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How Luckin Coffee is a Lesson on Investing Risk

Often, when something is too good to be true, it probably is

No, this isn’t an advertisement for exchange-traded funds. But, it might as well be because the latest accounting scandal to plague a U.S.-listed company is a reminder that investing isn’t as easy as it looks. Luckin Coffee (OTCMKTS:LKNCY), it turns out, was built on a mountain of lies, which ultimately brought Luckin stock to its knees.  

Four Luckin Coffee (LK) coffee cups are arranged in a row.
Source: Keitma / Shutterstock.com

Many in America want to blame lax Chinese financial oversight for the deception of U.S. investors.

Still, the truth is, we are just as guilty as the actual perpetrators inflating Luckin’s revenues.

How’s that, you say?

A Big Conflict

Well, for starters, America’s auditing system involves corporations paying auditors to scrutinize their books. That’s akin to me hiring my brother to audit my books. It’s an apparent conflict of interest. 

Fortune published an article in late June suggesting that despite rules put in place by Sarbanes-Oxley and the Public Company Accounting Oversight Board (PCAOB) to ensure proper auditing processes, the current compensation system makes it difficult to do the right thing.

“Auditors are hired by an individual company’s board, which may or may not be a good proxy for the company’s shareholder base writ large, much less the interest of the public market as a whole,” wrote Fortune contributor Jeremy Kahn.

“In fact, it could be argued that any individual company’s shareholders have little reason to want to hear inconvenient truths. The better a company’s results look, the more the stock will rise and the more money they are likely to make – at least in the short term.”

An Alternative Approach

Kahn goes on to suggest that were the stock exchanges to hire auditors, the conflict of interest would disappear. The more complicated the auditing assignment, the more the auditors would be paid. Only the fees wouldn’t come from the company, they’d be paid by the exchange. And the exchange would, in turn, charge the companies. 

It’s in the best interest of the New York Stock Exchange’s of the world to have a marketplace that is fair and transparent, Kahn argues. He suggests that the Wirecard (OTCMKTS:WCAGY) fiasco might have been avoided had the fintech’s auditor, Ernst & Young, had an incentive to uncover wrongdoing.    

Before I wrote about investments, I worked in the financial services industry. To this day, I am amazed at the conflicts of interest that continue to exist. This is despite the many acts of fraud that rob investors of their hard-earned capital.

Should the Fraud Been Spotted Earlier?

In April, I argued that the chief executive officer and board members had to have known about the chief financial officer’s actions to inflate the company’s revenues. 

“Regardless of what Luckin’s special committee does in the future, investors should be extremely skeptical of the company’s actions. It seems implausible that the CEO and other board members were completely unaware of the CFOs actions,” I wrote on April 15. 

“Anything short of replacing the entire C-Suite and board is, in my opinion, a failure to act in the best interests of shareholders. As Muddy Waters said in its report, Luckin is a ‘fundamentally broken business.’”

In mid-May, Luckin fired both the CEO, Jenny Zhiya Qian, and the chief operating officer, Jian Lu. On July 13, Luckin announced that chairman and co-founder, Charles Zhengyao Lu, was replaced as chairman of the board by Jinyi Guo, who also became interim CEO. Guo is also a co-founder and board member. 

Also, four board members stepped and down, and two new independent directors were appointed in their place. 

Looking Back

I concluded my April article by suggesting that anyone thinking of buying Luckin stock should stay away because where there’s smoke, there’s fire. In hindsight, we know that to be the case. 

However, Anne Stevenson-Yang, the director at J Capital Research, told CNBC recently that the fraud was relatively obvious.

“It’s a great morality tale. It seems to me that those of us who spent time in China could see from very early on that Luckin was inflating its numbers,” Stevenson Yang stated on July 6. “Luckin was a company that was terribly interested in memberships and in tokens, and in the visible growth of foot traffic to the stores — but not in actual revenue.”

In defense of Luckin stock investors, I invested in a fraudulent public company in the early 2000s. It was ultimately shut down by the SEC. Sometimes you only see what you want to see. I learned a big lesson from that.

The Bottom Line on Luckin Stock

My InvestorPlace colleague, Luke Lango, believes contrarian investors might consider making a bet on Luckin stock

While I understand where Luke’s coming from, all the math in the world isn’t going to remove the stench that emanates from Luckin. As long as a founder is involved in the running of Luckin, I can’t in good conscience recommend its stock to anyone. Not even speculators.

For investors who lost money on Luckin stock, chalk it up to a lesson learned. An expensive one.  

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2020/07/luckin-stock-coffee-is-a-reminder-of-the-risks-involved-when-investing/.

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