The more I study this very strange stock, Luckin Coffee (NASDAQ:LK), the more I see its danger. LK stock spiked 36% on June 5. It is now 25% higher, at $5.51 than the price it last traded on April 6 at $4.39, when NASDAQ halted the stock.
The most likely cause for this incredible rally is short-covering by every hedge fund in the world that thought LK stock would go to zero.
And why shouldn’t that happen? NASDAQ made it clear that they were going to delist Luckin Coffee stock; that is what the company said on May 19.
Luckin Coffee’s only “out” is an upcoming “NASDAQ Hearings Panel.” This was likely to occur, according to Luckin Coffee’s most recent SEC filing, 30 to 45 days after the request. To the best of my knowledge, no one knows the exact date of that hearing.
Short Covering and LK Stock
So let’s say that the request occurred on May 19 by Luckin Coffee. That means by June 19 or two weeks later the hearing will occur. After that, NASDAQ could immediately delist the stock.
That means that short-sellers would have no way to actually deliver the stock they have borrowed and subsequently sold. In effect, we are now witnessing a classic “short squeeze.”
For example, what if Luckin Coffee continued to operate as a private business? The brokerage firms that lent the publically-traded shares to hedge funds that subsequently shorted the stock would have to find a way to deliver. What we are witnessing now is an attempt by those brokerage firms to get ahead of the curve and force their hedge fund clients to “cover” their shorts.
These hedge funds have no choice but to pay whatever price is available to purchase and cover their shorts. That is the only true rationale reason why LK stock is now spiking.
Vince Martin Misses Two Key Points
Vince Martin, who also writes for Investorplace.com, wrote a recent article on LK stock in Seeking Alpha. Although the story is well written (as usual), it misses some fundamental points. I am not arguing with his conclusion, that despite being incredibly cheap the stock could eventually go to zero.
Between the recent Wall Stree Journal article and the company’s own admission of guilt, there should be no one who would ever trust, even after so-called audits, any numbers from the company.
Here is the first key thing that Vince Martin is reluctant to come to terms with about Luckin Coffee. It comes straight from Muddy Water’s founder, Carson Black, whose research firm originally exposed the Luckin Coffee fraud:
“China is to stock fraud as Silicon Valley is to technology.”
I referenced this very famous quote from Carson Black in my last article on Luckin Coffee. He makes this statement in a Barron’s article in September 2014. Carson has proven this time and time again. He has exposed various Chinese stocks about which his firm has warned investors – Luckin Coffee being the latest.
My point is that you should never underestimate the ability of a public Chinese company to figure out ways to defraud investors.
I have learned this the hard way. A public Chinese company I recommended to my institutional research clients committed massive fraud. My institutional research business eventually closed, as a result of this situation. I also was on the board of a foreign company that dealt with Chinese investors and clients. I ultimately became extremely cynical of Chinese business practices as a result.
Luckin Coffee Will Always Find an Exchange Harbor
The second point that I think Vince Martin misses is that the Chinese company will easily figure ways to list their stock elsewhere. This could occur even if the NASDAQ delists the stock. There are many exchanges in the world that are willing to accept this company, despite its fraud accusations and all.
That means that LK stock may not eventually go to zero, especially if there is a real business despite the fraud. Here are some exchanges it could list: Bermuda, Hong Kong, Shanghai, Luxemburg, the AIM Exchange in London, or some teeny exchange in the middle of nowhere.
As long as the particular exchange has a Bloomberg presence and gives the stock a ticker sign and the registrar can get a CUSIP number, Luckin Coffee could remain public somewhere.
That means that the fraud, even with new management, could potentially continue. It also means that short-sellers could actually cover.
That also implies that LK stock is massively overvalued. First of all, if investors find a way to sue the company, it could end up paying out a lot of money. Second, what insurance company would be willing to issue directors’ and officers’ (D&O) insurance policies to this company?
There will be none. That implies that very few truly outside directors, if any, would be willing to serve on the board. Unless, of course, someone pays them to look the other way, China is to stock fraud …
Bottom Line With LK Stock
Despite what is going on with the LK stock price surge, you must hold back all your urges to buy it out of a “fear of missing out” basis.
In the end, you will likely be very disappointed.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide, which you can review here.
