I have 4 major criteria that must be met before I can buy a stock for my long-term portfolio:
- Meaning: I must understand the business
- Moat: I must know that the business has a durable competitive advantage
- Management: I must know the CEO is honest, passionate and owner-oriented
- Margin of Safety: I must know the value and be able to buy at a much lower price
Understanding the industry, how the business makes money – that’s pretty straight forward. But good companies with big moats have big moat numbers and crooked management can fake those numbers and sucker in good investors. Those numbers are critical to calculating a value of the business because most of us calculate value based on an estimate of future earnings. Faked past earnings means wrong earnings growth estimates and a wrong TTM EPS starting point which leads inevitably to a very wrong estimate of current value. What that means is a bad boy CEO can turn your investment into a bad nightmare.
And that’s the catch with a lot of ADRs from China. Too many of them may be run by CEOs who don’t feel the need to tell the truth to American investors.
I see Chinese companies every day that appear to have wonderful meaning, moat and management numbers and are massively on sale. The problem is the numbers might be lies. The problem is the management might be liars. And from that, the problem is the margin of safety is an illusion.
Apparently I’m not alone in this. According to the article below, it appears that few hedge funds are big on China.
These are usually pretty smart guys. You’d think if there were values to be had in China, they’d be all over them. But during the last few weeks investors in two Chinese ADR companies (Chinese companies that are listed in the US) appear to have been scammed by their own CEOs and provide a case in point why hedge fund managers are being very choosy with China ADRs.
Puda Coal (PUDA), for example, recently and suddenly stopped trading. A SeekingAlpha writer accused the CEO of transferring all the assets of the company into his own name, selling half at a fraction of the market cap of the company, pocketing $32 million, indebting Puda for $400 million and then transferring the unsold half back to Puda encumbered by the debt. He did all that, apparently, and thought nothing of it. The company now owes an interest payment that is larger than its entire net earnings of last year. And its shareholders are likely to take a huge loss if the company ever opens trading on its stock. Check out the numbers on this thing. Awesome. Perfect really. And completely wrong.
Wrong numbers. Wrong valuation. It looks great but looks (and lying CEOs) and deceive.
The numbers created by the analysts following it and in the imagination of the CEO result in a value of over $340 per share for a company trading at $6 when trading was frozen. What a steal, except what was being stolen was your money.
And the CEO of Sino Clean Energy (SCEI) may be running a little scam of his own on US investors that was caught on video by a researcher in China who wrote up his findings in this article:
http://seekingalpha.com/article/268659-evidence-proves-scei-chairman-fabricated-production-videos
According to the researcher, SCEI is doing only a fraction of the business they claim in their accounting filings. His people staked the plants out and videoed the total lack of activity for days and days. In response the company released its own videos showing slurry trucks departing the company on a regular basis. Unfortunately for this CEO, he may have run the same two trucks through the scales multiple times for the camera in an effort to show activity. And he did it when it rained, which meant his dates were most likely phony, too.
Here’s the thing about Rule One Investing – the historical and current numbers are critical. Which means the integrity of the CEO is critical. Scams like Health South, Enron and World Com were perpetrated by lying CEOs (or CFOs or both) right here in America. They got away with it for years. But how much easier is it to run a scam on a bunch of investors half a world away? Answer – it’s a lot easier.
Conclusion: If you haven’t been there and kicked the tires, if you can’t get someone you trust to do it for you, then you can’t know if the CEO is running a scam. Both of these companies were being followed by analysts and both had experienced investment companies raising money for them. Other people don’t care as much about your money as you do and are willing to be careless with it. If you don’t know you can trust the CEO, be very cautious about making an investment in a Chinese ADR.
Having said all that, if you have a Chinese ADR you KNOW is great, let me know and I’ll see if I can blow a hole in your thesis. If I can’t, I’ll buy some, too.
Now go play.
