Wednesday, February 23, 2011

Panic Over Chinese Stocks Just a Matter of Accounting

Panic Over Chinese Stocks Just a Matter of Accounting
Wednesday - November 03, 2010 4:35pm
By Crocker Coulson

The summer of 2010 was a miserable time for investors who favored Chinese stocks listed in the United States markets. Despite generally reporting excellent earnings, smaller Chinese equities were crushed by a wave of scandals, short-selling and suspicion. Major financial journals and investing websites wrote about widespread fraud in Chinese accounting practices.

Previously unknown “analysts” published exposé-style reports insinuating all kinds of wrongdoings, including chairmen who stole money from their shareholders, inflated their revenues and skimmed profits from supplier contracts.

As a result, retail and institutional investors fled these stocks in a panic, driving down valuations to low levels. There is a famous saying that Wall Street knows only two emotions: greed and fear. In this simmering summer of 2010, fears about China burned up investors’ holdings, leaving many high-growth companies in ashes.

What led to this sudden explosion of panic about Chinese companies? It wasn’t the economy. China’s economic growth has trounced every developed country and moved to No 2 GDP position in the world. Instead, a few high-profile accounting scandals and massive restatements by prominent US-listed Chinese companies sparked fear that there was a systemic accounting problem in China.

Bearish market commentators such as James Chanos went so far as to say that China’s entire economy is a fraud, and that the books are cooked at almost every Chinese company his firm has researched, making it a “short seller’s dream”.

In an article entitled Beware This Chinese Export, the financial newspaper Barron’s said US investors should shun investing in any small Chinese companies, showing a systemic bias against companies from the fastest-growing economy on the globe.

These articles were even picked up and repeated in the Chinese media. Suddenly every Chinese company was guilty until proven innocent.

This environment of fear created a playground for short sellers and their cronies, amateur analysts and media, who could concoct almost any allegations based on snippets of information and heavy helpings of speculation.

Even flimsy “short” reports could drive down stocks values by 30 percent to 70 percent overnight, making huge profits for the hedge funds that sponsored these articles.

As a result many fine Chinese companies were sucked into a vortex of attacks from all sides, forced to defend themselves against rampant rumors and whisper campaigns.

What has driven this storm of anti-China sentiment in the US equity markets? Some Chinese companies have had very serious problems, including one whose chairman was sentenced to death for corruption, another which restated its earnings by 50 percent, and third which saw its auditor, audit chairman, CEO and CFO all resign in one day.

Every time there is a major stock meltdown, it drags down the value of all the other Chinese companies. Too many of these explosions, and investors start to think that Chinese accounting is synonymous with fiction.

Many Chinese Companies also filed reports to the local administration for industry and commerce offices that vastly understated their revenues and profits, giving short sellers the chance to claim that they fabricated the figures in their US financial filings.

The accounting oversight board in the US, the PCAOB, has been turning up the heat on smaller audit firms that have “outsourced” their responsibilities to local consultants. And the SEC has launched a number of investigations of Chinese issuers.

If Chinese equities have been a “short sellers dream,” the situation has been a nightmare for Chinese management and for US retail investors, many of whom have lost large parts of their savings due to the unscrupulous market manipulation of these funds and the unbridled China-bashing financial media outlets like Barron’s.

Dozens of shareholder lawsuits have been launched by ambulance-chasing law firms. Many mainland companies that are growing at 25 percent or 100 percent a year are now trading at under seven times this year’s earnings, a huge discount to comparable American companies or mainland companies traded in Hong Kong.

This has even led to talk of a “return to the mainland” in which mainland companies would delist from the US and Hong Kong and try their chances for an A-share IPO on the mainland.

In recent weeks it appears the tide has begun to turn and smaller Chinese stocks have been on a tear, bouncing back from extremely depressed levels. Why?

First, China is just too big to ignore and investors who like growth companies are finding slim pickings in the anemic recovery in North America, Japan and Europe.

Second, private equity funds are now on the prowl to buy out these undervalued companies. Baring Private Equity and Goldman Sachs recently teamed up to snap up the public shares of Nasdaq-listed Harbin Electric at a 20 percent premium to its trading price in a $750 million deal.

Several other such deals are reputedly in discussion stages, showing that big money recognizes the value of Chinese small caps.

Third, Chinese IPOs in the US have been the best-performing stocks in the US markets in the past few months.

But for this rally in China small caps to be sustained, Chinese management will need to raise their game to attract international capital and play on a global stage. Larger, reputable auditors have now become a requirement for many fund managers, who don’t want to be blindsided by the next China stock scandal.

Investors want to see a board of directors that is truly independent and providing constructive oversight to management. Insider transactions and family members in the executive ranks are going to be highly scrutinized.

From this summer of misery, good things will come. The best Chinese companies will raise their standards
of accounting and corporate governance and come out stronger.

Auditors and board members will take their oversight function more seriously.

The weak companies will wither and the strong will flourish. And those who had the nerve to invest
when panic was running wild in the streets will draw a rich harvest from China’s ongoing economic miracle.

Crocker Coulson is the president of CCG Investor Relations, a leading adviser to Chinese mainland companies listed in the US and Hong Kong.