A Hedge Fund Manager Helped Save Siberian Tigers
Everybody hates hedge fund managers, and even hedge fund managers don’t much like the short sellers among them. Short sellers are a peculiar breed who scrupulously avoid the happy talk that dominates the rest of the market. Instead, they specialize in ferreting out corporate bad behavior. Then they bet that the sins of such a company will sooner or later come out, causing the stock to collapse. This makes them about as popular as a fundamentalist preacher at a Mardi Gras parade. They are also not above public shaming to make a stock collapse sooner.
You might think this has nothing to do with wildlife. Let me fill in some background. In October 2013, the Environmental Investigation Agency, a conservation nonprofit, went public with the results of a five-year investigation in the Russian Far East. The forests there are the only habitat of the world’s last wild Siberian tigers and Amur leopards.
The tigers in particular have been the focus of a 25-year conservation effort by the Wildlife Conservation Society, the World Wildlife Fund, and their Russian counterparts. At a cost of about $7 million so far, that effort has succeeded in increasing the populations to about 500 tigers and 50 leopards. Each tiger needs hundreds of square miles of forest, and the biggest threat to their survival comes from illegal logging of that forest.
The EIA undercover agents had gone into the area posing as lumber buyers. They saw where the illegal logging was happening. Then they followed the wood back to a factory in China that was the single largest buyer. There they saw (and videotaped) former tiger habitat being turned into living room floors and packed in boxes labeled Lumber Liquidators, the name of the largest seller of wood floors in the United States.
That company made itself famous with the slogan “Hardwood for Less,” offering prices that were frankly too good to believe. This is how it managed it, according to Alexander von Bismarck, EIA’s executive director: “They were the largest customer of the worst actor in terms of cutting and buying illegal timber in that forest.” Apparently acting on information from EIA, federal agencies raided Lumber Liquidators’ offices.
At this point, a hedge fund short seller named Whitney Tilson of Kase Capital Management got interested. “It was a very high-growth, high-flying, momentum company, and it can be very dangerous to short a stock like that,” Tilson told me. “The key is to find a catalyst,” something that could drive down the stock, “and it’s usually bad news when two federal agencies stage a raid on company offices.” When that sort of thing happens to hospital companies implicated in Medicare fraud, for instance, “their stock drops 50 percent,” Tilson said. “What was stunning to me with Lumber Liquidators was that they went from $115 down to $100, and by the time I presented my case” at the November 2013 Robin Hood Investors Conference, “it was back to $115. So it was a dream short.”
A dream, that is, if you can sleep at night with the stressful realities of how short sellers do their job: They borrow shares in a company, often a stock market darling of the moment, and immediately sell them at the current price ($115) in the expectation that they will be able to return those shares, or “cover the short,” by purchasing shares at a much lower price later on, when the truth comes out. But waiting for the truth can be agonizingly slow. If the usual analyst happy talk continues to push up the stock and investors pile on, the short seller’s cost can go up almost without limit. An investor like Tilson generally has millions of dollars on the line in each investment position.
Tilson made a detailed case against Lumber Liquidators at that 2013 conference. Roughly since the 2011 appointment of a new chief executive, Robert Lynch, the company had somehow managed to more than double its gross margins—the difference between its cost for materials and the revenue customers paid to buy its products. How? Tilson noted that it had significantly increased its buying from China. He then cited the EIA report, which he called “meticulously researched and documented,” and concluded that “a meaningful portion of LL’s margin expansion could be due to buying illegal wood.” But he also said, in effect, so what? “Lots of companies are doing lots of even more nefarious things and regulators/authorities do nothing.” He still needed a catalyst.
His thinking, he told me, was that “if I’m certain they’re cheating on hardwood and if their operating margin has suddenly doubled in 18 months, they might be cheating elsewhere.” So he dug up and helped publicize bad behavior of a sort even ordinary consumers might care about: Lumber Liquidators was exposing its own customers to wood contaminated with large amounts of formaldehyde, a lung irritant and a carcinogen. Xuhua Zhou, a little-known hedge fund analyst, had reported the formaldehyde contamination in mid-2013. (Tilson may also have heard from a whistle-blower inside the company.) The television show 60 Minutes picked up on this side of the story, and when its report aired in March 2015, Lumber Liquidators stock finally collapsed (to the mid $30s), Lynch resigned in disgrace, and Tilson went laughing to the bank.
“Making a dollar on the short side is psychically much more rewarding then making a dollar on the long side, because it appeals to the contrarian side of investors,” Tilson said. “Making a dollar on the long side is just floating down the river with everyone else. In this particular case, identifying a company that was hurting its customers and doing illegal things—and now the company isn’t doing it—that’s an extra bonus.”
Early this month, a federal judge approved a settlement between Department of Justice prosecutors and Lumber Liquidators under the Lacey Act, the fundamental U.S. law against trafficking in illegal wildlife and wood products. The company agreed to pay a fine of $13.1 million, the largest ever under that law. It also faces five years of probation during which federal officials will closely scrutinize its environmental compliance. The company stock is now down 90 percent from its former high to below $15 a share, representing a loss of value of about $2.7 billion.
Better still, this case is likely to strike fear in the hearts of other U.S. retailers who up to now have treated China as a black box for hiding the environmental crimes that often make their discount pricing possible. It’s also a message to all of us as consumers: Prices that are too good to be true may well be the product of hidden crimes. You don’t want those crimes on the walls or floors of your home, in the frames around your kids’ photos, or, really, anywhere in your life. Shopping local “Made in the U.S.A.” products suddenly seems like a much safer idea.
But the best thing about this case is that it will slow the rate of deforestation in the critical habitat of the Russian Far East. So next time you see a wild Siberian tiger in a photo or on television, spare a kind thought—unlikely as it may sound—for a hedge fund manager. Tilson has moved on to other stocks. But I’m betting that this case will keep both him and Zhou on the lookout for bad environmental practices as one more clue to stocks worth shorting.
Also give thanks—and more to the point, donations—to EIA, the Wildlife Conservation Society, and the World Wildlife Fund. These guys are in this fight for the long term, sometimes at considerable risk to their lives. And hey, Whitney? When it comes to making such donations, I trust this is one more way you are already showing the rest of us an important lead.