Given the recent negative articles made by ‘research’ outfits who are already short the stock, we have put together a step by step approach to our due diligence process before investing in a name. We will avoid mentioning specific RTO symbols and recommendations.
1) Look for a low P/E in an industry you can understand. How simple is the business model? Can you understand exactly how the company is making money and growing revenue? Most of the RTO names have an implied chance of fraud already priced in and therefore trade at a very low P/E multiple when compared to better known Chinese stocks - think BIDU or recent IPOs like DANG and YOKU
2) Check the auditor. While no auditor, Big Four or otherwise, is a guarantee there is no fraud, you can limit this risk by checking the auditor. We prefer companies audited by associated firms of the Big Four (Deloitte Touche, E & Y, KPMG and PWC), we also consider smaller companies with Top Ten auditors such as Crowe Horwath. We tend to avoid names audited by lower tier names like Sherb and Kabani. This is not an indictment of these auditors, it reflects the likelihood that share price will languish due to the perceived increased risk of fraud associated with companies using less well know auditors.
3) Is there cash? You want to find a company that has positive cash flow from operations and a history of what we consider non-dilutive offerings. We look for prior offerings where capital is quickly put to work and results in a growth in fully diluted EPS. Along this line, you should question any offering done when, according to balance sheet, there is already plenty of cash on hand to handle any planned capital expenditures.
4)Watch the CFO. Ideally you never want to see a CFO leave. Realistically, these are growing companies and as with companies in the US going from start up to major exchange listing there will be turnover in key positions including the CFO. When they do replace a CFO, is it an upgrade and does the current CFO have credentials you would expect to find in a US publicly traded company.
5) Look for institutional support. You will often see GS, MS or Blackrock holding shares in your company, this is mostly due to investments associated with ETF’s or indexing. If the company is a member of one of the Russell indexes you will have some institutional support as a result of people indexing. Look for outsized institutional support, for instance it is easy to compare two Russell 3000 stocks and compare the dollar value invested by various institutions to determine if there additional support above the expected index ratio.
6) Our last step is reviewing Research reports. If you do not subscribe to a service that disseminates analyst reports, many websites post research reports to the public, Geo Investing and Trading China to name two. Some of the companies issuing research have visited the company and spoken to clients in an attempt to further verify revenues. Keep in mind, some research companies are paid for their support and some have been underwriters for offerings and this will be noted on the research report. Others are just pure research reports, weigh each price target and basis for estimates appropriately.
None of the above steps will guarantee you have found a company which is immune to short speculation, nor will it guarantee the company has not created an elaborate web of fraud. What is does is allow you to assemble a portfolio of very cheap well capitalized companies doing business in one of the fastest growing markets in the world.