CHECK-LIST FOR THE BAD GUYS

China Investment

If you are worried about investing in Chinese companies because of the risks of corporate crime, here are things to look out for, according to Violet Ho, Greater China MD of global risk consulting company Kroll:

• The first warning sign would be familiar to investors around the world: If it is too good to be true, then it probably is. Look for margins well above industry norms, rapid asset acquisitions after listing, related-party transactions.
• Most common fraud is using shell companies to process deals (often set up by key persons’ family members or friends). The shell company is injected into the supply chain and used to create bogus revenues. This is very easy to fake, especially with services, as only people in the management team can say if they actually received services.
• While all sectors may contain companies which commit fraud, those where the supply chain has multiple entry points, particularly where the upstream is farmers or plantations, are most prone. A large supplier base transacting without formal contracts or receipts means you cannot cross-check with reported financials and thus risk increases. This is also true for companies where revenue comes from sales of things you cannot see (virtual businesses).
• Don’t trust all-clears by auditors. If the fraud is perpetrated through collusion of multiple parties, both inside and outside the organization, it will be very hard for the auditor to detect.
• Compare statutory government filings with public disclosures. It is common practice for Chinese companies to under-report revenue to the local government by booking expenses in special ways to avoid taxes. This indicates they are corrupt on some level. And there’s the risk they get found out.

Finally, I cherish this insight by FT commentator John Plender on accounting practice in Chinese business. He says family entrepreneurs tend to keep four sets of books:

• One for shareholders (lousy profits);
• One for the tax man (just over break-even);
• One for the bank providing credit (great profits);
• One for themselves (reality).

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Thirdly, what matters to most investors is capital growth. Historic share prices are a matter of public record, so cannot be manipulated. If corruption has been a problem, it means capital growth would have been higher without it. But I would not complain about the average five-year share price increase for those same Hong Kong-listed firms — 164 per cent.

Moving beyond the negatives, which are far less than they are often said to be, what should we now expect?

• Official policy is likely to continue moving cautiously towards easing.

This is a politically difficult time because of the periodic mass changeover in important government positions throughout the country. Retiring officials still in power won’t want to make the mistake of easing up too soon on squeezing property speculation and damping down inflation. On the other hand, they wouldn’t want to see too much of a slowdown, which would cost them serious loss of reputation.

So… steady as she goes, with the outgoing leadership probably declaring “victory” in the second or third quarters, ahead of the October changeover.

• If there is an economic setback, China “has plenty of ammunition in its monetary policy arsenal… to deploy,” says former chairman of Morgan Stanley Asia Stephen Roach.
• With valuations now very attractive — an average forecast earnings-per-share ratio of not much above nine times – and a reduced downside risk to earnings growth, Deutsche Bank says it has “a very positive outlook for China’s equity markets.”

Of course, there is historic evidence that strong investment returns don’t correlate with strong economic growth. But rules based on history have a way of collapsing the moment they become well-known and investors base their decisions on them.

In this difficult new world of exploding public debt, what Roach describes as “untested and dubious” central bank policies, and mature economies struggling with poor growth and growing political disaffection, it surely makes sense to choose an economy growing at 8 per cent a year above those struggling to achieve 2 per cent? With retail sales, even in a slowdown, growing at 14 per cent a year? And to invest in companies whose earnings have been growing strongly, while most of those listed in the West haven’t done better than recover lost ground?

CopyRight – OnTarget 2012 by Martin Spring