Shenguan Holdings Group (tkr: 829 HK)

I'll keep this short.  Shenguan Holdings Group is a collagen sausage casing manufacturer listed in Hong Kong with a market cap of c.US$2.2 billion.

I did not realize this, but apparently sausage casing manufacturing is a fantastic business in China (sarcasm intended).  Shenguan's topline grew at 45% in 2010 with an operating income margins of 58% (I double checked this).  Even if I believe in the topline growth, I can name less than a handful of businesses in the world with margins in that region.  Certainly not a sausage casing manufacturer.

Sorry, I just don't buy it.  Fraud.

Interview - James Grant on Debt Crisis, Gold Standard and Other Matters

Recent interview (here) with Jim Grant, an excellent historian and thinker of financial markets and macro economics, talks about his view of the world.

Here is my takeaway from a portfolio positioning standpoint:

• Buy gold - the current fiat currency system (currency backed solely by faith in government) is structurally flawed.  The ability to print money offers central banks a too tempting short term remedy of 'kicking the can down the road' without solving the problem (until it is probably too late), and leads to many unintended side effects (e.g., inflation).  A currency needs to backed by something that cannot be conjured out of thin air, and gold seems to be as good as any (it has been tried and tested throughout history).  To be clear, gold standard isn't perfect, but it is clearly a far lesser evil.  In today's environment, not owning gold is to put complete faith in central banks and their decisions, and that is not smart.
• Be wary of assets propped up (artificially) by today's low interest rate environment (treasuries, corporate bonds, etc.).  Low interest rate coupled with money printing artificially props up asset prices.  It punishes the saver and tempts (or forces) people to move into riskier assets (for all the wrong reasons).  These assets are very prone to price reversal as central banks gradually look to exit/withdraw its current program of quantitative easing (which it must, at some point).
• Buy U.S. large cap, blue chip equities - Grant mentions Walmart and Hewlett Packard, but Apple, Microsoft, Johnson & Johnson, etc. are all very dominant franchises trading at very reasonable valuations (10x-13x P/E) with growth, healthy dividend and strong balance sheet.  I'm not sure why this is the case, but in the current environment, small/mid cap equities are expensive relative to blue chip large caps particularly given the generally less dominant position.  
• Hold healthy amount of cash and stay patient.  Markets are volatile, government policies are superficial and economies are fragile (with many undercurrents).  As financial crisis are now more closely packed to each other (because central bank policies only offer a short term remedy and not a permanent solution), it seems to be wise to hold cash and wait patiently for a better time (i.e., 'cheaper' time) to invest.

As a side note, sitting in Asia, another crisis is looming in China.  One that carries an uncanny parallel to the U.S. and European credit crisis.  I'll save the story and my observations for another time.  But alas, history and human stupidity repeats.

List of Chinese (offshore) High Yield Bond Issuers

Below is a fairly complete list of Chinese high yield bond issuers - most of them have publicly listed equities. Once again, Chinese high yield issuers have a tendency to be fraudulent (as I explained here and here). Not all of them are fraudulent (CITIC Pacific is probably 'ok' given their state-owned affiliation), but there is a long history of blow-ups and acknowledged frauds, such as Sino-Forest, China Forestry, Asia Aluminum, Chaoda Modern, Evergrande, etc.

Investors are forewarned.

China Offshore High Yield List:
-----------------------------------------
Agile Property
Central China Real Estate
Chaoda Modern
China Fisheries
China Forestry
China Lumena New Materials
China Oriental
China Property
China SCE
China South City
CITIC Pacific
CITIC Resources
Coastal Greenland
Country Garden
Evergrande Real Estate
Fosun Int'l
Franshion Properties
Fufeng Group
Giti Tire
Glorious Property
Greentown China
Guangzhou R&F
Hidili Industry
Hopson Development
Kaisa Group
KWG Property
Lai Fung
LDK Solar
Liansu Group
Longfor Properties
Lonkin Holdings
Melco Gaming
MIE Holdings
Neo China
Pacnet
Powerlong
Renhe Commercial
Road King
Shanghai Zendai
Shanshui Cement
Shimao Property
Sino-Forest
Sino-Ocean Land
SPG Land
SRE Group
Texhong Textile
Titan Petrochem
West China Cement
Winsway Coking
Yanlord Land
Yuzhou Properties

FT - Investors warned of Chinese bond risks

"...taking equity risk for a bond return", says Tom Jones regarding China bonds (read here).  How very true indeed.

The structural seniority of bonds (versus equity) is the primary reason bonds are safer than equity, and therefore, bond investors demand less return (duh...).  However, as (1) bond holders are generally unable to enforce in China and (2) fraudulent Chinese companies are drawn to the offshore high yield market (adverse selection as I pointed out here), this means the recovery rate of defaulted offshore high yield bonds is almost always zero (as in the case of Asia Aluminum and Ferrochina).

Basically, in the event of default, the downside of a bond is the same as equity (ie. zero - you lose all), whereas the upside is far less for the bond holder (upside on debt is always capped).  That makes Chinese offshore bonds an (almost) uninvestable asset class in my book.

Final word - investors are always lured in by the high cash coupon of a Chinese bond.  Don't be fooled! That coupon is illusory and the cash coupon is simply a 'cheap' way for the truly fraudulent company to lure in capital.

Piracy in China - Fake Apple Stores

This just takes it to a whole new level.  An article (read here) by BirdAbroad on fake Apple stores in Kunming, China.

Really forces you to think hard about the lack of respect for rules, the law and ethics in China.

Moody's analyzes Chinese companies for 'red flags'

A little late, but hopefully not too late.  Moody's comes up with report (article here) looking for 'red flags' amongst China bond issuers.  Companies named in the report include West China Cement, Winsway Coking Coal, China Lumena, etc.

I've always thought China high yield issuers seem to be particularly prone to accounting fraud.  There seems to be adverse selection going on.  It is not completely clear why this is the case, but I think it is a combination of:

• A need for fraudulent companies to tap the capital markets and/or borrow frequently due to its negative free cashflow and a need to sustain the ponzi scheme (after all, the whole point is to defraud the capital markets and siphon off cash).  
• Local Chinese banks are unwilling to lend to the company - in some cases, the local banks are probably suspicious of the company (it may also be unwise for a fraudulent company to defraud a state-owned bank).  The company has to resort to more unsuspecting overseas investors.
• High yield (overseas) buyers generally have larger risk appetite for leverage and 'hair' around companies (the attractive 'China story' doesn't hurt).  In return, they seek higher coupon/returns.  But the high coupon/cost never deters the truly fraudulent company, it is a 'cheap' way to keep up a facade and continue to siphon money
• Chinese high yield issuers are generally required to be restructured offshore, which takes the creditors further away from the assets (from a security structure standpoint).  And in the case of a default (or if the fraud is exposed), it is generally very hard to enforce in China when you are an offshore creditor.

Some Chinese high yield issuers that come to mind are: Sino-forest, GOME, China Fisheries, China Forestry, and a list of Chinese real estate companies.  Some are clearly fraudulent (like Sino-forest and China Forestry), others are simply full of 'red flags'.

China Zhongwang Holdings (tkr: 1333 HK)

Here is a good little summary (link: here) from South China Morning Post on the issues surrounding China Zhongwang, an aluminum extrusion company in China.  The company was *suspect* almost immediately out of its IPO gate.  For readers without access to SCMP, the issues include:

1. The company listed in May 2009.  Four months later, in September 2009, allegations emerged that the top 10 customers listed in their prospectus did not buy from the company in 2008 (or as I remember, far less)
2. Subsequently, the company hired Ernst & Young to look into these issues, but E&Y never completed its review (I wonder why...)
3. The company claimed to have produced and exported c.US$880million of aluminum extruded products  to the US in 2009.  However, US customs show that only US$514million of aluminum extruded product was imported from China in 2009
4. Third profit warning of the year (first two profit warnings in January and March)

wow...

I think a key point SCMP didn't mention is the margins of China Zhongwang stood at 38% (2010 operating income margin).  Aluminum extrusion is a simple and highly competitive business.  How is a simple commodity business capable of producing these eye-popping margins?  Understanding whether the business model and economics really make sense is one of the better ways of detecting fraud in China.  Numbers are deceiving, particularly in China.

This company is classic.

Nine Dragons (tkr: 2689 HK) - Puzzling Depreciation

Have you wondered why many capex intensive (commodity) industries in China seem to have far better income margins than their U.S. and European peers?

Part of the issue seems to lie in a puzzlingly low (under) depreciation phenomenon (putting aside companies with blatantly fraudulent accounting).  Take a quick look at Nine Dragons (tkr: 2689 HK), the largest corrugated packaging company in China.  Without getting into too much accounting details, depreciation is basically a way to recognize the gradual decrease of economic value of PP&E over its useful life.  PP&E is recorded at historical cost, but what is a sensible estimate of useful life of plants and equipment for the containerboard industry?  Let's compare Nine Dragons, side-by-side, with Smurfit Kappa and Rock-Tenn (also the largest in their respective regions):

I think you get the gist (sorry the table is blurry).  A large part of a paper company's PP&E is simply plant and machinery - it is a bit of a stretch to depreciate it over 25 years (especially machinery).  And while Smurfit Kappa and Rock-Tenn has older assets, they've done a pretty good job maintaining them and ensuring competitiveness.

I seem to see a lot of this under-depreciation phenomenon with many capex intensive commodity businesses in China (less so with SOEs).  I guess it is an easy way to boost earnings.  It would be interesting to see what happens to Nine Dragons' earnings if and when it goes back to a more reasonable depreciation schedule.

Dan Ariely - You're not stupid, but you can be fooled

I am a fan of Dan Ariely's studies on behavioral economics.  Here is a very interesting article (read it here) by Ariely on how some of today's internet giants take advantage of human mental flaws.

Personally, I find myself falling for Amazon's free shipping scheme (buying more items to get free shipping) and frequently anchoring (and comparing) the price I am willing to pay for in Apple App Store to the numerous free apps that are available - "free" is a powerful anchor.

Chaoda Modern Agriculture (ticker: 682 HK)

This is an embarrassment to the Hong Kong stock market.  Chaoda Modern Agriculture and China Green (ticker: 904 HK) are two of the largest listed vegetable farming and distribution companies in Hong Kong.  They are also two widely publicized and commonly acknowledged frauds in Hong Kong, yet it is still listed with a market cap of HK$11.1bn and HK$4.5bn respectively.

I won't spend much time writing this up as it is well publicized and understood.  In the case of Chaoda -

Margins.  In an industry known to be notoriously cyclical and low margin, this company has an EBITDA margins of 60% and has consistently grown at 20-30% p.a. since listing without missing a beat.  It appears be never subject to price or cost fluctuations.  If farming was that lucrative, why would farmers migrate to the cities in China?  Urbanization should be "ruralization".

Auditors. The number of changes in auditors ought to raise some serious questions.  The company was jointly audited by PWC and CCIF when it first came to the market in 2000.  PWC dropped off, with CCIF as sole for the 2002/3 audit. They added Baker Tilly for the 2004/5 audit, but dropped both Baker Tilly and CCIF for their 2006/7 audit.  They are currently audited by Grant Thornton.  The turnover of auditors should ring some alarm bells.  Any listed business that want to be taken seriously should stick to using a Big Four auditor ...unless they can't (to be clear, using a Big Four doesn't eliminate accounting fraud risk, but that is a story for another time).

Asset Size/Quality.  There have been many reports on Chaoda vastly overstating their asset size.  According to this Next Media report (source, in Chinese), a site visit of a 5,000 mu farmland in Beijing revealed it was actually only 1,000 mu.  There are other allegations in the report which you may read for yourself (in Chinese though).

Balance Sheet.  As a former high yield/distressed investor, I find it interesting that Chaoda has tapped the high yield/convertible bond market several times in the past, despite having a ton of cash on its balance sheet.  It recently raised US$150mm in convertible bond, despite having over US$300mm (RMB2,044mm based on its 2009/10 annual report) of cash on its balance sheet.  Does that make sense? Unless the cash... (reminds me of Sino-Forest, Longtop, China Mediaexpress...)

Long list of other red flags, but I will stop here.

One thing I've noticed is if one of the leaders in a sector (particularly the first company to list) is fraudulent, it is very likely the whole sector is fraudulent .  This seems to be the case in the agriculture sector (Chaoda leading, followed by China Green), forestry sector (Sino Forest, followed by several smaller guys), milk/infant formula and aluminum extrusion sectors (I'll write it up some other time) .  My guess is it is harder to be fraudulent in an established sector if the incumbent produces honest/accurate figures (people will always benchmark to the leader and ask questions).  Put differently, it is easier to produce fraudulent accounts if the company is first to come to the market in the sector (no established benchmarks to compare to) or if listed incumbents are already committing accounting fraud.

China Modern Agriculture has been listed for over 11 years (China Green for 7 years) and has been a known fraud for many years now.  Please do something about this, Mr. Charles Li...

Some Chinese Firms May Overstate Their U.S. Presence

Interesting video from Bloomberg Television's "Fast Forward."  Click on link:
http://finance.yahoo.com/video/marketnews-19148628/some-chinese-firms-may-overstate-their-u-s-presence-25799194

I think result could be very interesting if people conducted similar on-the-ground due diligence on Chinese companies listed in Hong Kong, particularly in industries which are fixed asset intensive or claims to spend a lot of capex.  Might be worth asking where all that capex has gone?

Tibet 5100 (ticker: 1115 HK)

Tibet 5100 is a bottled water company that sources water from Tibet (5100 meters above sea level), bottles it and sells it as a premium bottled water.  Pretty simple business.  The company IPO'd in Hong Kong on 30th June, up 23% on the first day with a market cap of US$1.2bn or HK$9.2bn.  After taking a quick flip through the prospectus, here are some initial thoughts -

Company structure/history:  The history and corporate structure section in the prospectus was a colorful read.  Some notes: (1) the founders of the company, Mr. Wang and Mr. Yu, needed to increase registered capital by US$12.8mm in 2004.  The founders didn't have the cash, but found Sichuan Hengsheng to inject the capital in September 2004 for 91% of equity.  Eight months later, in June 2005, the founders found US$12.8mm to buyback the shares from Sichuan Hengsheng.  Odd. (2) then in 2005, the company faced significant uncertainties (shortly after the founders have put in US$12.8mm?), and Mr. Wang decided to place his entire shareholdings with a Ms. Zhou (a trusted friend Mr. Wang has known since 1987?) in June 2005 in a trust arrangement.  Who is Ms. Zhou and how does this solve the "significant uncertainties"?  Bizarre. (3) in April 2009, Wilmar acquired a 25% stake for RMB175mm, but sold the shares back to the company a year later in April 2010.  The company cited a divergence in business strategies between Wilmar and themselves.  How could the strategy be that much different after only one year? (4) by middle of 2010, the company began discussions with several pre-IPO investors, a "second put option" was granted to the pre-IPO investors which allows them to put their investment back to the company if the company does not make HK$350mm in profit after tax for the year 2011.  This is contentious, but I am always skeptical of a company willing and able to provide a profit guarantee (especially a profit projection that is multiples higher then what they've historically achieved).  That's just not how a real business is run.

Short history with unbelievable margins:  The company started its first production line in 2006 and within 4 years is ranked first by volume (beating out Danone and Nestle) in China's premium bottled water segment with a net income margin of 32% with almost no marketing expenditure.  Is it that easy to build a branded consumer products company and become the leader in 4 years time?  I doubt it, not in a highly competitive market like China.  Unless...

Relationship with Ministry of Railways ("MOR"): 80.5% of revenue (and growing) comes from a lucrative contract with CRE (procurement agent of MOR) to supply bottled water on trains in China.  As a reminder, former minister for the MOR, Liu Zhijun, was dismissed recently for accepting a large amount of bribes in connection with various railway procurement contracts.  While the company states it has no relationship with Liu Zhijun, as part of the risk factor, it states that recent investigations on Liu Zhijun could have a negative effect on their relationship with CRE and the contract with CRE may not continue in the future.

US$1.2bn market cap in 4 years out of water (they pay RMB9,500/year for the rights to the water) with an equity investment of US$14mm.  Is creating a business that easy in China?

Inspiration - Chinese Accounting Frauds in Hong Kong

Charles Li of the Hong Kong Exchanges & Clearing was on CNBC and said he believes Hong Kong will avoid the worst of accounting frauds and Chinese companies listed through reverse mergers in the U.S. wouldn't see the light of day in Hong Kong.  He goes on to say, "“Regulation can always improve and it’s there to prevent detectable fraud, but when you have people that are determined to scheme the system, there’s only so much regulators and professionals can do.  No matter how stringent your regulatory system works, the bad apples will still exist.” (source)

While accounting frauds of Chinese companies listed through reverse mergers in the U.S. are probably more egregious (and obvious), personally I think the number of accounting frauds of Chinese companies in Hong Kong is far more numerous and dangerous (as it is more sophisticated and has been allowed to brew for many more years).

Let's see if I can't do a little social services and help Mr. Charles Li a little.