Over
the past few months Chinese stocks trading in the U.S. have seen their
shares fall off the cliff. If we had such a location as the "Great
Cliff of America" that would be the place where these stocks are plummeting.
With the U.S. economy sucking wind and the China ramping full speed ahead
it makes little sense that Chinese stocks are shunned by investors both
retail and institutional. Research conducted by China Vesting indicates
there are numerous Chinese companies being valued at anywhere from 3-5
times previous year's earnings and 2-3 times 2010 earnings estimates.
In the universe of equities, public companies just do not trade at these
sorts of valuations. At some point...some very smart people are going
to take these low valuation companies private and keep the cash...but that's
another topic.
Let's keep things really basic here...China's economy is doing very
well which translates into these China companies growing their revenue
and earnings. Common sense would dictate that Chinese stocks deserve
a premium rather than a discount to the market.
However, this is not a basic issue...it all boils down to one thing...TRUST.
People just don't trust the accounting numbers coming out of Chinese companies.
It doesn't help that two of the most famous Chinese public companies in
the U.S., Orient Paper (ONP)
and Fuqi International (FUQI)
have seen their shares drop 72% and
84% from their peaks due to accounting
problems...or the accusations of accounting problems. The public
is spooked because no one wants to be caught owning the next Chinese stock
that blows up.
The Low Down on Accounting
Why
does there seem to be more accounting problems with Chinese companies than
their U.S. counterparts? The first and most basic is reason is that
the Chinese companies are just cheap. We hate to generalize but that
is the honest truth. Most audits from a PCAOB firms costs a Chinese
company $75,000 to upwards of mid six figures per year. Keep in mind
the Chairman/CEO of the company probably pays an average of $2,800 per
year for an employee. Essentially he looks at the five or six auditors
who will spend 3-4 months auditing the company and realizes it's the equivalent
to thirty of his employees. This creates a vicious cycle where the
lost cost provider wins.
The irony is that because most of these Chinese companies have decent
sized businesses hiring the little dinky accounting firms is what creates
the most potential for problems. Most of these Chinese companies,
if they were American would undoubtedly hire one of the top ten global
accounting firms to handle their audits. However, seeing that the
Chairman/CEO wants to keep his costs minimal the lowest bidder wins.
In our opinion this going to change because the market is already voting
to ignore Chinese stocks due to a lack of trust. Without trust the
basic premise of investing is gone and people would just rather put their
money in a mattress.
No Longer Mom & Pop
The
story that is missing for the most part resides in the fact that most of
the Chinese companies that become public here in the U.S. are run like
a mom and pop operations. Unlike in the U.S., as companies get bigger,
systems are put into place...management systems, accounting systems, all
kinds of systems. Why? Labor is expensive so U.S. companies increase
efficiency and save costs by utilizing systems. However, in China,
labor is so much less than expensive than implementing systems that it
makes more sense to have a bunch of people doing a bunch of things.
The concept of "lean and mean" is foreign to China companies because the
culture is one of "farming and manufacturing" not marketing. This
is going to sound terrible...but the focus is really more about being the
"king" with thousands of servants/employees rather than a small crew and
maximizing profits.
Two years ago we visited an agricultural company that had over $200
million USD in revenue and only paper accounting. That's right...not
even Excel was used. All of the company's accounting could have resided
on a single blackberry but instead the paperwork filled up a nice one bedroom
apartment. The management behind these Chinese companies is just
not used to the Western world of doing things. The agricultural company
from earlier...did we mention that all employees double as farmers during
harvesting season (working on the Chairman's land). Need we say more?
Will these companies ever "GET IT"? Collectively it is going
to take a few generations...but we can tell you that the Chairman/CEO holds
the key. Out of all the companies we have visited or spoken to there
are a few bright exceptions that understand what it takes to be a successful
U.S. public company. They are few and far between but there are enough
to keep China Vesting busy.