As the followers of the Chinese reverse-merger sector are well aware, issues regarding accounting and corporate governance have played significant roles in triggering and sustaining the recent – though now turning – malaise in the stock prices of many small Chinese companies.
One of the foremost issues that has been discussed is the credibility of accounting firm BDO Limited’s audits. BDO Limited is the Hong Kong member firm of the international BDO accounting network and is a leading auditor of Chinese reverse-merger companies. BDO Limited’s clients include SkyPeople Fruit Juice (SPU), Gulf Resources (GFRE), China Marine Food (CMFO), China Biotics (CHBT), and Orient Paper (ONP). Author Note: CMFO, CHBT and ONP have all been accused of fraud by several vociferous members of the investing community, over the past few months – as of yet, no fraud allegations have been proven. Critics of BDO Limited’s credibility primarily base their assertions on the fact that the firm’s predecessor, BDO McCabe Lo was the auditor of the proven Chinese reverse-merger fraud China Expert Technology (CXTI) (A more complete description of the detractors’ claims can be found HERE). While I agree that such a disturbing link should merit further due diligence and more caution, I disagree with the notion that this troubling vignette from BDO Limited’s past should mean that all of the firm’s auditing work is now suspect.
Apparently Grant Thorton, another large and well-regarded network of accounting firms, agrees with me. On October 7th, Grant Thorton’s Hong Kong member firm merged with BDO Limited, forming an enlarged firm that now has a staff of more than 1000 individuals, including over 50 partners, and a client-base of over 200 companies. Patrick Rozario, the CEO of Grant Thorton’s Hong Kong member firm had the following to say about BDO Limited:
“Our partners believe that in line with the fast expanding business of the Firm, the business opportunities in China and around the region, we are joining a successful firm which has a solid reputation in the profession and great strength in Hong Kong. BDO provides a well established structure and support, in particular with its capabilities in China, for us to further develop our business. And, going forward, the enlarged practice would be well placed to provide a stronger service platform in both Hong Kong and China and further enhance our position in the market. We are very excited about this opportunity and the potentials and benefits that this strategic move will bring to our clients, staff and the accounting profession as a whole.” Source
This merger augurs well for all individuals who have an interest in Chinese reverse-merger companies that are audited by BDO Limited. This vote of confidence by Grant Thorton and the new resources available to the firm will likely translate into more thorough auditing processes. As a result, better information and greater confidence will be provided to long-investors and short-sellers, alike.
While US stock markets stagnated on Monday, Harbin Electric (HRBN) was away and sprinting. The shares of the China-based manufacturer of electric motors ended the day up 16.3% on news that its chairman, Tianfu Yang, in partnership with the major private equity firm Baring Partners, was bidding to take the company private at $24 per share.
While most investors in the broader US markets might ignore a privatization bid for a small Chinese company, investors in Harbin Electric and in its broader sector should see it as a landmark event – and not a particularly welcome one.
Harbin Electric belongs to a select group of companies that is composed of small Chinese firms that came to be listed on American stock exchanges using an alternative to an initial public offering (IPO) called a reverse-merger. A reverse-merger is a transaction whereby a shell company (an incorporated legal entity with no business operations) that is already listed on an American exchange “buys” the Chinese company that is seeking to go public. After becoming listed, the company usually undergoes a capital raise. With the reverse merger and capital raise completed, the Chinese company has essentially completed an IPO.
Harbin Electric underwent this reverse-merger process in 2005, when it was a small player in the electric motor market in China. Using the capital it has raised through its domestic listing and other secondary share offerings, the company’s growth over the past five years has been nothing short of spectacular. In 2005, the company boasted revenues and net income of $24 million and $10 million, respectively. For the fiscal year 2010 the company is expected to post $430 million in revenue and $90 million in net income.
Investors who have held a stake in Harbin Electric since its listing in 2005 have been richly rewarded. Over this period, the company’s share price has appreciated almost eight times over (as of its 10/12/10 closing price) – generating a 48.5% compound annual return.
Given Harbin Electric’s success, it should come as no surprise that a great number of small Chinese firms have followed its path into the US capital markets through the reverse-merger method. The firms that have done so greatly vary in terms of size and industry. They include China Security and Surveillance Technology (CSR), a firm engaged in the manufacture and installation of surveillance products that boasts revenue of almost $800 million, and Soko Fitness (SOKF.OB), an owner and operator of fitness centers and beauty salons that does $30 million in business.
While many firms have followed in Harbin Electric’s footsteps, not many have found its success. Firms like jewelry wholesaler and retailer Fuqi International (FUQI) and oil driller China Northeast Petroleum (NEP) have experienced accounting and corporate governance issues that have led to SEC compliance issues. Other companies like the paper manufacturer Orient Paper (ONP) and pro-biotics producer China Biotics (CHBT) have been accused of outright fraud.
As a result of these issues, a great pall currently lies over the entire Chinese reverse-merger sector. The discussions surrounding these stocks have devolved from debates over proper valuation to shouting matches regarding whether or not these companies actually exist. Unfortunately, as the intellectual level of discourse has fallen, so too have company stock prices.
The malaise in the Chinese reverse-merger sector has even affected companies with clean corporate histories and upstanding reputations like Harbin Electric. Where the company was once awarded a price-to-earnings (P/E) ratio of 25 at the end of 2007, its shares can now barely muster a P/E ratio of 12 – despite exponential growth in revenues and operating income. As of its close, today, Harbin Electric boasts a tiny price-to-earnings growth (P/EG) ratio of 0.5 and a petty forward P/E of 7.9.
These numbers are shocking when one considers the valuation of some of Harbin Electric’s peers. Chinese companies that listed on American exchanges through the traditional IPO route using bulge-bracket investment banks as underwriters command valuations many times greater than Harbin Electric’s. Firms like New Oriental Education (EDU) and Ctrip (CTRP) garner P/E ratios of 44, and 57, respectively, despite the fact that their revenue and earnings growth rates trail Harbin’s. Chinese firms that trade on China-based exchanges in Shanghai, Shenzhen, or Hong Kong receive valuations that are similar to or higher than those given to New Oriental or Ctrip. For instance, firms that trade on ChiNext, a recently launched Nasdaq-style exchange for small Chinese companies, command an average P/E ratio of 64.
The issue of valuation is at the core of Harbin Electric’s privatization bid. While Harbin Electric’s reverse-merger listing has given the company capital to support its massive growth, it has not given it a fair and proper valuation. If Harbin Electric were to be given a valuation that is consistent with that which is given to US-listed Chinese companies like Country Style Cooking (CCSC) and Sohu.com (SOHU), the firm would be reasonably priced at $50 per share (equivalent to a P/EG ratio of 1.0) – and even that might be conservative. For instance, if Harbin Electric were given a P/E ratio equivalent to that which is given to the average company listed on ChiNext, its share price would be $192 based on 2010 earnings-per-share projections.
Thus, with their privatization bid, Harbin Electric chairman Tianfu Yang and private equity firm Baring Capital seem to have a highly compelling arbitrage play on their hands. For a meager price of $24 per share, they can purchase the company and then list it again on the rapidly evolving markets in China at share prices potentially two to eight times higher than present. While Mr. Yang and Baring Partners will likely profit exorbitantly, current Harbin Electric shareholders and other American investors will miss out on the tremendous potential that the company holds. However, given the conditions that currently exist in the Chinese reverse-merger sector, these latter two groups may only have themselves to blame.
If American investors continue to allow stock prices in the Chinese reverse-merger sector to be dictated by xenophobia, unproven accusations of fraud, and excessive fears over corporate governance issues, Harbin Electric will not be the first promising Chinese company to flee American stocks exchanges through privatization and then relist in friendlier markets. If a large exodus does ensue, American investors will miss out on a tremendous amount of potentially once-in-a-lifetime investment opportunities. Given the American economy’s stagnant performance over the past few years and its likely continued underperformance, these opportunities are ones that American investors should not relinquish without a fight.
Disclosure: Author holds long positions in HRBN and in a number of companies in the Chinese reverse-merger sector.
My interest in investing is partly founded upon my fascination with human behavior. Financial markets are veritable treasure troves for those who share this fascination. In them, one can see ordinary people taken to the height of jubilation and then bear witness as they are dragged down to the depths of despair. The cause of this emotional about-face? A wandering curve set against an unassuming white background.
In financial markets, a lifetime of emotions can pass in days. Fortunes are created and squandered. Reputations forged and destroyed. Lives changed and lost.
Those investors who stand immune from the emotional effects of that wandering curve can count themselves as either hardened to the point of transcendence or simply psychopathic. The rest of us confront these effects as best we can.
This confrontation is not at all straightforward; rather, it is emotionally and physically exhausting. And yet, despite this promise of abuse, droves of people always return to the circus that is the financial markets.
Frequently, they are drawn by the markets’ most obvious, if unspoken, allure: the prospect of receiving something for nothing – of investing a little and receiving a lot. It is a notion that ought to be confined to casinos. But, like mice to grain, it follows money without fail.
Those who enter the markets following this intoxicating promise and escape still clinging to it are few and far between. They are the lucky few and are, not surprisingly, often very loud. They write books that echo the same promise (“Earn Money in the Markets Guaranteed!” “Simple Investing Secrets That Will Make You A Millionaire!”). These fortunate few will likely make far more money from their books than they ever did by following the strategies they promote.
Unfortunately, it is often the case that the best investors are the quietest. Perhaps it is because they understand that genuine, long-term, market-beating success is so fragile that their own voices might shatter it.
If they did speak, they might tell us that this notion of getting something for nothing is a false deity and that most of those who worship it will pay for their faith with the most valuable of currencies: happiness.
“True investing success,” they might say, “is bought and paid for by countless hours of research, intermittent days of despondent doubt, and years of practicing the simple virtue that most investors seem to forget about: patience.”
Many others try so hard to beat the market by trying to outrun it or out maneuver it. Ironically, in so doing, they will likely forever remain slightly behind it. And at every turn, they will find themselves slipping farther and farther behind.
Everyone else just seems to be along for the ride – a methodology which is, for a great many people, decidedly the best.
Some men and women accord the market with genius. They see it as a wizened and all knowing mathematician – an individual who divines greater truths from facts and figures and then expresses them with eloquent and simple proofs. He is never wrong.
I find the market to be an old man. A man whose mind has been relieved of the tiresome burden of memory. His life is a long walk – a walk toward home. His instinct ensures that he will remain on a true course, but it does not prevent him from stumbling or falling, or from taking a turn that will lengthen his plodding trek. Onlookers see him lumber by and grant him little thought save for one: “I am not him, nor will I ever be him.”
But they are him. All of them are. He is the sum of their attitudes and reasoning made manifest. His frequent stumbles are their moments of panic. His few instances of surefootedness are their moments of clarity. His occasional episodes of running are their moments of exuberance.
His walk resembles a wandering curve.
In the game of Poker, an oft-spoken adage is “You’ve got to know when to hold ‘em and when to fold ‘em”. Unfortunately, I am often reminded of this axiom at precisely the moment after I needed to hear it. This is but one of the many reasons that I am not playing on the World Poker Tour. Though my Poker knowledge is certainly lacking, I do know that the decision of when to hold or fold depends upon how well one knows two other variables: the odds of getting a decent hand and the behavior of the guy across the table.
Thankfully, the first variable – the odds of getting a decent hand – can be readily quantified. A skilled player knows that a deck of cards is finite and he knows the expected probability that a certain card will be drawn from the deck. Thus, with this information, he can easily determine the odds of making a decent hand and, if he plays these odds well, can probably bring in a decent haul playing online poker.
To become a great poker player, however, one must conquer a variable that is far more difficult to decipher – the behavior of one’s opponent. To do so, one needs to have a mixture of intuition and clear-headedness. Of course, having these two traits does not mean that a player can read his opponent’s mind. What it does mean, however, is that when his opponent puts him on the ropes, he won’t panic or immediately flee the hand. Instead, he’ll coolly and deliberately assess his situation and the previous actions of his opponent, and then make his decision to hold or fold. The same methodology applies to the moments when his opponent is showing signs of weakness, as well.
The same adage – “You’ve got to know when to hold ‘em and when to fold ‘em” – could readily be applied to the world of investing, as well; though its application would be wholly different. After all, unlike the odds of getting a decent hand in poker, the future return of a stock or a basket of stocks is not something that can be easily quantified. In the real world, there is no finite number of possible events that can affect a stock’s price – as many others have pointed out: in the realm of investing, the only certainty is that uncertain things are bound to happen.
Aside: Although devotees of Modern Portfolio Theory might suggest otherwise, an investor cannot simply use historical returns as a basis for predicting the future performance. (Just imagine if a poker player adopted a strategy for his current hand that was solely based upon what cards were drawn in the previous ones.)
Thus, unlike poker, the game of investing is not one that can be played using probabilities. However, it is a one that relies just as heavily – if not more – upon the same ability to remain calm and to reason deliberately that has ensured the success of so many great poker players. This ability to coolly consider the facts that tell what is and suggest what may be is an absolutely essential tool for an investor who is considering whether to sell or hold a stock.
Staying calm and reasoning coolly is, of course, not particularly easy. After all, the market, like a poker player’s opponent, is constantly suggesting to investors its own perception of reality – one that might support or undermine the facts that an individual investor is considering. When the perception of an investor and the market conflicts – perhaps in an instance where the market is saying that a stock is worth far less than an investor believes it to be – a significant amount of pressure is placed on the investor. It’s as if a poker player’s opponent has just gone all in on a decisive hand.
Through their deeds and words, the most successful investors in history have consistently reminded others that the proper strategy in such a tense situation is first and foremost to stay calm. Then, one must deliberately reconsider the facts and fundamentals that comprise a stock. If the only thing that has changed about a situation is the market’s perception of it, then investors needn’t fret. They should just call Mr. Market’s bluff and stay in their positions.
Here are a few examples of this type of thinking from my own investing experiences.
Gulf Resources (GFRE), a Chinese provider of bromine, crude salt and specialty chemicals, is, by far, my most successful pick to date. But if you had asked Mr. Market if it was a successful pick in late 2008, he’d have told a very different story. I originally purchased shares of the company at $3.20 in mid-2008. By December of the same year, they traded at $0.82 per share – almost 74% below where I purchased them. It was at this price that I made my last purchase of the company.
At that point, I was hardly calm, but I was ultimately able to restrain my urgent desire to flee the hand that I had been dealt. I am glad that I didn’t fold. In the year that followed that purchase, Gulf Resources rebounded to as high as $14.94 per share.
Harbin Electric (HRBN) is another hand that I have refused to fold. The Chinese maker of electric motors is expected to make upwards of $3 per share in earnings in 2010. However, the market has made a strong raise against the company, sending it down from its March 52-week high of $26.00 to its current price of just over $17 per share. I think Mr. Market is bluffing and will hold the shares until they reach a fair valuation.
Xyratex (XRTX) is a position that seems to be working out for me. This provider of storage solutions is trading at ridiculously low levels given its large cash position ($1.93/share) and future earnings potential (Forward P/E of 5.62). I’m up, but will still hold. I know how good this hand is, and will only cash in when I can get what it’s truly worth.
Those who play the stock market exactly like they play poker are bound to get busted. But the game does have a few valuable lessons to teach investors – keeping calm and deliberately considering the hand you’ve been dealt are great ones. Studying them and practicing them can help investors know “…when to hold ‘em and when to fold ‘em.”
Disclosure: Author holds long positions in GFRE, HRBN, and XRTX.
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.
Just thought that I would point to an article from MarketWatch.com author, Howard Gold. In it, he eloquently discusses a similar theme that I touched on in my August 24th post.
Remember “The Death of Equities,” BusinessWeek’s seminal Aug. 13, 1979 cover story? It claimed that investors, burned by years of poor returns in the 1970s, had abandoned stocks for good.
Well, last Sunday, The New York Times published what may as well have been entitled “The Death of Equities II.“
If you have been following the stock market for the last few months, you may as well have been watching daytime soap operas – you’d have found just as many twists and turns in either. Let me give you a very brief recap of the events of the summer season.
As the world has turned, young and restless traders and investors across the globe have helped to map out a market that is riddled with uncertainty and intrigue. The condition of the U.S. economy has seemingly been changing with the days of our lives – one minute it is upbeat and enthusiastic – the next moment, it is downtrodden and lethargic. Although corporate earnings have largely come in above consensus estimates, companies have seemingly chosen to use their copious amounts of cash to gobble each other up in bold, contentious displays of bargaining, rather than to expand their operations and hire more workers. Thus, the employment situation remains weak and consumer demand and sentiment have languished along with it. The capricious nature of the market has almost been enough to force even the hardiest of investors to check themselves into a general hospital. Now, many market participants seek a guiding light that will point the way to calmer waters. But from what source will this guiding light emerge?
Investors hoping for this light to come from near-term economic developments will likely be disappointed, as the most recent data suggests that the recovery is petering out. Whether or not this information reflects merely a minor bump on the path to economic growth or a major roadblock is up for debate.
Thus, if the news will not be forthcoming with positive developments, where else may an individual investor turn?
To a different strategy? Many commentators have boldly proclaimed that the age-old strategy of “buy-and-hold” is dead – that it isn’t enough to find good companies in which to invest for the long haul; rather, one must endeavor to profit from the volatility in the markets. What these commentators frequently fail to point out is the fact that research has consistently shown that over the long term, individual investors who pursue a marketing-timing trading strategy do not outperform the market.
To different asset classes? The recent stock-market malaise coupled with the strong performance in the bond markets have convinced some that the value of equities as an investment option has been permanently tarnished. This argument is nothing new, as previous decades of stagnant stock markets yielded such observations as well. In the face of poor performance it is certainly tempting to jump ship. Those who felt that market paradigms had shifted in the mid 1970s fell into that temptation, and, as a consequence, likely missed out on a substantial amount of the bull market in stocks that began in the early 1980s. Remember, historical after-inflation returns for stocks remain – by leaps and bounds – the highest amongst any asset class.
Now, I will be the first to admit that solely basing present strategies upon past returns is a recipe for failure. However, it would be folly to ignore nearly a hundred years of well-established historical paradigms.
My thoughts? Don’t let the soap-opera-esque twists and turns of the market lure you away from time-tested strategies. They have persevered for very good reasons.
I have a theory about horror films: What truly frightens the heck out of so many viewers isn’t so much the disturbing and grotesque imagery – rather, it’s the fact that what appears on screen does not rationally comply with the world that we know.
Consider the following: In the film, Saving Private Ryan, the viewer witnesses the often-grotesque deaths of many soldiers. While these visuals might certainly be disturbing to some, they do not deliver the type of intense fear that interrupts the blissful slumbers of quite a few horror-movie-goers. And why should they? Though the images from Saving Private Ryan may not make us feel warm inside, we expect to see them. In real life, soldiers do perish on far-off battlefields. What we see makes sense.
What doesn’t make sense are the following visuals: a horrifically mutilated girl crawls out of television screens and turns perfectly alive human beings into perfectly lifeless disfigured corpses (The Ring); a child crab-walks down a flight of stairs at a frightening pace and vomits when she reaches the landing (The Exorcist); a children’s doll comes to life and brutally murders people (Chucky).
Get the idea? When expected things happen (soldiers dying) – no big deal. When unexpected things happen (scary girl crawling out of TV) – panic. What really scares us – what really jars our minds – is when things happen that just don’t make sense.
Often, the stock market is a veritable factory for this type of fear. Consider the following example:
Xyratex Ltd., (XRTX) is a British data storage solutions provider whose six largest customers – NetApp, Dell, IBM, Seagate, Western Digital and Data Domain – are practically household names. By any rational analysis of its present financial condition, the company appears to be startlingly undervalued. The current consensus of six analysts expects Xyratex to earn $4.23 per share in FY 2010 on revenue of $1.6 billion. Given the company’s present share price ($11.49), this would equate to a P/E ratio of about 2.72 – or 2.26 if you back out the company’s $1.93 per share cash hoard. Granted, the analyst estimates for 2011 are not quite as rosy – $2.91 EPS on flat revenue – but even when one considers these less favorable forward projections, the company’s valuation remains shockingly low. Why then, does this company’s stock price languish at such low levels?
It just doesn’t make sense.
And that’s just it. When the recent stock market malaise began in late spring, this relatively unknown small-cap company seems to have been unfairly punished by the moody Mr. Market. What resulted was a dizzying 45% drop from the 52-week highs that Xyratex notched in April to the prices that investors see today. And when prices fall, investors tend to get scared.
“The stock price has gone down despite stellar earnings! Something must be wrong!” investors might reason. So they sell their stock, which, of course, lowers the price even more; this, in turn, creates more fear and induces even more people to sell their stock. What results is a self-reinforcing price depression that simply doesn’t make sense.
So how does it end? Well, if one trusts in the wisdom of noted investors Benjamin Graham and Warren Buffett, then the following conclusion to this stock market horror film seems realistic: At some point, the strong fundamentals of Xyratex will be made manifest in its stock price. Of course, there’s no telling when this may occur, but, for now, I am perfectly willing to wait until the end of this horror film.
Disclosure: The author holds a LONG position in XRTX.
Occasionally when I daydream, I like to imagine that I am an experienced and successful investor. The thought evokes warm thoughts: Me, staring at the desktop of my MacBook Pro – PDFs of press releases and SEC documents strewn carelessly about. Looking outside the window on my left to a radiant summer day. Looking towards the HDTV and Xbox 360 on my right that kept me from enjoying that radiant summer day. Logging into my investment account and being greeted with welcoming green numbers that intangibly massage all of my worries away.
Reality, however, usually has other plans. When it awakes me from my buoyant stupor I am greeted by several glaring facts:
These facts accost me whenever I conduct company research or log my performance at the close of the markets. They sully my confidence, trigger self-doubt, and lead to reticence when I am considering a possible trade. If only those cold facts did not exist. If only their influence upon my mind and emotions could be lessened.
While only time-tested performance can provide me the permanent pool of investing confidence that I so dearly desire, I have found one way to assuage the pangs of insecurity that abruptly awake me from my wishful day-dreams: By realizing that I am following in the investing footsteps of money managers with resources, levels of training, and experiences that far outweigh my own.
Thus, when I see that my carefully researched positions are supported with strong investments from well-regarded professional investors, I am able to rest a little easier.
Consider the following four small cap companies that I own that have attracted thorough due diligence and large investments from skilled money-managers.
I will be the first person to note that my untested background gives little reason for other investors to heed my opinions. So, if you decide to invest in any of the aforementioned companies, tell them that Fidelity Investments, Michael Dell or Hank Greenberg told you it was a good idea.
Disclosure: The author holds LONG positions in all of the discussed securities.