I have written extensively in recent months about how China is heading for a very hard landing indeed (see HERE and HERE) but also how official statistics from the PRC are simply overcooked - that is to say wrong: see HERE. As each week goes by the evidence that the hard landing is accelerating appears to mount as does the rapidly emerging scale of fraud that has taken place in that country. As such I would personally be cutting my PRC exposure to nil.
What is also becoming increasingly clear is that there is a very good reason why certain Chinese enterprises have eschewed the liquid markets of Shanghai and Hong Kong (where raising money has until recently been easy) in favour of US and UK listings. That is to say that it is always better to keep investors as far away as possible from outright frauds. My golden rule with US or UK listed Chinese companies has thus been that they are a short unless there is a welter of evidence to prove otherwise but that you should never actually own such stock.
But shorting can be dangerous. That brings us to the strange case of Nasdaq listed Short Focus Media Holding Ltd (FMCN) because here anyone going short at $24.51 has their downside capped at $2.49. If this unravels the upside (for a bear) could be massive. In the interests of disclosure, I should say that I was alerted to this company by a friend who is short. I have no position or financial interest in it at all.
Focus provides electronic billboards for advertising in Chinese cities and also sells advertising in cinemas across the country. Its historic accounts show that it is highly profitable, generates pots of cash and is expanding fast. And hence a Private Equity consortium, consisting of some big PE names backing Focus's chairman, has recently launched a bid at $27, valuing it at $3.5 billion. On an historic PER of 14.25 falling to 11.3 the PE firms may get a bargain but Focus says that the bid is subject to due diligence. And that is critical.
Firstly I wonder how the accelerating downturn in the Chinese economy is affecting trading. I cannot believe that it is entirely helpful - indeed, the most recent quarterlies do actually make mention of the slowdown.
But more important is the (unproven) allegation that the accounts are fraudulent. Here I quote Lieff Cabraser Heimann & Bernstein, LLP which is bringing a class action against the company. It states:
The action is brought against Focus Media and certain of its executives for violations of the Securities Exchange Act of 1934. Focus Media, a Cayman Islands corporation that maintains its principal executive offices in Hong Kong, is a multi-platform digital media company that operates a liquid crystal display ("LCD") network using audiovisual digital displays in China. It provides advertising services on displays in high traffic areas.
The action alleges that during the Class Period, defendants misrepresented and omitted material information regarding Focus Media's financial results and operations. Specifically, defendants failed to disclose that (1) Focus Media materially overstated the number of screens in its LCD network by approximately 50 percent; (2) the Company deliberately overpaid for acquisitions since 2005 in order to conceal losses; and (3) certain Focus Media insiders engaged in massive insider trading.
On November 21, 2011, research firm Muddy Waters LLC issued a report accusing Focus Media of materially overstating the number of screens currently in the Company's LCD advertising network. Muddy Waters also alleged that like Olympus Corporation, Focus Media routinely overpaid for acquisitions to conceal losses, noting that the Company had written down $1.1 billion out of $1.6 billion in acquisitions since 2005. Moreover, the report accused certain Company insiders for engaging in massive insider selling. On this news, Focus Media ADS fell $10.07 per share, or 39 percent, from its closing price on the prior trading day, November 18, 2011, to close at $15.43, on extremely heavy trading volume.
Muddy Waters has a good track record in spotting Chinese companies up to no good (Sino Forest). I have no idea whether the allegations are true or otherwise but I would imagine that the PE firms making the bid will be conducting extensive checks on the company given the risks that they would face if they were to be shown to have overpaid for a total blowup.
There are two possible outcomes here. The bid goes ahead in which case someone going short today loses $2.51 a share. Or the PE firms pull out. If that happens, however it is spun, it will - given the allegations made - be seen as disastrous and have investors heading for the exit at once without asking questions. At that stage the target price is anyone's guess but I'd settle for $10 a share as a first stop (that is two thirds of the level the day after the Muddy Waters research came out). Net assets - on the basis that the accounts are accurate - excluding intangibles are $6.65 a share.
On a risk reward basis I believe that you could do a lot worse if you are looking for a good short.