roller. You may get away with it 99% of the time, but when you trip the consequences far outweigh the rewards.

But this wasn’t the only story of a stock being halted in which the fund was involved.

Teton Capital  – Regulators halt Hong Kong-traded Hanergy Thin Film

With China Ocean, Teton found significant excitement in the region. The regional capital of excitement is often considered Hong Kong, and here the fund shorted Hanergy Thin Film (a popular short among hedge funds), which it found thin on gravitas.

After their short at 3.91 (HKD) ran profitable, and shares were halted by Chinese authorities on the Hong Kong Exchange, Teton was contemplating execution strategy but couldn’t get out of the stock. Regulators in this instance halted trading, but Teton eventually repurchased the stock at 0.4 (HKD) in the over the counter market, generating a tidy profit in this instance.

“If we are again lucky enough to have a short position in a Hong Kong-traded name that is halted we now know to cover quickly and avoid drawn out stock borrow fees,” Teton wrote.

Specifically, the hedge fund stated in a June 2015 letter:

We had been following the name since early in 2015, but the cost to borrow had been north of 40%. As more shorts were squeezed out in March and April, the cost to borrow fell to 20%. We decided that although the cost to borrow was higher than our normal 10% threshold, the ridiculousness of the name was so off-the-charts that it was worth paying the higher rebate cost. As rarely seems to happen when shorting stocks in a bull market, our timing was perfect. One month after initiating a 70bps position the Hong Kong securities regulator halted the name after a one day 45% decline in the stock price. The details of the investigation have not been released, but in almost every outcome that we can imagine, this stock promotion is now over. The only question is whether to cover in the OTC market at around 2 HKD/share or hold to what we feel is a more appropriate valuation of closer to 0. We have yet to make that decision.

Generally speaking we find that stock promotions, which we define as public companies where the management team has convinced investors, using deceptive rhetoric, that their business is worth more than 5x what an informed buyer would pay, are much more prevalent in Asia currently than the U.S. and Europe. As a result, three of our favorite short positions are Asian names that we would classify as serious stock promotions. Unlike our lucky timing in the Hanergy case, the other three Asian stock promotes we are short have been drawn-out and painful to the Teton income statement. Their day will come, as is the case with all stock promotes, but the waiting is no fun.

 

Teton Capital Hanergy FilmTeton Capital  – Bro love for Thomas Petterfy

Among Teton Capital’s better-known long positions include a stake in Interactive Brokers, which the hedge fund was required to reluctantly reduce as the valuation was just too rich. Lee is “very fond” of Interactive Broker’s business model and its CEO, Thomas Peterffy.

Peterffy has built an automated stock and derivatives trading juggernaut which also includes OneChicago, the single stock futures exchange. While Peterffy is well respected by not only Teton but generally inside the derivatives industry, the stock trading at near 25 times Teton’s estimate of 2018 forward earnings didn’t sit well. Lee, however, couldn’t bring himself to push the sell button on the beloved long as the stock was shooting higher, trading more than $6 over the fund’s $34 price target.

While the position is still positive, Lee isn’t emotional and looks for improvement. “Attachment bias on the long side is a recurring error that we have made here at Teton over the years, and one we will strive to avoid in the future.”