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Are all chinese microcaps the same? Part I.

|Includes: ALN, AOBI, CBEH, CGA, CHNG, CIHD, CSKI, FEED, Fuqi International, Inc. (FUQI), HFGB, LTUS, NED, SGAS

 Several weeks ago there appeared a good article, summarising all major problems smallcap chinese companies are facing with. It is here:

The subject of this article is whether these problems are universal and what can be done to avoid them. Let’s consider in order.

1.       Trust to the accounting. This problem is not unique for chinese smallcap’s (and not smallcaps altogether), but statistically there is much higher probability of accounting fraud for this type of stock. Among most notable examples one can mention FUQI, CGA, CHNG, FEED, RINO, CBEH. The simplest way to decrease the risk associated with accounting fraud is to gather information about the auditor. Best case it would be a reputable international auditor chain. These examples to follow include CIHD.OB (Mazars CPA), HFGB.OB (Baker Tilly Hong-Kong), NED (Deloitte Touche Tohmatsu), AOB (Ernst & Young Hua Ming). If an auditor is not a well-known and respected brand, the tip could be to check it with Public Company Accounting Oversight Board – PCAOB ( PCAOB was created according to Sarbanes-Oxley Act and is entitled to overview the public companies auditors job. It should be born in mind, that now PCAOB is not allowed by chinese authorities to check the work of chinese auditors or chinese branches of international audit companies. Therefore only US branches would be checked, but still it is some kind of guarantee. Several options are availiable:

a)       Auditor is not a member of PCAOB – risks are prohibitively high in that case

b)       Auditor is a member of PCAOB and no inspections are done – better than above, but risks are still high. Example – Samuel H. Wong (auditor of ALN, ENHD.OB, SGAS.OB)

c)       Auditor is a member of PCAOB, inspections were conducted, deficiences found and fixed within required time period. For me that is more or less acceptable, but finally consider on your own. Example – Friedman LLP (auditor of LTUS.OB)

d)       Auditor is a member of PCAOB, inspections were conducted, deficiences found and not fixed within required time period. This means that an auditor doesn’t concern about the quality of its job. Example – Paritz and Company (auditor of TGLP.OB). Report can be found here:

e)       Auditor is a member of PCAOB, inspections were conducted and no deficiences found. Actually it gives some level of assurance.

And do not forget to read the auditors opinion. Sometimes it will be clearly stated that auditor has adverse opinion on the financial statements.

2.       Accounting fraud should’t be mixed with another problem familiar for small chinese companies. I can call it business interruption, i.e. situation when company busuness model suddenly came under threat due to operational factors. Such factors include loss of a key customer or supplier, quality problems, intervention of authorities, etc. This not a fraud, but a mismanagement. One recent example here is CSKI – latest share drop was not due to accounting problems, but because of revenue projection cut. Company cited problems with agreements renewals with distributors, but that sounds strange – how can information diclosed in US regulatory filings affect its business with non-public chinese companies? And sudden health problems of the CFO add to this odderness. I have no idea  how to deal with this problem. At best you can check whether such issues occured in the past. And if they did it’s better to avoid this stock.

3.       Absence of M&A activity is another important factor. Though chinese microcaps often acquire their non-public peers and non-peers, I can’t  remember any M&A between public companies. So, check carefully how much companies were acquired in the past, are they of similar industry, do they have same owners with acquirer, how much was paid for them and what was the form of payment (shares, cash). Excessive M&A activity and M&A activity in non-related sectors should alert. Beware also of so-called business acquisition companies. These are actually nut-shells with no operating activities and big cash pool, prowling the market about to find somebody to swallow. Beware because you are not able to predict what would be the target and therefore in what industry you suddenly find yourself.

4.       No dividends – true as well. The only substitute are share buy-back programmes. And the only company that I know which uses such form of cash return to shareholders is NED.

5.       Regulations – everybody knows, China is not a free country. But level of government intervention varies greatly. I prefer companies working on B2C markets: food, drugs, education, entertaiment. The rationale is that one can hardly imagine, that government suddenly decides to hault entirely food or drug supply. I avoid industries that depend heavily on government – construction, banks, natural resources companies, engineering companies. Think twice about exporters as buying them you implicitly sell yuan, as strong yuan will hurt their competitivness.

Admitting that all these issues persist I nevertheless believe that many chinese microcaps are good investments. They have impressive growth rates, high operational efficiency, strong balance sheets and, last but not least, fastly growing market with 1.3 billion consumers. And, at the same time valuations are extremely low, P/E being usually within 4-6 range,  which represents 70-80% discount to valuations of their US counterparts. So, the main challenge is to keep all potential issues in mind and to analyse candidates with due diligence.

Disclosure: Long ALN, SGAS.OB, HFGB.OB, NED, AOB