Since bottoming at the end of October, the MSCI Emerging Market Index (MXEA) and MSCI Asia Ex-Japan ...
09/26/2007 12:00 am EST
Updated September 28, 2007
Remember the late 1990s, when high-flying companies with poor disclosure and iffy accounting crashed and burned, along with their shareholders?
Well, if you accept the implications of a startling new report, the next decade’s wave of flameouts and blowups may be Chinese. And you can buy them as easily as ExxonMobil or GE on the New York Stock Exchange.
RateFinancials, an independent research firm based in New York, which tracks publicly traded companies and sells its research to institutions and hedge funds (short sellers among them, we surmise), found that the ten largest Chinese companies listed on the NYSE were characterized by lack of transparency, poor corporate governance, domination by the Chinese government, and questionable accounting practices.
And we’re not talking about electronics bazaars in Shenzen; this is the elite of corporate China: PetroChina (PTR), China Mobile (CHL), Sinopec (SNP), China Life (LFC), Suntech Power (STP), and so on. Their total market value approaches $1 trillion. They are the proudest exemplars of China’s Economic Miracle.
And yet, argues Victor Germack, RateFinancials’ president, “the quality of earnings and the governance practices are very poor.”
Corporate governance is dismal across the board, he says. Unlike US companies listed on the NYSE, the Chinese companies do not have a majority of independent directors. In fact, they’re not required to formulate any corporate governance policies, he adds.
And all these companies are majority-controlled by the Chinese government, which last I looked was officially Communist, whatever that means these days.
This is not like when, say, British Airways or Deutsche Telekom were privatized; these Chinese companies remain state-run enterprises in every sense of the word.
“Related-party” transactions among different state-owned enterprises are rampant, and the Chinese government actively manages these companies, moving executives like chess pieces from one entity to another, Germack says.
Transparency is also a problem. None of these companies file annual proxy statements, so unlike with their US counterparts, investors can’t find out complete information about how much executives are paid. In fact, much of their disclosure is inadequate, the report claims.
And then there are some classic accounting red flags.
Many of these companies, the report says, have a history of negative working capital. That means current debts exceed current assets. Keep that up long enough and you’ll have problems financing day-to-day operations.
They’re also falling short in cash flow from operations, which helps companies repay debt and fund capital expenditures. That may force them to go to the well repeatedly to raise funds, either through debt or equity offerings.
Another issue: according to the report, many of these companies haven’t set aside sufficient reserves for bad debt (if some customers don’t pay their bills). “This may be indicative of earnings management,” the report says. It could also be setting these companies up for future write-offs.
Is it a double standard? "All of our listed companies, including Chinese companies, adhere to our high listing standards," an NYSE spokesperson said. Foreign companies listed on the NYSE are required to disclose any significant differences between their governance practices and those of US-based companies.
For me, this raises two questions.
First, how can these companies list on the NYSE, whose standards are so stringent that it and Sarbanes-Oxley are allegedly driving potential issuers away to London and Hong Kong?
Well, it turns out there’s a loophole in those standards wide enough to drive an SUV through: as foreign private issuers and “controlled companies” (more than 50% controlled by a person, group, or company), they are exempt from some of the requirements their American counterparts face.
Is it a double standard? “All of our listed companies, including Chinese companies, affirm our high listing standards,” an NYSE spokesperson said, adding that foreign issuers were required to disclose how their accounting statements differ from US GAAP.
Second, many of the most prominent China bulls pride themselves on avoiding the riskiest Chinese stocks by buying shares in Hong Kong or American Depositary Receipts (ADRs) on the NYSE.
Well, if the questions raised by the RateFinancials report pan out (and the firm claims to have blown the whistle on such corporate basket cases as Calpine, Winn-Dixie, and Delta before they filed for bankruptcy), then the layer of protection of buying Chinese “blue chips” may turn out to be thin indeed.
None of this may matter, of course. The Chinese economy roars ahead at more than a 10% annual clip, with no slowdown in sight, and Chinese companies are making money hand over fist.
And although those of us who predicted a crash in the Chinese stock market turned out to be right a couple of times (and even Berkshire Hathaway’s Warren Buffett has sold some of his stake in PetroChina recently), the Shanghai Composite index remains on a tear. It has doubled so far in 2007, while Hong Kong’s Hang Seng is up 37% in 2007 as a buying frenzy continues to drive all things Chinese to greater heights.
Bubbles and manias tend to go on much longer than the skeptics expect. But when they end, what once looked like “quality” assets are often revealed to be dross.
“It’s like the housing market,” says Germack. “When the music stops and there are ten players and only seven chairs, somebody’s going to fall on the floor.”
If he’s right, China investors should fasten their seat belts.
In an earlier version of this commentary, we said that according to RateFinancials, the Chinese companies we mentioned use international accounting standards instead of US generally accepted accounting principles (GAAP). In fact, some of the companies’ financial statements are in international accounting standards and others are in Hong Kong GAAP, but the results are reconciled into US GAAP. That paragraph has been removed in the updated version.
Comments? Please email us at TopProsTopPicks@InterShow.com.
Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed here are his own and are not necessarily the views of InterShow.
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