Chinese small caps... how to spot a winner, how to spot a fraud

I continue on my quest to highlight great opportunities in the massively underpriced small cap Chinese market. Many of these companies are trading at prices that would make value investing icon Ben Graham blush - below net cash value, which is the ultimate sign of market fear for a company.  Quite frankly, some investors are afraid these companies are fraudulent.  Some may be...but I have some guidelines on how to spot the ones that aren't. 

First, an overview. The recent drop in Chinese markets has punished small companies in particular, as Chart 1 shows:  since late 2010, Chinese small caps have dropped a whopping 44% vs all caps falling 25%. The large underperformance is further magnified when we consider that the S&P 500 is up 20% in the same period. 

Additionally we can see that Chinese small caps have been hit the hardest in volumes, which tends to happen in market downturns, shown below. Although the general Chinese volume has remained unchanged, we can see that volumes for small cap companies have decreased considerably, down more than 60% in the period. This lack of volume symbolizes the absence of willingness of investors to take part in the the small-cap equity markets currently.

Part of that lack of willingess to participate is fear -  the fear that these companies might actually be fraudulent in the worst case scenario, or at the very least have poor internal controls.

Where is the fear coming from?

A few Chinese small caps have, indeed, been discovered to be fraudulent. One that got the most attention was the Chinese timber and Canadian-based Sino Forest. It share price, once in the mid twenties, crashing down as investment firm Muddy Waters' exposed some of its more-than-questionable practices, leaving Hedge Fund investor John Paulson with close to a USD 700 million loss. 

Consider me an optimist, but I do not believe that every Chinese company trading on North American exchange is a fraud. Even if 25% of these companies would be considered fraudulent, the risk-to-rewards ratio for someone who bought a basket of Chinese small-caps would still be very profitable, given of how some of these companies are valued. There are also ways to partly mitigate the fraud risk that a company might carry.

So if you've got nerves of steel and are willing to stare down all the fear out there, you have the oppotunity to pick up some brutally cheap shares and some very exciting opportunities, especially at the micro cap level.

One such micro-cap company is China Xiniya Fashion (NYSE:XNY), which produces higher-end semi-casual and business clothing for men. The company sells its wares in second-tier Chinese cities so as not compete directly with international brands. The company IPO'd on the NYSE late November 2010 for  USD 11 at the peak of the Chinese stock market. The stock is now down 90% from the IPO price and the company has a market capitalization of around  USD 60mn, leaving any would-be investor looking at a terrible price chart.

What's so good about this company? Well, apart from revenue growth of 450% and earnings growth of 430% since 2007, the company has a cash balance of about $180mn as of the last quarter, and net cash and net current assets of of $135mn of $200mn respectively, which means the company is trading at a net cash discount of 51%. I could go through a detailed analysis, but there is no point in doing this since the company isn't trading on traditional financial measures. It's actually not trading on any financial measures. It's simply priced on the worst possible outcome.

How can we tell if this company is fraudulent?

There often doesn't come cheap companies like this, but let's be realistic and look at the company's potential to be fraudulent,  since it is what many investors are thinking when they look at the company. First off the cash balance: we know that at least USD 75mn of the cash on the balance sheet is real, since it came directly from the proceeds from the IPO. Unless the CEO directly pocketed the cash and covered his tracks, which is not beyond the realm of possibility, we at least know that this cash exists.

Secondly the company did go through an actual IPO, unlike Sino Forest and others who went through a reverse merger to gain access to North American equity markets, which was basically a loophole to skip scrutiny. This means that its books actually went through a somewhat rigorous process. So that is always a plus.

Thirdly, the company has been buying back shares, although not aggressively, and so have insiders such as the CFO and the CEO for a combined 1.23 million shares of the company or close to 2% of the company. Buying back shares, especially by insiders, shows that insiders are willing to put their own money on the line and into the comppany, which is always a good sign. An analyst questioned management on the Q1 earnings call, asking why the company wasn't more aggressively buying shares given their extremely low price. The CEO said that the company does have expansion plans which will require more capital, and the company also prefers to have a large amount of flexibility. The company could buy back its shares at USD 2 or something, which would satisfy most current investors, but the company is more focused on the long term.

Fourth, the board has one independent accountant, Alvin Ang, who has worked for the accounting firm PWC and is Certified Accountant from Singapore.  Ang has a lot of experience dealing with implementation of Sarbanes-Oxley in other companies, which does alleviate some fears regarding internal controls and financial reporting.  More importantly, the company's CFO Chee Jiong Ng, a former senior manager from PWC, is also a certified accountant from Australia. Having accountants as part of your directors and executive team does not necessarily mean that the company is not fraudulent but it should give investors a bit of confidence.

I can't tell you to go buy China Xiniya Fashion, but I suggest you use my research as the basis for your own evaluation. 

How do I know if a Chinese firm is fraudulent?

I must admit that I had to dig a little bit to discover the potential gem I described in this article. Many of the Chinese companies I had originally screened with the Saxo Bank Stock Screener either had debt, which I didn't want, negative press such as lawsuits or accusations, or had growing equity base (a growing number of shares) which is always a bad sign for a cash-rich company, or unusual executive turnover.

The last one is always a dicey one that I tend to watch out for in almost all companies: when the Chairman or CFO or CEO change too frequently it is usually a bad sign. For a Chinese small-cap company, a parade of CFOs is a potential sign of shoddy bookeeping. 

Bottom line: I still haven't found a magic red flag in that will tell me if a Chinese company is a fraud. But I will not accept the lazy excuse that 'it must be cheap for reason.' Smart investors are willing to dig into a company and find out if there's an opportunity there - particularly at these incredibly cheap prices. 

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Matt Bolduc, aka Value Stocks Guy, writes regularly about value stocks and the principles of value investing.  If you’d like to be notified by email whenever Matt has a new piece focusing on value investing, become a member of TradingFloor.com – it’s free, and you can log in with your Facebook, Twitter, LinkedIn or Google account.  You can also bookmark the Value Stocks Guy page.