In the midst of the accounting scandals that are currently affecting a significant number of Chinese companies listed overseas, Eric Rosenkranz was in typically ebullient form on Squawk Box recently, warning investors to stay wary of new initial public offerings (IPOs) of Chinese companies. He explained how many firms keep multiple sets of books, telling viewers, “I’ve been investing in China for the last 10 years and there’s one thing I’ve learnt – with many Chinese companies there are usually two sets of books, and whenever there are two sets of books, there are usually three.”
The first set of books minimizes taxable profits and is designed to be submitted to the tax authorities.
The second set exaggerates earnings and is designed to be shown to potential investors or to banks.
The third most closely reflects the true information on the company and is, therefore, the one that investors really need to seek before investing.
Eric went on to suggest a check list of 3 boxes that he requires to be ticked before investing in a listing:
1) Whether the company is listing on a “reputable” exchange such as the NYSE, NASDAQ or Hong Kong Stock Exchange.
2) Whether it is a new or reverse listing – dangers lurk within reverse mergers that use shell companies to list – of the 200 Chinese companies that have gone public in the U.S. over the last four years, 75 percent had done so via reverse listings.
3) Whether the company that is listing uses one of the “big four” accounting firms: KPMG, Ernst & Young, Deloitte and/or PWC.
Unless all 3 boxes are ticked, Eric would suggest steering clear but flagged the quality of the auditor as being the most crucial factor.
As an independent non-executive director of Focus Media Network (a company unrelated to Focus Media China), which listed on the Hong Kong Stock Exchange’s GEM board in July 2011, he was quick to point out that Focus Media Network keeps only one set of books, had to pass the stringent regulations of the Hong Kong Exchange, and retains PricewaterhouseCoopers as its accounting firm.
Even “big four” accounting firms are not necessarily 100% reliable – Eric looked at Deloitte’s role in failing to pick up sooner apparent accounting fraud at Chinese financial software firm Longtop Financial – “It’s not Deloitte U.S., it’s a subsidiary of theirs, which is a Chinese company and one of the issues is U.S. regulators are not allowed into China to look at the books. So the U.S. regulators from the SEC have been forbidden because of country sovereignty issues from looking at the books,” he said.
Whilst this is fascinating and while China looks to be of good relative value today, we still see China exposures as being a relatively small part of portfolios. The global economic backdrop is not supportive of any equity valuations right now, China is at a different stage of the economic cycle and may be entering into the end of the fat growth inflationary stage that western economies exited over a decade ago. Also, at this stage, the understandable inability of regulators to keep pace with the huge boom in all things Chinese in recent years means that, right now, we just do not trust the reliability of any numbers coming out of China – corporate or sovereign.
As Nouriel Roubini recently observed, China will be a huge opportunity on the next growth cycle but depending on how much debt China takes on, the next bust (and, therefore, major buying opportunity) is at least two years away and possibly more. A small exposure to proven stock pickers right now at current Chinese valuations is the most that we would recommend and even then you would need to keep your finger hovering over the sell button…
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