China Finance: Worried about stock fraud? Look at the auditors
My TradingFloor.com colleague Matt Bolduc recently wrote an excellent article about how to avoid fradulent companies when picking Chinese small-cap firms. Matt is right: one of the major concerns facing any investor in Chinese equities is the question of accounting. Can you trust the numbers you are given in the financial reports?
In general the market is taking a rather dim view when it comes to this topic, as witnessed by over 200 Chinese equities currently trading at a P/B under 1 according to Saxo Bank's stock screener. This is legitimised by the long and sad list of financial irregularities and fraud by companies which have their major assets or earnings in China. But if we’re comparing track records, we should go into more detail than simply stating there have been a lot of accounting issues.
In order to get some feel for the track record of accounting firms in China, I started out with a list compiled by the Pittsburgh Tribune earlier this year detailing Chinese companies that have run into trouble in the US. I added on some later breaking stories like Qihoo 360 Technology (NASDAQ: QIHU for example) and some cases from Canada and Hong Kong. While this list isn't exhaustive, it cotains over 100 individual cases that taken together provide at least a good starting point for assessing an auditor track record.
In general, we can say that you would be better off buying stock in a Chinese company that has been audited by a Big 4 accounting firm (KPMG, Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers) than one that has had its books checked by a smaller accounting firm. This is no surprise: the Big 4 handle China's huge state-owned enterprises (SOEs) and most Chinese IPOs, so there’s some natural selection favouring them.
However, just five auditors have been involved in auditing a full 30% of our troubled Chinese companies. They include two Big 4 firms: Deloitte and E&Y.
Deloitte has already had some SEC trouble with its China-based accounting business, as well as plenty of negative media coverage, and the percentage above is not flattering, either. The discrepancy becomes even clearer when we examine D&Ts auditing presence at the troubled firms on our list compared to their Big 4 rivals.
China, clearly, has been a headache for the otherwise respected firm of Deloitte & Touche.
Even so, your overall best bet to avoid fraud when choosing a Chinese equity investment seems to be to stick to companies that have been audited by a Big 4 firm. Companies audited by PWC, in particular, have fared very well in my initial group of over 100 companies.
But among the smaller companies trading below market-to-book, you’re unlikely to find any Big 4 audits. In this instance, you can have a look at the table I have provided at the end of this piece to act as some sort of guide. It’s not exhaustive, but it has enough data to at least be somewhat relevant as a way to check the track record of the auditor in question.
Do please note however that I have not differentiated between the seriousness of the issues involved, so as far as these numbers are concerned, an auditor resignation from a small-cap counts exactly the same as what happened at Sino-Forest.
Most of the companies were structured as RTOs (Reverse Take-Overs, a type of merger used by private companies to become publicly traded without an IPO) but a few companies with legitimate IPOs also made the cut, so an IPO in itself is no guarantee of safety. However, only 15% of the companies in my sample had gone through a proper IPO, so if you're looking for some reassurance it definitely doesn't hurt.
In a climate where equity prices are so vunerable to rumours and potential short seller attacks, checking the track record of your auditor is important, if for no other reason than that it’s a favourite red flag among many short sellers.
Others category consists of companies with only one occurance.
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