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. Take Fuqi
International (NASDAQ: FUQI), for example. 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. And the increasing
number of negative research reports aren’t helping things…
A company called China Marine Food (AMEX: CMFO) 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, though the
evidence seems to suggest that there’s more to the story.
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.
Nonetheless, I fear the taint of the scandal in the China market helps
tamp down the stock prices of these stocks, along with worries about a
China slowdown. These ought to resolve themselves over time.
Ultimately, good results will drive fundamentally sound stocks higher.
And since we are starting at such a low multiples, the returns could
be substantial.
Chinese stocks are speculative, but good speculations on the old
truism that value and price ultimately meet. Tread carefully on these
plays.
[Independence Note: Unlike scores of other penny
stock resources, we’re 100% independent from the companies we talk
about in the Sleuth – that means that we never accept
compensation in exchange for profiling a company, and our editors
never own a position in any stocks they talk about.]
