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Confessions of an RTO Addict

I manage a small fund that traditionally focused on high conviction investing in high yielding assets, International Equities, and special situations. My interest in RTO’s originally emerged while I was quantitatively screening for stocks, I just happened to stumble on what I believed to be a hidden gem. The company was China Agritech (OTCPK:CAGC) an organic fertilizer company which was growing revenues 50% yet trading at a 10x Multiple. I initially bought in rather conservatively, because it is a Chinese small cap after all and I had no prior experience in the sector. Just months later the stock doubled and my concerns about china small caps were now greatly alleviated. I took my profits, up 121%, and started scouring the RTO space for more compelling buys.
                Initially I planned on keeping about 25% of my portfolio in these names for asset allocation purposes, however buying these names really became addictive. After all why pay 15-20x earnings for a U.S. company growing 15% a year when I can buy RTO companies growing 40% at less than 10x earnings (and the RTO companies have stronger balance sheets, at least they claim too, but more on those claims later). Slowly the RTO segment of my portfolio grew until it was around 70% of total assets. At this time I was actively talking and meeting with dozens of these companies executives; discussing their growth plans, financing strategies, and product developments. I now dedicated the majority of my time to following all RTO developments and looking for the next easy double.
Which now brings me to the present
Currently I believe a majority, as in greater than 75%, of Chinese RTO’s are conducting serious erroneous accounting and/or fraudulent activity. Whether it be by faking cash balances, making up customer contracts, hiding operating expenses under CAPEX, or dozens of the other favorite methods. The bottom line is now it is nearly impossible for an investor, individual or institution, to invest in any RTO and be confident your company isn’t fraudulent. I’ll guide through my reasoning below which in aggregate should prove my point.
1.       Origin of RTO-For a Chinese company RTO’s are clearly not the most efficient way to access capital and any business doing so has either incompetent managers, was duped by promoters, or is fraudulent. This reasoning derives from the following reasons
A.      Why would a company sell equity at what is 99% of the time sub 8x multiples, and usually sub 5x, even sub 3x? Venture Capital and Private Equity financing are available a lot more than most of these RTO promoters would like you to believe. Bank loans are also another option that can be accessed readily and can free up funds previously allocated for working capital. Because these growing companies use Chinese RTO’s this means either the management has no idea how to run an efficient business or their earnings (as presented in SEC filings) aren’t actually accurate. Either way I don’t want to be invested.
B.      Why not file a S-1 registration statement and avoid the whole RTO process, which would save 100’s of thousands and save shareholders from unnecessary dilution?  Once again management was apparently duped (by fee chasing promoters) or doesn’t care about shareholders.
2.       RTO Margins: Profit Margins are absurdly high for RTO companies in comparison to their other Chinese peers. In one comparison RTO’s beat their peers by 1346 basis points on gross margins, which begs are the question, are these businesses really this lean, efficient, and streamlined? No, actually these management teams are actually the most inefficient businessmen I have ever met. They buy acquisitions at 6x earnings while their common trades at 3x. They pay 100’s of thousands to their relatives giving them plum jobs in their business. They have no understanding of how to properly finance anything in an accretive way, or if it somehow was accretive (which is extremely unlikely) their clearly was a better alternative. In reality these margins are elevated due to management conducting fraudulent activity, like the always popular hiding operating expenses in CAPEX (which is nearly impossible to find as an investor).
3.       Corporate Structures-Reverse Merger investors have no legal claim to the company’s assets. If these Executives want to walk away and say “Adios thanks for the millions,” they can, and this is happening. After all a large portion of these companies are already falsifying their accounting records, why not just disappear completely? This is starting to happen in increasing numbers, and the trend will continue.
4.       Anecdotal Evidence-Almost every RTO that undergoes intense scrutiny, and I mean intense, checking licenses, land rights, balance sheet intangibles, revenue recognition policies, contracts, SAIC/SAT checks, SEC disclosures, related party transactions, etc has serious problems usually in multiple categories.  The problems with licensing, land rights, etc aren’t that much of a concern as they usually can be remedied. But companies claiming revenues they don’t have, omitting expenses, claiming assets they don’t have, faking cash balances, etc are serious problems, and unfortunately for investors there is no way you can check these. Even institutions/investment banks/auditors have gotten the wool pulled over their eyes even after spending months on the ground.
As an investor there is no way to be confident the RTO you are investing in is what it claims to be in SEC filings. KPMG, Deloitte, and other big names have overlooked blatant and obvious fraud, and these are the most competent auditors. The smaller names, who I’ll spare from embarrassment, are even more clueless. They literally sign off on anything without scrutinizing the numbers. Because of this, investors might think they are buying a company with 160 million in cash, earning 50 million a year, and trades with a market cap of 140 million. In reality they are buying a company with fabricated cash balances, overstated net income, and trades at an absurdly high valuation once one realizes it is actually 1/10th the size it claims to be, and 1/100th as profitable. Even for investors conducting on ground DD, you still can be duped. Consider the recent examples of factories that remain dormant all year, but when investors schedule visits, all of a sudden the factory is bustling with activity.
An interesting recent development has unfolded in the sector and may offer an early first glimpse into just how many RTO’s are frauds. MaloneBailey, an previously mediocre firm, has started scrutinizing their Chinese RTO clients trading on major exchanges. So far the results should be a wake up call for longs, Malone-Bailey has (had) 4 RTO clients trading on major exchanges, while this is a statistically small sample, the results are astonishing. MB’s clients were CELM, NIV, CIL, and CDM. In CDM, which is now halted, MaloneBailey found irregularities that indicate that accounting records have been falsified, MaloneBailey has since resigned. In NIV MaloneBailey “found accounting fraud and irregularities in forging accounting records and bank statements during 2010 NIVS audit.” MaloneBailey has also resigned in NIV. In CIL MaloneBailey found “accounting fraud involving forging of the Company's accounting records and forging bank statements, in addition to other discrepancies identified during its testing of the Company's accounts receivable.” Once again MaloneBailey resigned. In CELM MaloneBailey found problems again, and has since resigned.  Once MaloneBailey started scrutinizing their clients they found fraud in every single client, all stocks are now halted.
MaloneBailey: I applaud your work as you seem to be the only firm actually doing your job, and as far as I’m concerned your better than Deloitte, KPMG, and everyone else.
Lesson to longs: There is no successful RTO buy and hold strategy, your just holding until either their auditor finds fraud or short sellers do, and either way you lose money.
The author is assembling an international research and due diligence team and will be investigating Chinese RTO’s, he plans on publishing his findings no matter the result.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long CHGS puts.