China Watch Blog has picked up a good article from the SCMP which warns investors about the risks of investing in mainland firms.
Shirley Yam in her column says: “Honestly, I can’t understand all the hype about mainland private enterprises cooking the books. To me, every listed mainland private entrepreneur lies, unless proven otherwise. The difference is only in degree.
“It is not about the devilish nature of human beings, but about the country. No entrepreneur who honours credibility can be successful in a country where pricing and power are so distorted.”
And the chance of being caught is low. A foreign professional who has a set of assumptions formed in a developed country will not easily discover the lies. And no major mainland entrepreneur has been forced to face a foreign court for lying, so far. As long as they stay home, they are pretty safe.
So where is the motive to be honest?
Investors who have been paying a premium for shares in mainland private enterprises should buy a veteran Hong Kong auditor a drink – they know some of the tricks.
One basic misunderstanding is the credibility of financial accounts. Let us take the company’s bank statement – the core verification document – as an example.
At the bank, auditors should be able to verify the cash flows and therefore the profitability claimed by an issuer.
Ten years ago, when the first batch of private enterprises arrived in Hong Kong, auditors accepted bank statements that had a chop as the real deal, as they always had.
Then came the scandal of Euro-Asia Agriculture. Instead of fields, journalists found barren land and no sight of the HK$100 orchid bulbs the company claimed to be growing. Shocked auditors and investors then realised that bank chops can be brought and sold, and many weren’t locked away in a vault.
So the auditors decided to go and meet the bank manager. That sounds good, but here is the account of a Big Four partner speaking about his subordinate’s experience.
It was a rainy day. One of his auditors arrived at the lobby of a city bank. He had called the bank manager a few days ago to set up the meeting to cross check the account of a client who was seeking listing in Hong Kong.
The receptionist ushered him into the office of the bank manager. Name cards were exchanged. The two spent 30 minutes going through the bank statement, item by item. “It’s all true,” said the manager.
Our auditor happily left the office, thinking that the manager had save him a lot of trouble. He jumped onto a taxi. Before it turned the corner, he realised that he had forgotten to ask the manager to sign one of the papers.
He headed back to the office and found a different man sitting in there. “Excuse me, I am looking for the manager,” said the auditor. “I am the manager,” answered the man. “There must be some misunderstanding,” said the auditor, showing him the name card he had been given less than an hour ago. “I don’t know what you are talking about,” answered the man.
A bank or government official collaborates with a dishonest entrepreneur for all sorts of reasons. A successful listing by a company based in the region means job creation; political credentials; the repayment of a loan or simply personal financial gain.
To make sure auditors actually meet the real bankers instead of actors, some auditors now conduct surprise visits to banks.
When examining the fundamentals of a company, some auditors resort to classic detective work. They hide in the bushes or in the restaurant across the street of the factory, where they spend hours counting the number of loaded trucks leaving the factory. Some hire so-called credit verifiers.
With agricultural, mining and forestry industries, fact-finding can be more difficult.
For layman investors looking at a prospectus, the financial statement is, therefore, never the first section to read. Instead, it is the section named “directors, senior management and staff”, where the background of the officers in charge is described. After all, people matter more than numbers in China in assessing credibility.
Are the major shareholders too “young” for their listed achievements? Do they give their full name in Chinese characters? A name like David Zhang could refer to thousands of people. From their background, do they appear to know anything about the business? How did they make their first “pot of gold”? Was their rise to fame too rapid to be true? Are they into other risk businesses such as property?
Who is the chief financial officer? A Hong Kong accountant who has little experience might raise the first red flag. There is a good chance they were hired as an “investor relations manager” rather than a real CFO. Most likely, if there is a “finance manager” who is a mainlander and has worked at the company since day one, he or she is the real CFO and the other is just a “face”.
Who are the independent directors? You don’t want to see this combination: a 30-something accountant fresh from the Big Four; a professor at the local university; and the chairman of a local or even national industrial group. They are likely all there just to get paid.
The next section to read is “history and development” of the company. These boring pages talk about each and every major transaction of the company’s ownership and assets. From these, you get a close look at the way the major shareholder did business.
Be wary if the story is too complicated or makes no business sense. Watch out for state assets being sold to the company for a dirt cheap price, fake asset injections done to get loan approvals, or company ownership held by “independent third parties” for vague “financial reasons”.
These are all ways to hide something. Management will always say “that’s the only way to do business in China”. True, but imagine, as the investor, you are on the other side of the table.
Reproduced from the South China Morning Post