In the early afternoon of March 3rd, 1836, Colonel William Barret Travis, the commander of a mission-fortress known as the Alamo, arose to explain the situation to his fellow men at-arms. They were surrounded by an enemy force over ten times their number, he told them, and their only decision, now, was not whether or not to save their own lives, but rather to choose the manner in which they would die. Travis then unsheathed his sword, confidently drew a line in the sand, and asked his comrades to signal their willingness to die by stepping across the line.
Almost two centuries later, a similar line has been drawn. The locale, however, is no longer a tangible fortress and the line’s crossers and detractors are not dirt-covered would-be-revolutionaries. This new line has been drawn across stock charts and message boards, across magazines and investment accounts; and those deciding whether or not to cross the line are investors and commentators who risk not bodily harm, but rather the loss of financial resources and personal pride.
The choice, now, is not between cowardice or death, but rather between belief or non-belief. Investors are being asked to choose between faith or skepticism in the business practices and financial statements of a number of small Chinese companies that are listed on American stock exchanges.
This predicament has all the makings of a classic investing controversy. All the old forces that comprise a fierce financial debate are present – fear is here, as is exuberance, volatility, and the opportunity for tremendous gain – and so are some less frequent participants – xenophobia and bigotry.
Swept up in these forces is the individual investor, who is left to sort out fact from fiction by wading through an ocean of “independent” reports, blog posts, message board threads, ad hominem attacks, and company press releases – all while observing tremendous volatility in the stock prices of a number of a companies that were hitherto largely unknown.
I count myself amongst those individual investors who have experienced this volatility first-hand. After reaping tremendous gains in a number of US-listed Chinese companies in 2009, I have garnered highly disappointing losses in 2010 as a result of these same investments. These losses are all the more disappointing if one considers that the US-listed China sector had appeared to have finally gained true credibility in the early months of 2010 – a period when the stock prices of many such companies were reaching new highs and their fundamentals appeared stronger than ever.
Since this time, the US-listed China sector has undergone a veritable swoon – one brought on by a confluence of company financial restatements (NEP, FUQI, etc.), accusations of fraud (CSKI, ONP, CHBT, etc.), fears over the Chinese economy (Jim Chanos, China real estate, etc.), and volatile American markets. This swoon has induced both pain in the pocketbook and the theft of personal sanity of many an investor as each is left to consider whether the current systemic depression in the prices of US-Listed Chinese companies is indicative of true problems – fraud, impending economic collapse, etc. – or is rather the result of short-term “noise” that is hiding the true value of these companies.
In this article, I will attempt to present a synopsis of this dilemma as well as my own perspective upon it. I will begin by briefly describing the notable trend of small Chinese companies seeking listings on US exchanges. Then, I will consider some of the apparent catalysts for the significant plunge in the stock prices of US-listed Chinese companies. Finally, I will provide my own broad analysis of the current situation and suggest its possible resolution.
China’s economic development has not occurred within a bubble. Indeed, the country’s export-oriented growth model necessarily requires significant international cooperation. This cooperation has not only been limited to trade, it has also extended into the realm of finance, as well.
The listing of Chinese companies upon American stock exchanges is a foremost example of this financial cooperation. This behavior has resulted directly from mitigating factors within China. As other authors have noted, achieving access to domestic capital markets in China is an extremely arduous and time-consuming process – especially for smaller companies. Thus, it has been the case that smaller, more entrepreneurial private Chinese companies are forced to wait for years before receiving the capital that they desperately need in order to expand their operations. Unfortunately, in a dynamic economy such as China’s, waiting a few years for capital can mean a loss of market share and a reduction in a firm’s ability to compete. Faced with these domestic conditions, it is no wonder that capital-hungry companies have jumped at the opportunity to list internationally in the United States. Hundreds of Chinese companies have chosen to do so.
The over 700 Chinese firms that have listed on American exchanges vary widely in terms of size and sector. These firms include the online search giant Baidu (BIDU) and the state-owned oil and gas company Sinopec (SNP) and also much smaller companies like American Lorain (ALN), a manufacturer and distributor of snack foods and ready-to-eat meals. These Chinese companies also notably vary according to the means by which they achieved listings on American exchanges. Some, such as the online travel services provider Ctrip (CTRP), were brought public through the traditional IPO process by notable Wall Street firms. Companies such as these hold vaunted statuses and command rich valuations. Countless other firms, like the bromine and specialty chemicals producer Gulf Resources (GFRE), came to market through a process known as a reverse merger – a transaction whereby a shell company (an incorporated legal entity with no business operations) that is already listed on an American exchange (usually the Over-the-Counter Bulletin Board) “buys” the Chinese company that is seeking to go public. The result is that the Chinese company is effectively made a publically traded entity at a sliver of the cost of a traditional IPO and much more quickly. After being publically listed, the company can then raise capital through a share offering or a PIPE (Private Investment in a Public Entity) transaction.
Many small Chinese companies have gone public through this reverse merger process with the help of a number of facilitators. These facilitators include American financial firms like Halter Financial, Rodman and Renshaw, William Blair, Brean Murray & Carret, Roth Capital Partners, New York Global Group and Global Hunter Securities. They also include Chinese consultants such as Du Qingsong, Kit Tsui and Benjamin Wey. To support these companies following their listings, a number of smaller American accounting firms like MSPC, Frazer Frost, and Kabani & company now boast specialties in providing SEC-required GAAP auditing services to Asian firms.
As noted earlier, a number of these reverse-merger firms first became public on the less liquid and less covered Over-The-Counter Bulletin Board (OTCBB). As these firms have grown their operations and improved their transparency, a number of them have qualified for listings on the Nasdaq or the New York Stock Exchange. For example, China Security and Surveillance (CSR), a manufacturer, distributor and installer of security products, first appeared on the OTCBB and transitioned to the NYSE in 2007.
During the market panic in 2007 & 2008, many of these-thinly traded reverse-merger firms were sold indiscriminately as investors fled apparently risky assets. As a result, holders of US-listed Chinese companies suffered steep losses despite the fact that the fundamentals of many of these companies strengthened as China’s economy continued to grow in spite of the global economic downturn. At their lowest levels, shares of some Chinese companies were selling for a quarter of their book values.
Investors who purchased shares of these companies at these depressed levels were richly rewarded in 2009 as many companies saw their share prices appreciate by leaps and bounds during the market recovery. Coming off its March 2009 low of just over $3 per share, Fuqi International (FUQI), a manufacturer, wholesaler and retailer of jewelry, saw its stock price skyrocket to approximately $32 per share only seven months later.
However, the example of Fuqi International (FUQI) also serves to highlight the potential risks associated with investing in US-Listed Chinese companies. In March 2010, the company announced the discovery of several material accounting errors that resulted in overstated profit margins. Since then, Fuqi has been delinquent in its required SEC filings of its 2009 annual report and its quarterly reports for the first two quarters of 2010. Currently, the company still trades on the Nasdaq exchange, but may be delisted if its does not file with the SEC by September 28th. Due to these accounting errors, the company is facing a number of shareholder class-action lawsuits.
It was during the early months of 2010 that much of the momentum behind the stock prices of small US-listed Chinese companies began to wane. As prices decisively fell off their highs, a wave of critics began to highlight a number of issues that haunt US-listed Chinese firms. These issues include: specious accounting procedures, the lack of transparency, the safety of invested capital, stock dilution, and outright fraud. While the significance of some of these issues can be readily substantiated, others have been emphasized far beyond what reason and evidence will support. Let’s go through these issues one-by-one.
One of the foremost critiques of US-listed Chinese companies – and one of the most substantiated – is that they lack strong accounting practices. A large amount of such companies tacitly agree with this critique as many have readily disclosed material deficiencies in their internal control procedures in their statements to the SEC. Such revelations should certainly not be welcomed, but they should be expected. These companies often operate in environments that systemically mitigate access to the required technology and the skilled workforces that make possible compliance with modern internal control requirements.
Author Note: Some investors have accused Chinese companies of accounting fraud for certain financial restatements regarding the proper valuation of derivative securities such as warrants. It must be understood that this type of restatement DOES NOT reflect fraud nor does it necessarily reflect accounting incompetence. This type of restatement is due to convoluted changes in accounting law brought on by the passage of the Sarbanes-Oxley Act in 2002 and has been made by a number of companies, not just those in the US-listed China small-cap sector.
Critics of small US-listed Chinese companies are right to point out that some of their auditors, such as Kabani & Co., Frazer Frost, and MSPC, have had troubling backgrounds. However, it is folly to suggest that the presence of a few inconsistencies reflects a vast conspiracy of fraud.
Progress is being made, a number of smaller Chinese firms such as Duoyuan Printing (DYP), Asia Pacific Wire & Cable (AWRCF.OB) and China Media Express (CCME) have retained top-tier accounting firms such as Ernst & Young and Deloitte & Touche to audit their financials. The trend in the sector is clearly toward improving accounting practices.
Author Note: On the day of publication of this post, Duoyuan Printing dismissed Deloitte and Touche as its auditor for highly suspicious reasons – including a disagreement between management and auditors over whether certain original bank statements should be allowed to be reviewed. Such an instance highlights further risks associated with investing in US-listed Chinese companies.
The oft-repeated critique regarding the lack of transparency is easily the most well-founded. Oftentimes, investors in US-listed Chinese companies wait for months at a time just to receive a press release. Moreover, company annual and quarterly reports are often barebones. As a result, investors are kept in the dark regarding information that is readily available about American companies. The language gap also makes things very difficult. For instance, most American investors cannot do simple online due diligence because finding specific companies often requires an understanding of Mandarin characters.
Though transparency is certainly low amongst these companies, progress is being made. Many of the more seasoned Chinese companies have hired active investor relations firms and have recruited CFOs that are fluent in English. Moreover, company representatives now frequently present at investor road shows and sector-specific conferences. Recently, a number of companies (China Biotics & China Media Express) have held events for investors to showcase their operations.
Investors must be cognizant that it is somewhat unfair to apply modern-western standards of transparency upon very young private companies that operate in an atmosphere that is the economic equivalent of the Wild West. Other authors have made a prudent observation that investing in smaller US-Listed Chinese companies is very much akin to early investments made in small American firms at the dawn of the 20th century. During this period, transparency amongst public companies was virtually nonexistent as companies were not even required to report their results to investors. Worse yet, many American firms flaunted state laws and bribed officials to get ahead. Moreover, accounting practices were undeveloped, at best. Valuations of company shares were often solely based upon the dividends that companies chose to issue.
Investors should expect more transparency from US-listed Chinese companies, but they should also expect to wait for it to come.
Another critique revolves around fears that investments in US-listed Chinese companies are simply not safe – that the capital invested in these companies are not well-protected by law. Like the critique regarding the lack of transparency, this one is also well-substantiated. Simply put, the legal system within the United States would be hard pressed to prosecute Chinese individuals or seize capital within China without the assistance of Chinese authorities. At this point, there is little precedent to suggest that such assistance would be forthcoming.
Other critics have voiced a more alarming scenario: that investors will awake one day to discover that the autocratic government of China has unilaterally canceled all foreign ownership in domestic Chinese companies. To this doomsday scenario, I can only respond thus: If such an event were to take place, investors would likely have much more to worry about than the value of their portfolios – for such a drastic measure could only be accompanied by far worse scenarios like a total trade suspension or a declaration of war. With respect to this doomsday scenario, investors need not worry. The trend for China over the past three decades has clearly been toward more international cooperation. Moreover, if the growing nation wants the rest of the world to respect their new ownership claims in a number of international companies and resource deposits then they will most certainly have to respect foreign claims on Chinese assets, as well.
Though more guarantees need to be forthcoming to completely allay this specific risk that is associated with investing in US-listed Chinese companies, investors should be optimistic about some developments in the sector. For instance, the OTCBB listed, China Organic Agriculture (CNOA.OB) fully cooperated with an investor class-action lawsuit brought against it (the claim was eventually settled outside of court). Also, several small US-listed Chinese companies like Tianyin Pharmaceutical (TPI) and Sino-Agro Foods (SIAF.PK) have undertaken a dividend policy. For investors in these companies and in the broader US-listed China sector, these developments are certainly positive.
Many critics have also cried foul of the large amount of stock offerings that US-listed Chinese companies have undertaken, especially over the past year. The justness of these critiques varies widely according to each company’s unique situation. Many companies, such as Universal Travel Group (UTA) and China Gerui Advanced Materials Group (CHOP), have undertaken bold expansion strategies that require large amounts of capital. That their capital raises take place during periods when their stock prices have been fairly or unfairly depressed is no fault of their own. Investors should note that though many of these stock sales have caused upfront dilution, they often promise – and ultimately return – much more in the form of increased revenues and profits. For example, Puda Coal’s (PUDA) offering in March 2010 is being used to support the purchase, upgrade and integration of a several coal mine projects in Shaanxi province. As a result of these mine acquisitions, Puda’s forward earnings projections have significantly increased.
Investors should be concerned, however, with repeated offerings – or offerings without a clear purpose – at prices near or below book value. While some companies, such as Lotus Pharmaceuticals (LTUS.OB) have demonstrated care for shareholder value through word and act, others, like Sutor Technology Group (SUTR), which issued shares at a price that was 50% below book value, have not.
With offerings of stock, investors should bear an open mind. With market sentiment regarding Chinese high-growth companies as capricious as it is, the pricing of offerings will likely vary widely over the long term. Some will be highly advantageous – such as Fuqi’s $100 million offering at $21.50 – others will not be. Ultimately the most important factor that determines the value of a stock offering is the plan by which the raised capital will be deployed. Investors in US-listed China securities should heed this.
Of all of the expressed critiques of US-listed Chinese companies, the most numerous and loudest involve accusations of outright fraud. Unfortunately, many accusations have been colored by racial slurs and xenophobic comments. Such accusations that evoke these sentiments should simply be ignored. However, accusations that are based on more thorough research and are presented in a deliberate and reasoned manner, such as those made by John “Waldo Mushman” Bird and the (unfortunately) anonymous “China Company Analyst” must be heeded and further explored.
The most substantial evidence that supports the legitimate accusations of fraud are financial documents that are submitted to the State Administration of Industry and Commerce (SAIC), a regulatory entity within China that is primarily responsible for licensing the operations of businesses. Accusers suggest that when SAIC and SEC statements do not match – as in the cases of China Biotics (CHBT), China Sky One Medical (CSKI) and China Marine Food Group (CMFO) – the Chinese company is committing outright fraud.
However, there is much disagreement regarding the value of these filings as a means of indicating a company’s financial performance. Company representatives have downplayed their importance – calling them minor filings that are merely used for business registration purposes. Accusers allege that Chinese law mandates that SAIC filings are audited for their veracity when they are filed by companies that operate as Foreign Owned Entities – as US-listed Chinese companies do. Both responses may well be correct, in which case Chinese companies are skirting certain regulations. It bears noting that in most developing countries, China especially, the law is not necessarily what is written, but what is practiced.
Ultimately, the accusations of fraud regarding SAIC filings rest just a heavily upon the shoulders of the accounting firms of US-listed Chinese companies. To provide approval to annual reports filed with the SEC, auditing firms will have reviewed statements filed by Chinese companies with the State Administration of Taxation – China’s equivalent of the Internal Revenue Service. These statements – unfortunately not available to the public – carry a weight that is recognized by both sides of the SAIC issue. These statements must absolutely be materially similar to their SEC counterparts or else fraud is most certainly present. If auditing firms have reviewed these filings, found them to be materially less than reality and still given their approval, then they are complicit to fraud.
The endgame scenario for the SAIC discrepancy issue is a simple one to imagine. When new SAIC filings are released for companies with a previous discrepancy, they should materially match those statements that are issued to the SEC. If such a scenario plays out, investors would then know that SAIC filings truly are not as important as detractors hold them to be. On one of his many websites, “Chinese Company Analyst” has disclosed that this scenario has been playing out for an “increasing” number of companies with earlier discrepancies.
Other accusations of fraud rely on charges that a company’s operations are materially different than those reported. Accusations of this type have haunted China Biotics (CHBT) and Orient Paper (ONP). Both firms have strongly refuted such accusations. Notably, Orient Paper has engaged a legal firm and Deloitte & Touche to certify its operations. China Biotics has responded by hosting an investor day where it will be showcasing its production facilities and retail outlets.
Of those companies that have been most actively accused of fraud – China Northeast Petroleum (NEP), Orient Paper (ONP), Fuqi International (FUQI), China Sky One Medical (CSKI), Lihua International (LIWA), China Marine Food Group (CMFO) and China Biotics (CHBT) – all continue to trade on senior exchanges and report to the SEC (In previous cases of clear fraud, such as those of China Expert Technology and China Energy Savings Technology, company managements mysteriously disappeared and the entities ceased reporting to the SEC once fraud allegations surfaced). Recently, China Northeast Petroleum (NEP) resumed trading after a nearly three and a half month trading halt. The company is now up-to-date on all of its required filings and successfully underwent a forensic audit to ensure that its officers were not misappropriating company funds. All of the firms have responded to the accusations brought against them in some manner – some certainly have been more vociferous than others.
As a result of the many critiques that have been leveled against small US-listed Chinese companies, the shares prices of these firms have notably plummeted since their highs earlier in the year. Almost all of the reverse-merger firms now boast single digit price to earnings ratios and many can be purchased at forward earnings multiples of less than five. If the financials and operations of these firms are proven to be accurate and in-line with company claims, then the current systemic price depression in the sector is surely a tremendous buying opportunity. If not, then this sector represents a vast value trap. For my own part, I am cautiously inclined to believe that the former scenario is the truest representation of reality. For detractors’ claims of fraud to be accurate, they are asking investors to believe that multiple instances of highly sophisticated frauds are being actively perpetrated. My carefully weighed opinions lead me to believe that such vast, highly specialized frauds simply do not exist.
The vociferous responses of many small US-listed Chinese companies to the fraud accusations made against them have served to draw a line in the sand. Unlike at the Alamo, no lives are at risk – no blood will be shed. Supporters and detractors have signaled their positions not with sabers or bullets, but with two words – “long” and “short.”
That a showdown is coming for US-listed Chinese companies is undeniable. What’s left to guesswork is the timing of this showdown and its result. Will the answers that so many investors seek come in the following months or could it take years? Will this period be remembered as the last gasp of a notable, but ill-fated trend in American financial markets or as a turning point – a period when the livelihoods and credibility of numerous auditors, bankers and businessmen were fully vindicated?
While the ultimate results will surely not be as clear cut as supporters or detractors wish them to be, results will come. Fortunes will be made. Follies will be many.