Archive for October, 2010

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.

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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.

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Random Market Musings

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.

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