CNOOC: How Accurate Is Investment Information in Emerging Markets?

For years I have been pointing out the problems with information in emerging markets. Much of the information especially about securities is simply false. This is not because the managers of companies in emerging markets are any less venal than their counter parts in the developed world. Certainly in the US we have recently seen our share of fraudulent financiers. The difference is a question of a law.

In law and economics there is a function as to the probability of a law being obeyed. The function is the probability of getting caught versus the severity of the punishment. For example, in many states in the US the penalty for murder is death which should be a good deterrent. It isn’t because less than 50% of the murderers are ever caught.

The same is true with information provided by companies. Information has value and is only disclosed for consideration or if required by an enforced law. In the US we have strict laws that are supposed to require disclosure. Still, many companies either fail to disclose or do not give timely, accurate or completed disclosures.

The situation is much worse in emerging markets because the legal disincentive is much weaker. Last week we had an excellent example. According to Asia Times, the Chairman of CNOOC (CEO), Fu Chengyu, the Hong Kong and New York listed unit of China’s biggest offshore oil producer, China National Offshore Oil Corp, admitted that information provided in the company’s annual report was not correct. According to the annual report for 2008, Fu earned 12.047 million yuan (US$1.77 million). On April 13 a spokesman for the China National Offshore Oil Corp. said that the compensation for Fu including an incentive scheme was only a show designed to give Western investors the idea that CNOOC had adopted measures that were similar to other multinational oil companies. On April 19^th, at the Boao Forum for Asia annual conference, Fu confirmed that his salary was set by State-owned Assets Supervision and Administration Commission of the State Council and that his pay listed in the report was inaccurate.

So far, to the best of my knowledge, there has not been any reaction from the regulators. Although this appears to be a violation of Rule 10b-5 as a failure to disclose a material fact, the SEC at this time has taken no action. Neither have either Chinese watchdogs, the Hong Kong SFC or China’s CSRC.

Many people might not feel that failure to disclose information about compensation is important. In fact, some investors might rightfully point out that Fu was most likely getting paid less than his western counterparts, so the shareholders actually benefitted. Still, it leads one to wonder that if a Chinese state owned company made a show of their compensation package just to please western investors, what other parts of their annual report might just be there to please western investors?

It is also not just China. With inadequate or economically inefficient legal infrastructures, emerging markets are replete with organizations typical of relationship based systems. Many of these firms are either state owned or family owned. State owned companies are managed ultimately by politicians, who manage for political reasons, not for profit. If those reasons require the suppression of information, it is suppressed.

Although majority family owned companies are managed for profit, the agent managers are obviously going to be more responsive to the needs of the majority owners. Where there are insufficient protections of minority shareholders, which is in most of the world, there will be insufficient legal disincentive for full, complete and timely disclosure. What does eventually appear may not accurately reflect reality.

For those investors who believe that audited financial statements are adequate protection, let me point out that CNOOC is listed in New York, and so should be subject to audited statements as required both by US federal law and the rules of the exchange.

This web site is often filled with charts and numbers about companies all over the world. There are also economic projections and forecasts. The hope is that these numbers will bear some relationship to reality and help investors control their risk. But before investors put too much faith in any numbers they should ask themselves whether the economic incentives to refrain from providing complete, accurate and timely information exceed the legal disincentives from doing so.

Comments

[Ricard:]

Mr. Gamble,

Although I've found cause to disagree with your viewpoint in the past, I've come to respect if for the clarity in which it is delivered. This article is an excellent example of immaculate articulation. Good luck in your future endeavors.

May 06 10:37 AM

[searcher:]

The fact that a security is listed on the NYSE is of very little relevance in determining the credibility of management disclosures; or any other exchange for that matter. This is not cheap cynicism but a result of the globalization of the securities trade. It's the Wild West and will be for at least another 20 years. Fisk and Gould would be very well connected and at home in Shanghai.

May 06 02:29 PM

[Alan Young:]

Plenty of US companies have fudged their numbers, with little punishment. Is Dick Fuld in jail, or still quibbling over bonus payments?

China actually may be better at deterring certain types of crimes. Fatally-toxic peanuts and spinach ship from US warehouses with distressing regularity, resulting in slaps on the wrist for managers of the responsible companies. In China, food adulterers have been executed, promptly and publicly.

May 06 03:53 PM

[ArtfulDodger:]

If fudging the amount of compensation of one Chinese CEO is the best example of erroneous info coming out of China, those of us invested in China have very little to concern ourselves about.

Long CEO from $75.50

May 07 01:41 AM

[William Gamble:]

searcher
"security is listed on the NYSE is of very little relevance in determining the credibility of management disclosures"

The quality and credibility of the disclosures is based on two things. One from law and economics and the other from game theory. The function in law and economics is what is the severity of the punishment vs the probability of getting caught.

For example, the US has been prosecuting insider trading since 1935. The Hong Kong exchange has been prosecuting it since 2007. Tokyo since 2001. So since the probability of getting caught is higher in the US as is the severity of the punishment, it is logical to assume that the quality of information is better in the US.

Its not one or the other, its a spectrum based on the economic efficiency of the legal infrastructure.

Game theory has to do with reputation

May 07 12:08 PM

[William Gamble:]

Alan Young
In China, food adulterers have been executed, promptly and publicly.

Actually the reverse is true. In the poison baby formula case, the local authorities knew about the problem as early as April when the head of the company, Sanlu I believe, informed the local, (not the national authorities). The national authorities learned a few months later but the story was suppressed until September after the Olympics.

Nine years ago I wrote an article about the Chinese tax system. I thought as you did. They must be able to collect their taxes because they can shoot the evaders. The reality is that they (the government = Chinese Communist Party) would have to shoot themselves, which they do not want to do. The people in government were making the money and evading the tax.

In the poisoned milk scandal the people who covered it up were the government. The courts also initially declined to hear the case and then the government offered a lump sum settlement.

May 07 12:14 PM

[William Gamble:]

ArtfulDodger

I am glad of your trust. Of course, it is your money.

Personally why would they cover up something so trivial as compensation? The minimal nature of the cover up actually makes me more worried. They could have easily told the truth. There was not down side, but they decided not to for PR reasons.

I was speaking in Hong Kong during the SARs epidemic. The story was broken by the editor of Southern Weekend who was replaced by the guy who covered the story up.

No government wants to admit to bad news. It is worse when the government owns the company and controls the agencies responsible for enforcing disclosure.

May 07 12:19 PM

[Ricard:]

Any of you remember options backdating? Maybe the Chinese are simply learning from us...

On May 07 01:41 AM ArtfulDodger wrote:

> If fudging the amount of compensation of one Chinese CEO is the best
> example of erroneous info coming out of China, those of us invested
> in China have very little to concern ourselves about.
>
> Long CEO from $75.50

May 07 02:25 PM

[William Gamble:]

Option back dating like SUVs and derivatives are all functions of law. In each case there was a powerful economic incentive to overcome a legal disincentive. CNOOC is a subsidiary of a state owned company. Since the state is the principal and wants to encourage private investors, there is no legal disincentive. On the contrary, the incentive obviously was to create the image of something that was exceptionally profitable so the state's assets would increase.

May 07 02:49 PM

[ArtfulDodger:]

Mr. Gamble:

Understand your point quite well. But I respectfully disagree.

And perhaps it's because I've done so well in China.

But let me tell you, there are other nations I've come to trust much less.

Thank you for providing us with your view and for attempting to warn us. I hope you're wrong.




On May 07 12:19 PM William Gamble wrote:

> ArtfulDodger
>
> I am glad of your trust. Of course, it is your money.
>
> Personally why would they cover up something so trivial as compensation?
> The minimal nature of the cover up actually makes me more worried.
> They could have easily told the truth. There was not down side, but
> they decided not to for PR reasons.
>
> I was speaking in Hong Kong during the SARs epidemic. The story was
> broken by the editor of Southern Weekend who was replaced by the
> guy who covered the story up.
>
> No government wants to admit to bad news. It is worse when the government
> owns the company and controls the agencies responsible for enforcing
> disclosure.

May 07 11:51 PM

[William Gamble:]

Artful Dodger

I've done well in China as well. I shorted it last year.

The past is never any guarantee of the future. Recently we have had a lot of comparisons with the Great Depression. Let us consider another bit of history. For two thirds of the past 60 years emerging markets barely grew at all. If we look at historical trends the past few years has been an anomaly.

I believe that the anomaly was very simple. A few laws were changed and it allowed the entrepreneurial genius that is part of every nation to be realized. This can change overnight and from recent new, is.

May 08 04:41 PM

[ArtfulDodger:]

Dear William Gamble:

You wrote: "I've done well in China as well. I shorted it last year."

Aha! Yes, I like that.

However, I watched China to see what its leaders would do after its first crash back in the early 2000s: dive more into socialism or continue its neo-capitalist ways.

They did the latter without flinching.

So I began investing in China a few years ago when the Shanghai was about 1800. As it hit 4850 (or there abouts), China had a huge jump in prices (from about 6% to 11%) and the government announced it was going to slam the brake on the money pump.

So, I began selling and taking profits. The Shanghia ran on up to about 5300, but I was completely out by then.

I did not short China as you did, but for the first time in my life I shorted the US beginning last summer. Then sold my short position in the US in November.

I began buying back into China last fall when they announced rate cuts and then later a stimulus package. I am still long China.

Something I think you have overlooked is that the Communist Party leaders are invested in the Chinese stock market. They are not simply passive onlookers, as America's leaders are. They have incentive for their companies to do well.

No, history is not a perfect picture, Mr. Gamble, but we surely do not need history to realize that the Chinese government is on the side of its nation's businesses and is doing most everything it can to help them grow and prosper.

Can we say the same about Obama, Pelosi, Reid, and the rest? I don't think so.

At this point, I think there is one risk in investing in China, and it is a remote one: regime change.

The last three years my group and I have sent a young man to China to check some things out for us. We've made a really good contact there, and it's helped me a lot.

I would hope that if a roiling turmoil among the Apparatchiks were to begin heating up, he would warn me in time for me to pack my tent and scoot out of the Golden Dragon before the overthrow.

At this time, I like what I see there. I like the business ethics that they promote. I like the way the government is not against its businesses.

Those folks are worker-bees, except for some of the younger consumer-minded ones, and I don't think that's going to change anytime soon.

Long CHL, CEO, PTR, HNP, YZC, VISN, SOHU, NTES, PWRD, and related companies that are not in China: KHD & PKX.

I wish you well with your investing, except, of course, i.e., perhaps, maybe, if and when you short China again!

May 08 05:14 PM

[William Gamble:]

" the Communist Party leaders are invested in the Chinese stock market"
Of course they are! That is the problems. Probably 98% of the stock market is owned by various state owned entities. No one knows because it is easier to determine the age of a Chinese gymnast.

The problem with any state run firm is that it is runs for political reasons, for profit. They prop up failing firms (see the ICBC loan to Greentown) by making loand that won't be paid back. They force firms to retain workers and change CEOs at will.

I am not worried about regime change. The problem is that they will stay. Worse, since they control information they will tell you that they are doing well. This may result in temporary rises in the stock market, but over time it is not sustainable.

Yes, you might have made money now, which is great. When investing in emerging markets especially do what they do, keep the time horizons short. The political will can and does change overnight, you won't hear about it, and it may be the wrong decision.

May 09 07:07 AM

[ArtfulDodger:]

Mr. Gamble:

Good points and well said. And thank you for your warnings. I sincerely believe that you mean well.

Now, let me agree with you that all you said China does they indeed do.

But in that respect, what about our own government?

Have our leaders not lied, exaggerated, cajoled, cudgeled, and coerced “private businesses” into taking them on as partners, accepting their money, and making deals they did not want to make?

Have our leaders not poured billions into companies that, were it not for powerful unions lobbying them, they would otherwise have let go busted?

When the non-unionized southern cotton mills were going broke in the sixties and seventies, the government never sent them a cent. They merely poured more rules and regulations on them to make sure they went busted.

In the meantime, however, they bailed out a busted New York City and Chrysler.

You don't think politics had anything to do with that?

In fact, this very statement that you wrote about emerging markets could have come right out of any paper in the US regarding our own government: “The problem with any state run firm is that it is runs for political reasons. . . They prop up failing firms (see the ICBC loan to Greentown) by making loand that won't be paid back. They force firms to retain workers and change CEOs at will.”

Did our own government not step in and fire the CEO of a private company without the slightest excuse except that the union bosses did not like him?

Look what our government has done to BofA. Here was a company with a great balance sheet until the government began forcing it to buy busted-out companies and spend all its capital at a time it would surely need it.

Mr. Gamble, I don’t trust any government—that distrust in government Jefferson called patriotic, but I call anyone today with that view someone who is aware of history.

Remember WMD? Remember the Y-2-K-Con? Remember bombing Iraq to “wag the dog”? Remember Papa Bush floating out six different tales to remove Iraq from Kuwait before hitting on one that the American people would buy? Remember our own government turning tanks on its own people at Waco and then whitewashing that whole-burning? Are you old enough to remember our government using Charles Keating and Senator Alan Cranston as scapegoats for the entire S&L Debacle that it caused? How about the government's having sued banks and lending institutions all over the nation in the 1990s, thereby forcing them to invent the subprime loan? And now what do our leaders say about the financial crisis: "Wallstreet got drunk and threw a party."

And may I ask you this: which government do you think is the more pro-business and pro-growth at this time, the US or China?

May 09 09:47 AM

[ManInTheMirror:]

Here's a good article on why information is valuable. It explains how Crazy Eddie's ran an enormous fraud for 18 years:

www.whitecollarfraud.c...

Aug 21 03:53 PM