China-Based Stock Frauds

January 14th, 2011 by Potato

Note: I am not actually alleging fraud myself in any of these cases. I have for the most part not looked into the stories one way or the other except for personal interest. Despite the fact that I love reading the stories of the investigations of short sellers, I am not myself a short seller, and hold no position in any companies mentioned.

John Hempton brought to light the case of a Chinese internet-based travel agent with a non-functional website, over the course of several posts. Though I found the reporting to be a great read, UTA is up ~40% since JH published his research. An even better time to short, or was the thesis wrong? Unfortunately I’m not going to invest the time to look into it for you, so you’ll have to figure it out yourself, or wait for the fullness of time (like me).

Kerrisdale Capital (registration may be required to view post) goes into great detail outlining another case of a Chinese private education company with again, a non-functioning website, and a teaching facility with no desks for students. It’s actually rather amazing the amount of work they went into their investigation, and to me at least, their report reads like a financial detective thriller. They also outline the mechanism of profiting from the fraud, as well as another way of spotting one: they issue more shares when the share price is high, with no concrete need or plan for the cash. The cash just sits there, despite the ostensibly high earnings growth rate.

One of the interesting parts of the Bronte Capital post was that the amount of interest income they were reporting on their income statement didn’t jive with the amount of cash they had on hand. There’s a post at Seeking Alpha on that topic.

Financial Uproar had a post recently looking at a Chinese small-cap that had my magic words “trading for less than the cash on the balance sheet.” Unfortunately, the company is mired in an accounting scandal, with class-action lawsuits mounting, and the filing of their latest quarterly results weeks late now. Using the quick John Hempton test, I looked at the most recent available data I could find: they have something like $90M in cash, and are trading at a market cap of $80M. However, that big cash stockpile made something like 25 bp of interest income in the last quarter, which is suspiciously low. Moreover, they didn’t pay down at all a revolving line of credit — why keep a LoC open with cash on hand doing nothing? Something smells funny here. If this were a local Canadian small-cap, trading this cheaply, I’d be tempted to investigate further, maybe try to figure out who was right in the accounting dispute and whether there was any business activity to back up the statements. But it’s not Canadian, it’s Chinese, so there’s really nothing more I can do but examine the financial statements, and those are now definitely suspect. Like I said at the beginning, I’m not a short seller, but I am very good at staying the hell away from stuff, and that’s exactly what I intend on doing here.

There are enough of these stories out there that I’m even worried about investing in China in general. I was going to look into some BRIC ETFs (not necessarily because I wanted to invest myself, but Netbug was asking me about emerging markets), and I have to say the lax regulation/fraud risk issue is enough for me to not bother. Besides, the Canadian market is plenty levered to the Chinese growth story anyway.

4 Responses to “China-Based Stock Frauds”

  1. This and That: Interest rates, portfolio performance review and more… | Canadian Capitalist Says:

    […] One of the biggest risks in investing in emerging markets is widespread corruption and fraud. Blessed by the Potato highlights recent examples of alleged fraud in stocks of China-based companies. […]

  2. Disagree Says:

    Earlier years when American investors commented Canadian mining companies, it was like: a man, a spade, and a hole just dug on the ground. That’s all about mining companiesā€¦…although their shares prices are booming recent days, that story’s merit remains.

    Fraud companies are everywhere, every time. As investors, we have to do our due diligence and take the reward and risk as a whole. While there are abundant Chinese companies you should avoid at all cost, there are more abundant Chinese companies are doing great and investors are making huge money, for both growth and value types.

    This article is serious flawed and biased.

  3. This and That: Interest rates, portfolio performance review and moreā€¦ | MoneySense Says:

    […] One of the biggest risks in investing in emerging markets is widespread corruption and fraud. Blessed by the Potato highlights recent examples of alleged fraud in stocks of China-based companies. […]

  4. Potato Says:

    It’s a good point: fraud sneaks in everywhere, and one shouldn’t write off an entire sector because there may be some losers in the bunch. Nonetheless, a bit of extra caution is warranted when the numbers look too good to be true.