Chinese Stock Fraud? Street Smart Investors Are Not Fooled

Recently, there have been multiple reports of financial fraud coming from numerous US listed Chinese companies.

Is this really surprising?

It should not be at all.

First of all, financial reporting fraud exists for companies of all sizes. Witness Big 4 auditor D_T pulling out of Life Partners Holdings (LPHI). And I’m sure you remember good old Enron, Worldcom and all the rest from 8-9 years ago.

Secondly, even a cursory glance at the 10k for some of the Chinese companies in the news recently would tell a street smart investor to stay away.

For example…take China MediaExpress Holdings (CCME). Trading in this stock was halted on the NASDAQ and its auditor pulled out.

Here’s a quick look at some important things an investor would have considered prior to purchase:

Significant dilution of common stock for an acquisition. Neither debt nor retained earnings were used in any capacity for this.

Heavy concentration of equity (not always a bad thing), multiple classes of stock, various “off-shore” entities having taking direct interest, no other management or director ownership stake.

And the biggest granddaddy giveaway of them all that this company was one to not touch with a 35 foot pole…
The CEO owns the company that controls this companies destiny!


What a street smart investor knows is that you must never rely on the financials alone for any business you are considering…you have to read the footnotes and read between the lines.

(Side note: I don’t know why, but one habit I got into when I first began investing, which sometimes seems redundant, is to look at every single audit opinion on every company. While a qualified opinion or other problem with the audit would most likely be disclosed on an 8-k…you just never know. Better to always see with your own eyes.)

Onward…

In much of my research, I come across small Chinese companies that appear on the surface to be possible value plays. But digging just below the surface shows frequent stock issues (meaning shareholder dilution), off-balance sheet arrangements with management, management conflicts of interest and more. Even if the numbers look great for these types of businesses, you’ve gotta pull a Nancy Reagan and “just say no.”

Here’s an example…

With sound revenue and earnings growth, what is the need to raise outside stock when they could have just used retained earnings? The amounts were roughly the same.

I have no particular bias against Chinese companies, or companies of any particular geographic origin. I do, however, have a bias against companies that do not operate for the benefit of shareholders. These are the easiest ones to pass up.

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