China Stocks: Checklist for Quality
posted by The Traveller on Wednesday, August 25, 2010

Many U.S.-listed Chinese stocks are currently priced with so very unreasonable forward multiples that the only possible conclusion for the low share price is that the market doesn't believe the numbers. You could argue that when numbers look too good to be true they can't be true. And there is undeniably a higher degree of risk involved with investing in Chinese small caps than with your average U.S. company. However, it is our strong belief that there is a large number of high quality China companies being unfairly punished by the market for the mistakes of selected few well-known names from the space.

For determining the quality of a stock it is not enough to look at reported numbers and published guidance. It is always a good idea to be sceptic and to do your very own due diligence before investing your money in a tiny company on the other side of the world, where you don't get any other first-hand information than what the company chooses to disclose to you. What matters is management credibility and trust in the reported facts and financial results. Here is a list of 10 criteria I consider important for determining quality in U.S.-listed China stocks.

1. Quality Auditor

As I pointed out in an earlier article, the quality of a company's independent auditor should be the most important factor for investor confidence and trust in the reported numbers. While I acknowledge that it is unreasonable for a tiny, newly-listed company to hire a Big4 auditor, I believe that with maturity of the business comes the responsibility to upgrade to a high or the highest standard. For now I have drawn a line at $200 million market capitalization where I expect all larger companies to have hired a Top10 or better a Big4 (Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers) auditor.

2. Analyst Coverage

This one is very important in my opinion, especially for foreign-listed Chinese companies. Having two or more analysts (I am not talking about IR firms like RedChip here) covering a stock gives investors a much enhanced transparency into a company's business. While the depth of the analyst research might vary and not all analysts will be completely unbiased, investors will be able to benefit from the due diligence of the research firm (or institutional investors) and management will get valuable feedback from analysts about deficiencies and possible problems, also what (institutional) investors want to see in regards of transparency, communication and earnings quality.

3. Active and Effective Communication with Investors

What I want to see is regular press releases with updates for investors, business outlook and timely reporting of material events. The very minimum should be a press release for quarterly earnings, preferably with a conference call following. Passive communication as in management or an investor relations firm responding to shareholder questions is all fine, but can't make up for the failure of management to actively communicate their story with investors.

4. Strong Independent Board of Directors

Many U.S.-listed Chinese companies, especially those that went public through reverse mergers, are controlled by just one or two majority shareholders. While many investors view high insider ownership as just a positive for a stock, I see it as a warning sign if the company doesn't have a strong and influential independent board and audit committee.

5. Effective Internal Controls and Procedures

U.S.-listed companies are required to report in their SEC filings on the effectiveness of internal controls over financial reporting and disclose any material weaknesses. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant's annual or interim financial statements will not be prevented or detected on a timely basis.

6. Chief Financial Officer

A qualified, full-time CFO who is physically located at the company's headquarters and deeply involved in the company's day-by-day operations should be mandatory for any public company that reached a certain level of maturity. Many Chinese small caps hired English-speaking CFO's whose main job is U.S. GAAP reporting and investor communications, but who are not very involved with the company's actual business and spend a good time of the year outside of China.

7. Dilution and Equity Transactions

Two points have to be considered here. First a consideration of management for current shareholder interests when pricing equity offerings or private transactions. Pricing new shares at a very unfavorable price, close to a stock's 52-week low or with a steep discount to market, should raise a bright red flag. And secondly, multiple privately negotiated transactions that lack the transparency and due diligence of underwritten secondary offerings could be a warning sign.

8. Earnings-per-share Forward Guidance

I want to see company management's commitment to creating shareholder value by acknowledging that in the long run the only thing that matters is growing earnings per share. By providing forward EPS guidance additionally to revenue or net income guidance, management provides additional transparency and shows that shareholder interests are on their minds.

9. Limited Share-Based Compensation

Several companies in the Trading China universe have the bad habit of paying for every little, er.. type of service, with warrants or newly-issued shares. Pay attention to the frequency and number of shares that are being issued for 'consulting services', investor relations, management or external compensation and one-time events or 'exceptions'. As a shareholder you want management to have your interests in mind all the time and not to view stock as a cheap currency that is always preferable to available cash on the bank account.

10. Timely Reporting and Filing of Quarterly/Annual Reports

It doesn't stand for quality if a company has repeatedly filed NT-extensions with the SEC for their quarterly or annual reports. While I admit that there might be special circumstances that justify the one-time delay of an earnings report, those deadlines do not come as a surprise to management, and repeated offenses might indicate that a company is not well-prepared in their financial reporting which in turn increases the risk that there are deeper structural problems than the rather unimportant delay of a 10-Q filing.



At August 28, 2010 10:20 pm , Blogger aw said...

What will it take for the 'markets' to give these microcaps a look? A lot of these stocks have reported solid, if not spectacular, figures and yet the prices are still stagnant. When do you predict a turnaround?

At August 29, 2010 9:14 am , Blogger The Traveller said...

The general markets do again look very vulnerable here, I wouldn't interpret Friday's GDP numbers and the small rally as a game changer. I would do a rigorous quality check on my Chinese holdings because it is likely that all those names with credibility issues will underperform in a market characterized by risk aversion, no matter how good the story is the plain numbers tell you.

At August 29, 2010 10:04 pm , Blogger jimidean said...

with regard to auditor quality, bigger does not necessarily mean better, several large usa fraud blowups were audited by big 4. I don't have any more comfort based on who the audit firm is. I like to do my own f/s analysis on inv., rec., etc. No substitute for doing your own homework.

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