Successful Investing in China Despite the Risks

Investing always involves a kind of leap of faith. Investors have to believe that the numbers they are looking at are real. They have to believe that the financial statements reasonably reflect reality. Without that trust, there is no point in going further. The investor is like a cook unsure of the safety of his ingredients.

This is why things like auditors and listing requirements and boards of directors are so important. This is why due diligence is important: asking questions, talking to people on the ground. They give some assurance to investors that what they see is real and not a fraud.

Sometimes the lines can be very fuzzy. And sometimes the taint of fraud dogs a market, making all the stocks of that market cheap, whether they are fraudulent or not. Such a market is also very susceptible to rumor.

I think the market for the U.S.-listed China-based companies has that taint. That explains the very cheap multiples that many such companies trade for. I’m talking about price-to-earnings ratios of 5–8 times for companies growing 20–30% a year.

But investors will have to be careful, as there seem to be a lot of questionable apples in the bin. And they will have to do quality due diligence to stand up to rumor and extreme price volatility.

There have been several cases of fudged numbers. I wrote about Fuqi Intl. before. It is a China-based jeweler whose stock trades on the Nasdaq. The stock dropped 37% one day in March after the company announced it would have to restate past results. The stock has continued to drop since. The stock was $30 per share and is about $6 today.

There have been other grim casualties. But the pace of digging up scams seems to have quickened. I’ve been trading e-mails with my Beijing contacts for weeks. One veteran hedge fund manager, who would like to remain anonymous, told me how he was “very worried.” There are too many scams, which is not good for the market. He said, “Another big development is these detailed negative research reports. There are three–four quality reports coming out each month from different outfits. This is compared to maybe only two–three reports all of last year!”

A company called China Marine Food has recently been fending off challenges to its accounting. A website called Chinese Company Analyst performs detailed financial analysis of Chinese companies. In a highly detailed report, it contends that China Marine Food is a fraud. I can’t do justice to the report here, but here is a damning snippet:

“I question how [the company] could generate $7.6 million of revenue, $1.7 million of net income and $1.2 million of operating cash flow in its first five months of operations with (i) $44,000 of startup capital it received from its original founder, [and] (ii) $414 of capex…”

China Marine Food dropped more than 20% on the day these allegations came to light. The stock has continued to fall. The company has defended its accounting. It may or may not be a fraud, but the evidence seems to suggest that all is not quite as it seems.

Most recently, another case has come up with Orient Paper. This is a company I put on my watch list after one of my Beijing contacts told me about it. It seemed to have great fundamentals and traded very cheaply.

I never looked at it in detail, but I remember thinking it seemed fishy that the stock of an operating company could go from $1.50 to $15 within a year. That just doesn’t happen. Resource companies can make that kind of leap — you have a new discovery or the underlying commodity takes a big jump. But it is rare that a basic operating company involved in something like paper becomes a ten-bagger in a year’s time.

On June 28, a company called Muddy Waters released its “inaugural report” on Orient Paper contending that it was a fraud. The stock closed at $8.33 before the report. It dropped 13% that day, but the snowball was only just getting started. Two days later, the stock hit $4.11.

But this is one where the line is:

Fuzzy.

The Muddy Waters report is detailed. The authors of the report talked to suppliers. Some of the suppliers offer a very different view of Orient Paper’s capacity than what Orient Paper claims. Muddy Waters tried to track down customers. Some of these they found did not exist or were small mom and pop shops. Yet Orient Paper reports millions of dollars in sales from such customers. Muddy Waters tried to match SEC filings with tax filings in China. They claimed to find major discrepancies. There are pictures of site visits showing old machines. There are other observations about the number of employees and trucks and more.

It all adds up to a pretty damning dossier.

Yet there is another side. Rick Pearson, one of my Beijing contacts, also visited Orient Paper. In fact, he was on the same site visit as the Muddy Waters’ crew. More incredibly, Pearson knows the authors of the Muddy Waters report, both old classmates of his.

Pearson wrote up his views for TheStreet.com. He has a totally different view of the company. He bought the stock after the report! As he writes:

I was quickly on the phone to the company, to its IR firm and to other major investors who own the stock. Everyone was equally shocked by the report, and the company vowed to respond immediately. I know a number of investors who have toured ONP, met management and invested in public and private offerings by the company. The investors have all expressed interest in buying at these levels.

Pearson was also critical of the due diligence of his former classmates, who apparently asked few questions of management on the visit and didn’t speak Mandarin. He felt like they were there to “check a box” to say they’d visited the company.

Pearson’s piece must’ve helped settle the market, because it rose 44% the day his piece came out, to back over $7 per share. (The fact that the stock moved so much during this whole period shows how little investors really knew about the company. This is why I say you have to have strong due diligence. Otherwise, you’ll wind up locking in losses on the merest rumor, to which Chinese companies seem susceptible at the moment.)

So what does all this mean? I don’t know if Orient Paper is a fraud. I have a lot of respect for Pearson’s research and expertise. He was a former investment banker. He lives in Beijing. He speaks Mandarin. And this — U.S.-listed, China-based stocks — is his métier.

I suspect that Orient Paper’s accounting is not entirely up to snuff. I suspect it’s probably not a high-quality company (that doesn’t mean that you can’t make money in it). I don’t really know. As I say, I have not done my own due diligence on Orient Paper.

But the point of this piece is really to show you how tricky the market for U.S.-listed China-based stocks is right now. It also helps explain the low valuations we see. Don’t just assume that a China-based stock is a bargain because it trades for 6 times earnings and is growing 30% a year. It may not be quite what it seems.

Regards,
Chris Mayer
Whiskey & Gunpowder

August 2, 2010