Chinese small caps and dodgy accounting

[petec]

Hi all,

 

I have very recently started looking at Chinese small caps.  Most of my investment experience to date has been in big and very high quality companies so I am slightly out of my depth.  Example: ZST Digital Networks is off 68% today as their auditor has resigned.  That's clearly not good news but the company has (or claims to have) $55m in cash and no debt and trades for $8m market cap, or 0.9x TTM PE.  How easy is it to fake cash on a balance sheet?  My instinct says the income statement is easier to fake than cash on the balance sheet but maybe I am wrong.  And how little does one pay for a company that has exhibited steady growth and buildup of cash?

 

Excuse the braindump but if anyone has experience of investing in companies like this (Chinese smallcaps or those under an accounting cloud) I'd be very interested to hear what you have to say in general or specific to this case.

 

Many thanks

 

Pete

[JAllen]

I would stay totally away from these unless you're going to go to China to see their operations.

[abyli]

I would stay totally away from these unless you're going to go to China to see their operations.

 

Even you are going to China to see their operations, even you can talk to their management team, stay far, far away from these. :-)

[Ross812]

It's very easy for them to fake cash on their balance sheet. The Chinese government does nothing to protect foreign investors and the company's board can do as they please with your money. There has to be trust between the company and shareholders that management will act for the shareholders (owners) when making decisions to mutually benefit the owners and company. Amongst Chinese small caps, there is a huge disconnect between the paper shares trading and the underlying company. I would go so far to say, often the shares you buy give you no rights of ownership and are not worth the paper they are written on. Even if the company has 55m in cash in the bank, there is nothing to stop management from diluting any ownership you may have a right two and taking the company private themselves. 

 

Look else where. The fact their auditors won't even deal with them should be a huge red flag!

 

[Ballinvarosig Investors]

I would stay totally away from these unless you're going to go to China to see their operations.

In most cases, Chinese companies involved in accounting scandals have real and active operations.

[JAllen]

I would stay totally away from these unless you're going to go to China to see their operations.

In most cases, Chinese companies involved in accounting scandals have real and active operations.

 

True.

 

Then how about: "I would totally stay away from these".  :D

[Sportgamma]

The governance and oversight risks are simply too high.

 

http://dealbook.nytimes.com/2012/04/24/fraud-heightens-jeopardy-of-investing-in-chinese-companies/?nl=business&emc=edit_dlbkam_20120425

[Ross812]

Just in case anyone has a hard time figuring out what the consensus is:

 

If you go to China and get a tour of their facilities - DON'T INVEST

 

If you buy some of their products and its better than the I-Phone - DON'T INVEST

 

If you research everything and are positive its the best investment in your life - DON'T INVEST

 

To sum it up: DON'T INVEST

 

 

The fact that 10 people withing 10 minutes told you to run away should tell you something!

[A_Hamilton]

Just in case anyone has a hard time figuring out what the consensus is:

 

If you go to China and get a tour of their facilities - DON'T INVEST

 

If you buy some of their products and its better than the I-Phone - DON'T INVEST

 

If you research everything and are positive its the best investment in your life - DON'T INVEST

 

To sum it up: DON'T INVEST

 

 

The fact that 10 people withing 10 minutes told you to run away should tell you something!

 

I generally agree, but I think that if these guys are audited by a big 4 company, that has to say something about the firm's survival. I know that there have been scandals recently, but I feel like legitimate Auditors have got to be all over these companies at this point.

[Ross812]

A big four auditor goes a long way, but I know of at least one example of a big four auditor getting tricked. There are many legitimate Chinese companies, but the risk is a complete loss to invest in any of them. Until the Chinese government has some method to protect foreign investors, the space is too risky for me.

[FFHWatcher]

Speaking from personal experience, even if there are real operations, even if there is a real auditor (big 4), even if there is real cash in the bank, who says that as a shareholder, it is yours?  Who says that the excess cash flow can leave the country?  North America and Europe have laws to protect property and shareholders.  In China, to my knowledge, there is no legal way to prosecute or file a lawsuit against wrongdoings by North Americans.  Therefore, there is really nothing stopping executives from pilfering the company. 

 

The company I was a shareholder in had the founder raise a bunch of capital in North America, move all that capital to China for operations and acquisitions and then he went down to the 'Registrar's Office' and transferred the ownership in the company back to himself.  He then raised more money with Citic (one of the largest state owned investment companies in China) through selling equity and issuing debt to them, and at the end of the day, there is apparently nothing shareholders can do about it.  Hundreds of millions of dollars of capital and stock .... poof...gone.  The largest State investment company is doing nothing to stop it,  or to make it right and there seems to be no legal remedy. 

 

Bottom line, you have no legal recourse in China, to my knowledge.  Without legal recourse and consequences for the perpetrators, it is simply too risky to invest there.  What is stopping the criminals?  They are stealing money from non-Chinese investors and China is doing nothing about it.  Imagine if Citic bought into a company in North America, the employees/original founders decide to go down to the registrar's office, transfer those shareholdings back into the founders name, and rip Citic off for hundreds of millions of dollars....  What do you think Citic would do? It would be a friggin' International incident!!  They/chinese firms do it everyday to us.  I can't believe more isn't being done.

 

Why not just invest in Argentina oil operations?

[king888]

http://www.sec.gov/news/press/2012/2012-31.htm

 

Trivia Question:  What is the Chinese equivalent to the SEC?  What is the Chinese equivalent to a DEF14-A filing?

There are Market Misconduct Tribunal and SFC for Hong Kong Stock Exchange but I don't kmow abot China Mainland version.

 

The level of fraud is high not only in US-listed Chinese companies but also in Hong Kong Exchange as well. This website that provide a insight on fraud at HKEX http://webb-site.com/

 

From my experience, the fraud in HKEX is likely to associate with penny stocks and the stock that has done too many capital raise or has a poor disclosure in annual report. I think it is detectable if you have done some homework.

 

Having big-4 auditor is not fraud-proof when we are talking about US-listed chinese companies. But I think the easiest way to detect the fruad is if the margin and cash flow are too good to be true,it is likely to be a fraud.

 

I did buy into two US-listed Chinese companies last year ,I sold one and still holding on another ones. I was lucky to exit first position with moderate gain.If I still hold it until today, I would be on substaintial capital loss. But I still believe it is not an outright fruad. It is a car-dealerships in Beijing that went on IPO in December 2010. The reason that it did IPO in US market was becuase the coming new car quota regulation in Beijing. If it did an offering in HK or Shanghai ,no one would buy the shares. So it went on US-listing route where investors were less informed. The car quota was annonced 3 weeks after IPO's date if I remember correctly.

 

My point is this space requires a lot of due-diligence.It might not worth your time. Do not buy base on financial statement only.

For another company that I still have a position, I am on 50% gain but not sure if it is worth my time or not. I went to visit its AGM in Shanghai becuase share price was on a crash last year so I need to make sure that at least the company exists and they were conducting real AGM.This company had management installed from American biggest shareholder after the accounting was cooked by previous Chinese executives.So I have a reason to believe that it is not an outright fruad. But there is nothing 100% sure.

 

[Olmsted]

Hi all,

 

I have very recently started looking at Chinese small caps.  Most of my investment experience to date has been in big and very high quality companies so I am slightly out of my depth.  Example: ZST Digital Networks is off 68% today as their auditor has resigned.  That's clearly not good news but the company has (or claims to have) $55m in cash and no debt and trades for $8m market cap, or 0.9x TTM PE.  How easy is it to fake cash on a balance sheet?  My instinct says the income statement is easier to fake than cash on the balance sheet but maybe I am wrong.  And how little does one pay for a company that has exhibited steady growth and buildup of cash?

 

Excuse the braindump but if anyone has experience of investing in companies like this (Chinese smallcaps or those under an accounting cloud) I'd be very interested to hear what you have to say in general or specific to this case.

 

Many thanks

 

Pete

 

I would read every post on Bronte Capital and get into the mind of its author, John Hempton.  If you can approach a Chinese company like you are  looking for a fraud (abnormal profit margins, inventory, not enough employees, not enough R&D, doesn't "smell right", etc.) and do it rigorously, and cannot find evidence of fraud - you may be okay. 

 

My gut tells me that there have got to be legitimate companies in China at great valuations because fraud has become the assumption a priori.  If someone is good enough at fraud detection/detecting absence of fraud - there has got to be good money to be made there. 

 

For me, there are too many landmines to even consider a single Chinese company (especially with the undervalued companies already in my portfolio) - but someone with better info, better forensic accounting, etc. may have a different viewpoint.

 

Also check reports by Muddy Waters and Citron.  Other board members may have further suggestions.

 

Best of luck.

[alwaysinvert]

Speaking from personal experience, even if there are real operations, even if there is a real auditor (big 4), even if there is real cash in the bank, who says that as a shareholder, it is yours?  Who says that the excess cash flow can leave the country?  North America and Europe have laws to protect property and shareholders.  In China, to my knowledge, there is no legal way to prosecute or file a lawsuit against wrongdoings by North Americans.  Therefore, there is really nothing stopping executives from pilfering the company. 

 

The company I was a shareholder in had the founder raise a bunch of capital in North America, move all that capital to China for operations and acquisitions and then he went down to the 'Registrar's Office' and transferred the ownership in the company back to himself.  He then raised more money with Citic (one of the largest state owned investment companies in China) through selling equity and issuing debt to them, and at the end of the day, there is apparently nothing shareholders can do about it.  Hundreds of millions of dollars of capital and stock .... poof...gone.  The largest State investment company is doing nothing to stop it,  or to make it right and there seems to be no legal remedy. 

 

Bottom line, you have no legal recourse in China, to my knowledge.  Without legal recourse and consequences for the perpetrators, it is simply too risky to invest there.  What is stopping the criminals?  They are stealing money from non-Chinese investors and China is doing nothing about it.  Imagine if Citic bought into a company in North America, the employees/original founders decide to go down to the registrar's office, transfer those shareholdings back into the founders name, and rip Citic off for hundreds of millions of dollars....  What do you think Citic would do? It would be a friggin' International incident!!  They/chinese firms do it everyday to us.  I can't believe more isn't being done.

 

Why not just invest in Argentina oil operations?

 

You get the post of the day award, sir. And of course, the same goes for Russia.

[Hielko]

I own one Chinese company. It's has been public since 1996, has been paying out more dividends that they raised in capital in the '96 IPO (also no debt) and think this is the only way to be reasonable confident that you are not getting screwed; you need to see that management is willing to return (a lot) of capital to shareholders.