It’s been a phenomenal year for Nio (NYSE:NIO) stock. The once-tiny electric-vehicle (EV) startup rocketed in value as aggressive investors from all walks of life have piled in. Shares are now up 1,400% since the start of the year.
More conservative investors might worry: China has produced some stunning fraud cases over the years. And is the Nio story just too good to be true?
Companies from Sino-Forest to Luckin Coffee (OTCMKTS:LKNCY) were once worth billions before wiping out – and taking investors’ hard-earned money along with it. And the one common element? These fraudulent companies all sprouted financial figures that looked “too-good-to-be-true.” Company size and pedigree don’t prevent fraud either. Enron proved that no matter how awe-inspiring you get, accounting tricks can still send your company straight to bankruptcy court.
So, how can investors know if Nio stock is legitimate? To lift the curtain, here are three things YOU can look for:
Nio Stock Test 1: Strength of Underlying Business
To find fraudulent companies, I first examine how “real” the company looks.
Luckin Coffee offers an excellent example of a firm that failed this test with a capital “F.” In 2019, a fast-growing coffee chain, Luckin Coffee, took Wall Street by storm. As its supposed growth accelerated, shares shot up from $15 to $50 in less than a year. Why should investors settle for slower-growing Starbucks (NASDAQ:SBUX), investors reasoned, when they could ride rocket-ship growth with Luckin?
There was just one problem: Luckin’s sales weren’t entirely genuine.
It turns out that Luckin management inflated sales by more than $300 million. And they did it with intent to deceive: to throw off investigators, stores started skipping numbers on order tickets to make it seem more customers came through.
Any sharp observer would have seen through the charade. A similar fraud happened in the early 2000s at Buca Di Beppo, a Minneapolis-based Italian restaurant chain. The company collapsed after investigators revealed the restaurant had 1) started including free employee meals in revenue and 2) manipulated same-store-sales figures. But you don’t need to hire private investigators to find these things out. When you start seeing empty restaurants and ask yourself, “how on earth do they stay in business,” that’s a sign that something’s probably wrong.
Does Nio Pass Test 1?
How can American investors know what’s happening a world away? In the case of Nio, we must travel to China to observe stores ourselves or compare the company to other EV makers.
And here’s where things get tricky: the central Chinese government doesn’t publish vehicle registration statistics. Instead, it relies on state-sponsored organizations to report car sales, giving some room for data manipulation (something observers have repeatedly accused the Chinese government of doing).
Even the data inconclusive looks inconclusive. Tesla’s (NASDAQ:TSLA) Model 3 sales in China remained somewhat flat since May, while Chinese rivals XPeng (NYSE:XPEV) and Li Auto (NASDAQ:LI) reported 165% and 31% quarter-over-quarter growth rates in the same period. And overall, the government-sponsored China Association of Automobile Manufacturers projects that sales of EVs will decrease by 11% in 2020.
So, where does that leave Nio with its reported 21% quarter-over-quarter growth rate? That’s something every investor should ask themselves before buying.
Test 2. Using Non-Standard Metrics
The second way companies like to fool investors is to blind them with unorthodox metrics. “Adjusted EBITDA” is a favorite since the measure ignores stock options and capital expenditures. But as Warren Buffett once said, “does management think the tooth fairy pays for CapEx?”
In the early 2000s, Worldcom and Waste Management Systems both used faulty EBITDA metrics to mislead investors. The former recategorized operating expenses as capital expenditures, while the latter stretched out depreciation by lengthening its depreciation schedule. Ordinarily, these tiny details would make any investors’ eyes glaze over. But don’t let that happen to you. These metrics allow managers to get away with a lot.
Does Nio use these unorthodox measures? Again, results are mixed. The company does publish typical GAAP figures, including sales, margins, and profits. That’s fine. But the Chinese firm also focuses investors on vehicle deliveries, an unusual metric.
A quick look through their balance sheet shows why. Typically, companies like Tesla and Ford (NYSE:F) will take payment BEFORE delivering vehicles. For instance, Tesla had $4.5 billion in customer deposits and deferred revenue on its balance sheet in its latest filing. Nio, on the other hand, will often deliver vehicles BEFORE receiving any payment. According to its Q3 filings, the company held $218 million in trade receivables.
Make sure you watch out for unexplained trade receivables. It could mean companies trying to pull forward sales.
Test 3. Unexplained Profitability
When it comes to investing, make sure you trust your gut. Studies have shown that people are strangely good at making snap decisions with limited data. Perhaps it’s millennia of evolution, but when something doesn’t “feel” right, there’s usually a good reason why.
Gut instincts don’t always pick up on frauds – thousands of Enron employees willingly bought shares in their employer before the company went bankrupt. But often, that “sinking feeling” will steer you away from the worst companies. The bankruptcy of department store Sears, for instance, mostly spared retail investors who saw the company’s empty stores as a sure sign to stay away.
In the same vein, ask yourself this: does Nio stock feel right?
If you can say, “yes!” then do your due diligence and invest. But if an investment in Nio will leave you awake at night, wondering if you’ve just thrown away your hard-earned savings, then it’s better to zip up your wallet and invest elsewhere. It’s better to hold onto your cash than to lose it to something you worry could be a fraud.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.