It looks like small investors can compete against institutional and professional investors after all.
That may be one of the takeaways from the recent collapse of Archegos Capital Management. The money manager’s failure also highlights regulatory gaps that allow stocks to be unduly influenced, the potential for hidden short squeezes and investment opportunities among Archegos’s pummelled stocks.
First, consider an investment made by Archegos, the Canada Pension Plan Investment Board (CPPIB) and Alberta Investment Management Corp. (AIMC). All three acquired large stakes in GSX Techedu Inc. , a firm operating in the highly competitive Chinese online education market.
These purchases were rather gutsy considering half a dozen short-sellers had published negative reports alleging extensive fraud at the company. Particularly scathing was one by Muddy Waters, a research firm not to be dismissed lightly, as it had previously uncovered several other frauds involving Chinese firms – starting with Sino-Forest Corp. in 2011.
GSX Techedu’s stock has now tumbled 75 per cent since mid-March.
Just prior to the crash, Archegos’s portfolio had more than US$10-billion in assets, leveraged to US$50-billion of exposure to eight known stocks. What could go wrong?
Well, in late March, the firm got a margin call, and brokers liquidated at whatever prices they could get. Some brokers incurred multibillion-dollar losses – but fortunately, they were able to absorb them and prevent a contagion of defaults.
Whales slipping through the regulatory cracks
A second takeaway is that regulatory gaps for some big investors – the “whales” – played a key role. Since family offices such as Archegos have no outside investors, there is no requirement to register with the market regulator or adhere to a lot of prudential requirements.
For one thing, Archegos was able to far exceed prescribed lending limits on margin accounts. For another, it could disregard disclosure rules on the ownership of investment stakes – because instead of buying stocks, it could buy swaps. These instruments provide exposure to just fluctuations in stocks bought and held by brokers.
The swaps explain why Archegos does not appear on lists of institutional investors. Instead, brokers populate the tables. In the case of GSX Techedu, the first nine spots on its Dec. 31 list were all occupied by brokerage houses, such as Goldman Sachs and Credit Suisse. They had bought large blocks of shares to create swaps for Archegos and others.
Short squeeze behind the scenes?
A third takeaway is that Archegos’s portfolio had the appearance of a short-squeeze operation. The hallmarks, anyway, were there: Stocks in the portfolio were heavily shorted and experiencing rapid gains as positions were accumulated. And before the dam broke, there were discussions in the media like this one in February: “ViacomCBS Stock’s Monster Rally Could Just Be a Short Squeeze.”
After Archegos hit the leverage wall in late March and its trades became public, Muddy Waters founder Carson Block, told Institutional Investor: “I don’t believe [Archegos] had any fundamental basis for going long. They went long because they thought it could squeeze.”
Buy when there is forced selling in the street?
“Never let a good crisis go to waste,” Winston Churchill said. The fourth takeaway is that the forced selling of Archegos’s stocks may have created opportunities for value investors. Here are three candidates:
Tencent Music Entertainment Group is a subscription-based music-streaming service in China. It announced a US$1-billion share repurchase program after the sell-off and received a buy recommendation from Kerrisdale Capital, an independent investment research firm.
Baidu Inc. has the dominant internet search engine in China, with a 72-per-cent market share. This business spins off a good, stable cash flow, and there is US$25-billion in cash on the balance sheet. Add to this the company’s investments in artificial intelligence, cloud computing, autonomous driving and other areas. Baidu is a nice blend of value, safety and growth prospects.
ViacomCBS Inc. is expanding into the growth area of streaming content, differentiating itself with Pluto TV. This package uses an ad-based model that provides content for free instead of on a subscription basis, as most other suppliers do.
Larry MacDonald can be reached at email@example.com
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