On March 15, Yongye International, Inc. (NASDAQ:YONG) notified investors that it was not able to file its 10-K on time due to some accounting issues. Then on March 18, NASDAQ halted trading of the company's stock and demanded the company to provide additional information to satisfy its listing status.
YONG has been accused of fraud numerous times in its somewhat brief listing history. The latest development definitely reignited investors' fraud fears and may potentially endanger the going-private deal the company is contemplating.
YONG drew my attention initially because of its promising business potential, great business performance, and super cheap valuations. However, after examining the company a little bit further, I came to the conclusion that investing in this company is too risky and decided to stay away.
The biggest concern to me is that the interest of YONG's management is not aligned with that of investors. According to YONG's annual report, YONG is entitled to 95% of the profit from Yongye Nongfeng, its operating unit in China through a CJV agreement. The remaining 5% interest goes to a company controlled by YONG's CEO, Mr. Wu. Prior to June 2011, none of YONG's management, including its CEO and CFO, owned even a single share in YONG. This is a sign of disaster in my opinion. Investors dislike the VIE structure when investing in Chinese stocks. And, this lack of share ownership will further weaken YONG's control of its operating units in China. Even though Mr. Wu bought about $3 million of YONG's stock in June 2011, the share count is too small to significantly improve the situation.
In addition, I believe YONG is too generous in terms of giving out stock awards to its management and directors. For example, YONG gave out 217,000 shares to its CEO and 145,000 shares to its CFO for free. Those shares were worth more than $1 million and $700,000 respectively at the time of the award. This is too generous, in my opinion, for a small company like YONG. The company should have given out stock options instead to protect YONG's shareholders.
YONG also had some unusual activities that did not make a lot of sense. For example, it paid more than $30 million for a distributor list in Hebei province. Management did provide explanations but those explanations were not very satisfactory.
Finally, although YONG books great profits year after year, the company is always short of cash. That's because YONG carries a huge account receivables on its book. More strikingly, YONG believes that all of the receivables can be collected and thus a reserve for bad debt is not necessary. That's simply too aggressive to my liking.
After being involved in Chinese small caps for several years, I've come to realize that Big Four accounting firms can be fooled just like a small potato firm. YONG's auditor is KPMG, a Big Four auditing firm. If YONG turns out to be a fraud, that would not be the first time KPMG had been fooled. China Integrated Energy, Inc., a Chinese company in the biofuel industry, used KPMG as its auditor before being exposed as a fraud. China Mediaexpress Holdings, Inc., another fraudulent company, also used a Big Four auditing firm.
Additionally, the presence of a big institutional investor does not decrease the risk of fraud. Some investors bought into YONG mainly because Morgan Stanley invested heavily in this company. However, investors should realize that big investors make mistakes as well. For example, Starr Investments, a firm run by former AIG chief Maurice Greenberg, invested tens of millions in CCME. Even mighty John Paulson was fooled by Sino-Forest Corporation.
So in a minefield where even Big Four auditing firms and big institutional investors can be fooled, what's the right investing strategy? I believe the solution is to invest in companies and industries that are relatively easy to verify from the outside.
That's why I mainly focus on two sectors nowadays when investing in Chinese small cap stocks: Real estate and online video gaming. In the real estate sector, I like Xinyuan Real Estate Co., Ltd. (NYSE:XIN), a residential housing developer. Moreover, among the online video game companies, I like Perfect World Co., Ltd. (NASDAQ:PWRD) and Netease, Inc. (NASDAQ:NTES).
Disclosure: I am long XIN, PWRD, NTES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.