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This is a follow-up article to the one that appears here.

In part 1, I discussed how the structure of the company (reverse merger) could be a red flag. Now we look at other aspects that play a role in finding well-managed U.S.-listed China stocks.

Every investor in the U.S. China space approaches due diligence differently. Some look to SEC-filings, some may request information in a detailed manner all at once, while others may simply request information at different times or stages. Regardless of an investor’s method to obtain information on a potential company, it is a proven fact that exercising thorough due diligence is indicative of more profitable returns.

When it comes to doing due diligence, Yibing Wu, President of CITIC Private Equity Funds Management (a subsidiary of the Chinese state-owned conglomerate CITIC Group), says financial statements of Chinese companies tend to be "less trustworthy" than those of western companies. To discover the truth, Wu relies on the global "Big Four" accounting firms to audit target portfolio firms, as well as on CITIC's own due diligence measures.

"We interview the suppliers, we interview the customers, the competitors, and we do cross-checking on inventory," says Wu. "We do cross-checking on receipts and we talk to (employees) at various levels of the company."

The due diligence process mentioned above is hard to achieve if you don't have a sufficiently sizeable due diligence team to do the groundwork in China. So what can we do ourselves to protect our investment?

For value investors, like myself, due diligence is becoming more and more important. Especially after the recent scandals and attacks of short sellers.

Chinese U.S.-listed stocks trading below book value with enough margin of safety built is not enough anymore. Investors in Chinese stocks are faced with cultural differences and unfamiliarity with Chinese (local) business rules. Understanding cultural differences, potential pitfalls and due diligence success factors will help you to approach investing in U.S.-listed China stocks with greater confidence.

It’s important to do your own due diligence on your investments – because ultimately, only you are responsible for your success or failure.

Nowadays more and more investors are interested to read about (accounting) red flags.

Fifteen important red flags to watch out for:
  1. Management of a company starts bashing short sellers (See press releases, conference calls or presentations). If management is sure about their company they know that everything will be alright in the future.
  2. Unusual accounts receivables growth (See 10-Ks, 10-Qs). If accounts receivables grow at a faster pace than the company’s sales, it can indicate that the company is making bad sales to companies unable or unwilling to pay, which could result in bad debt down the road (Orsus Xelent Technologies). Unusual accounts receivables growth may also indicate that the company is booking revenues before the proper time, which is one of the most common practices within the universe of manipulation. Future sales are simply recognized early, inflating earnings. The tell-tale sign, of course, is accounts receivable growth in excess of reported revenue levels.
  3. Unusual deferrals on the balance sheet (See 10-Ks, 10-Qs). If you spot an item under the assets section called “prepaid assets” or “deferred assets,” take a closer look. This could be a sign that the company has created artificial revenues with a simple journal entry: crediting revenues and setting up a prepaid or deferred asset. An explanation could justify this, but it has to make sense. For example, an entry could be justified with this explanation: “Setting up revenues under contract with a major customer as earned in the current year but scheduled to be paid over a five-year period per contract.” As long as this explanation can be documented, it should be accepted. However, to represent earned income in the current year, there must be a delivery of the goods or services in the current year. Also look for more dubious explanations, remembering that if it doesn’t make sense, it is probably not for real. For example, “Setting up deferral in anticipation of current-period earnings not yet booked and long-term in nature, pending completion of international provision agreement with subsidiaries and with major customers.” What does this mean? The company has made no effort to prove that these revenues are for real, so they probably are not. Booking current year revenues for long-term deferral occurs, but it is unusual.
  4. A lot of (new) footnotes and disclosures (See 10-Ks, 10-Qs), particularly of things that happened years ago.
  5. Big increases in director’s fees and perks (See director’s compensation section of proxy statement).
  6. Amended SEC filings (See Ks, Qs).
  7. When you see the words "formal" or “informal investigation”, “subpoena” or "Wells notice” (See 8-K filing with updates buried in Ks and Qs).
  8. New lawsuits/legal disclosures and/or risk factors (See “Risk Factors” or “Legal Proceedings”sections of 10-K).
  9. Lucrative consulting contracts/severance agreements with current and/or former directors and executives (See exhibits section 10-Ks and 10-Qs, and in proxy statements).
  10. Falsifying actual revenue earned. The previous kinds of revenue reporting are often based on actual revenue to be earned in the future. It manipulates the facts by showing the revenue before it is actually earned. However, another kind of manipulation involves simply making up revenue and reporting it (Rino International).
  11. Capitalizing current year expenses (See 10-Ks). Another favorite way to manipulate earnings is by capitalizing some current year expenses. This sets up a prepaid or deferred asset instead of reporting the expense itself, boosting current year earnings. The idea is to write off these prepaid expenses over several years, but once a company starts artificially increasing net earnings, it tends to only get worse over time. It is not normal to set up expenses and amortize them over many years; some exceptions include payment of a three-year insurance premium and amortizing it over the following 36 months, and similar, easily explained cases. But when the prepaid amount is quite high and remains unexplained or explained poorly, it could be a form of manipulation.
  12. Sugar bowling (See 10-Ks). This is the practice of deferring some revenue until future years. When a company has an unusually successful year, it may “sugar bowl” some of those earnings to offset lower results in the future. This is also called “cookie jar” accounting, and as cute as it sounds, it remains a form of manipulation. The fact that the adjustment sets up a reserve to be used in the future is seen by some as a more benign form of manipulation. But remember, if a company thinks it is acceptable to underreport revenues this year, it can use the same rationale to over-report revenues in the future. You deserve accurate reports, whether exceptionally optimistic or pessimistic; that is the only way you can truly judge a company.
  13. Inattentive audit committee (See proxy statement). In the proxy statement, it will always say how often the audit committee met. They should at least meet a minimu of four times a year
  14. Off-balance sheet subsidiaries (See 10-Qs, 10-Ks). Off-balance sheet subsidiaries can be used for all kinds of manipulation, and this technique was one of the favorite creative accounting methods used by Enron. For example, a company can loan money to its subsidiary and, without exchanging any funds, set up the obligation through journal entries. Then annual journal entries are made each year to report interest income by the parent company. Even though no cash has exchanged funds, this boosts net income through a series of sham transactions. A similar use of off-balance sheet subsidiaries is to assign some portion of current expenses to the subsidiary, which reports a large net loss. Meanwhile, the parent company can control the level of net earnings reported. It is completely false and misleading, but the results look spectacular.
  15. Changing auditors like a pair of shoes (See 8-Ks).

Here are some interesting facts.

A study done by Deloitte Forensic Centre found that financial executives such as chief financial officers and accounting officers accounted for 44 per cent of the individuals alleged to have committed financial statement fraud. Chief executive officers made up 24 per cent of the total.

Deloitte analyzed 430 accounting and auditing enforcement releases related to 392 companies and issued by the US Securities and Exchange Commission (SEC) between January 2000 and December 2008. The study was limited to releases that concerned financial statement fraud, which includes improper disclosures and manipulation of assets and expenses.

Of the cases, revenue recognition fraud was the most common form of financial statement fraud, accounting for 38 per cent of all such schemes, the study found. But since 2003, instances of revenue recognition fraud have fallen in all but one year.

Improper disclosures made up 18 per cent of the schemes and manipulation of expenses represented 16 per cent, according to the study.

Technology, media and telecommunications companies made up 30 per cent of financial statement fraud schemes alleged by the SEC, while consumer businesses made up 29 per cent, financial services 18 per cent, and life sciences and health care 12 per cent.

The SEC has found that more than half of all enforcement actions for financial reporting and disclosure violations filed by the SEC during a five-year period involved improper revenue recognition. In most enforcement cases, senior management was held accountable.

Common ways in which revenue was improperly recognized include: recognizing revenue in advance, bill and hold, fictitious revenue, and improper valuation of revenue. Improper expense recognition includes improper capitalization of expenses, overstating inventory, understating bad debts/loan losses, and failure to record impairments.

Many times, company executives also rationalise that what they are doing is for the benefit of all shareholders. For example, if they doctored the numbers so they don't breach certain debt covenants, and as a result, they are able to sustain the business longer, or borrow more, then all shareholders will benefit.

There are usually three conditions that need to exist for fraud to happen - the so-called "fraud triangle". First, pressure or incentive to commit fraud. Second, rationalisation on the part of the fraudster, be it that they are doing it for the good of all shareholders or that they deserve what they are taking. And finally, opportunities need to be there for fraud to be committed.

The most common assets inflated by dishonest companies are Accounts Receivables and Inventories.

Corporate scandals of course are not recent phenomena. In fact, if we had studied history, we would have found similarities between scandals of recent years and those of a few decades ago.
For example, Charles Ponzi discovered an arbitrage opportunity in the form of international reply coupons (IRCs) in the 1920s. One could buy IRCs cheaply in one country and exchange them for stamps of a larger value in another country. He sold this scheme to the public, and raised money with the expressed intention to profit from such arbitrage. In effect, what he was doing was to use the capital investments of subsequent batches of investors to pay off the early investors. At the peak of its popularity, Ponzi would have to buy some 150 million IRCs to be able to make money for his investors. But there were only about 30,000 IRCs in circulation then.

Rodney Hay, executive director with Deloitte Forensic in Singapore and South-East Asia, said financial statements are not the only factor that contribute to value when trying to identify undervalued companies. Another bigger factor is the reputation of the company, its directors and the country it operates in. "Investors should carry out integrity due diligence as well, look at the soft indicators and not just the hard financial numbers."

He cited studies which show that when we surround ourselves with people of less ethical integrity than us, we open ourselves to their negative influences. Another study suggested that when people are constantly reminded of a code of conduct that is expected of them, the propensity to commit fraud is much reduced in an organisation. So companies should come up with a code of conduct for all employees, and regularly remind them of it.

From that perspective, companies which are trying to increase their value can start by improving their reputation - particularly those operating in a country with a high risk of fraud, he said.

The key to finding red flags is analysis. Here are some good starting points:
  1. Always study the trend. Eventually, all forms of manipulation are going to show up in an odd adjustment in the long-term trend, on the balance sheet, the income statement, or both.
  2. If it doesn’t make sense, ask questions. Call or e-mail a company’s investor relations department and ask specific questions regarding footnotes, trends, or dubious changes in the financial statements.
  3. If explanations don’t make sense, stay away. None of this is so complicated that it cannot be explained in non-accounting terms. Obfuscation is one of the unavoidable symptoms of manipulation. In other words, if an investor relations representative seems like they’re tap-dancing around the truth, then you have every reason to avoid the stock.

Red flags are fish feed for short sellers to which stocks give you a due diligence advantage. For investors that want to minimize risk look for U.S.-listed China stocks that have institutional ownership and are backed up by IR-firms, investment boutiques or banks. Due diligence is already (partly) done, which of course doesn't mean that there will be no red flags anymore. Chinese OTC BB stocks with no IR or institutional ownership are the most vulnerable.

As mentioned in part I, my Top-5 of U.S.-listed China stocks at this moment are Weikang Bio-Technology (OTC:WKBT), American Lorain (NYSEMKT:ALN), China Botanic Pharmaceuticals (NYSEMKT:CBP), New Energy Systems (OTC:NEWN) and SkyPeople Fruit Juice (NASDAQ:SPU). Four of them have institutional ownership and all have an IR-firm:
Weikang Bio-Technology
Institutional ownership: Unknown
IR-firm: Elite IR
American Lorain
Institutional ownership: 12.7% (Guerrilla Capital Management, Wellington Management, Whitebox Advisors)
IR-firm: HC International
China Botanic Pharmaceuticals
Institutional ownership: 0.6% (Guerrilla Capital Management)
IR-firm: CCG Asia
New Energy Systems
Institutional ownership: 0.5% (Invesco, San Francisco Sentry Investment Group)
IR-firm: HC International
SkyPeople Fruit Juice
Institutional ownership: 17.5% (Sansar Capital Management, AQR Capital Management, Thompson Horstmann & Bryant Inc. etc.)
IR-firm: HC International

Disclosure: I am long OTC:WKBT, ALN, CBP, SPU.

Source: 15 Due Diligence Red Flags for U.S.-Listed China Stocks