Rodman note on Barron's article
We traveled to 10 cities and met with eleven companies in China from August 30th – September 10th. The sweltering heat was just giving way to more pleasant autumn weather. I recall that in Beijing, right up to the time of the Olympics in August 2008, there was always some major construction that’s the talk of the town. However, this time, the limelight was focused on Shanghai, which is hosting the 2010 World Expo and has thus far attracted ~59MM visitors from across the globe. Not only that, Shenzhen was celebrating its 30th year as a Special Economic Zone, its status declared by Deng Xiao Ping in 1980. In addition, the cranes are still swarming the tier-2 cities, from Changsha to Wuhan to Chongqing. Needless to say, business is brewing.
Interestingly, the Barron’s article, which questioned the validity of the U.S.-listed Chinese small-cap companies, was published the weekend that I arrived in China. The article has been brought to the attention of all participants in the space. In fact, the Chairmen of most companies that we visited were very well aware of the article, and some had been actively contemplating auditor upgrades even before the recent onslaught of unfavorable media attention; meanwhile, others are waiting to scale up before doing so. We expect a wave of these auditor upgrades over the next 12-18 months. For smaller companies with less than $200MM revenues, switching to a ‘Big 4’ auditor would fit like a child in high heels. A more prudent intermediate step is to engage them on a project-basis to help with improving internal controls and/or SOX compliance. Note that both China North East Petroleum Ltd. (AMEX:NEP, Market Outperform) and SkyPeople Fruit Juice (NASDAQ:SPU, Not Rated) have done so.
Our take on the allegations of fraud – they assume intent, namely, the management teams’ intent to deceive American investors for economic gain. After meeting with the eleven management teams and touring their factories, we think that to the contrary, most founders are more concerned about reputation and the long-term growth trajectory of their companies. Virtually all of these entrepreneurs harbor 10-20 year plans to position their franchises for industry dominance and greatness, as entrepreneurs should, and genuinely seek the partnership of American investors to realize their visions. Most of these founders have been recognized and honored by, and received the support of, their local governments. Golden plaques proudly hang in the lobbies of their headquarters or in the Chairmen’s offices – these are the honorary and reputational assets that the Chairmen are working to preserve. They want their enterprises to become success stories of economic advancement. Their regional governments are counting on them to set examples for other local enterprises, to stimulate the regional economy, and to lead them out of poverty and into urbanization. In sum, by reducing the intentions of Chinese companies in listing in the U.S. to unscrupulous economic gain, the American investment community has failed to realize that for most Chinese enterprises, there is much more at stake – local reputation and honor, which can be thought of as collateral for their investments.
Besides tapping into the American capital markets, Chinese companies also list in the U.S. to gain authenticity in using an American brand name, which buys them credibility with both suppliers and customers. Therefore, the company’s U.S. listing is an integral part of its business strategy. In sum, for most of these companies, there is much more to be gained by succeeding in the eyes of American shareholders than by deceiving them financially.
Our general view is that China is a formidable growth story, and serious investors should not overlook both the growth potential of this geography and the vast differences in valuation between U.S.-listed Chinese companies (frequently known as ‘orphaned’ stocks) and their peers traded on the Chinese exchanges, or even those that had gone through a lengthier IPO process in the U.S.
Contrary to the temptation to use small-cap China stocks as quick trading vehicles, we believe that success in the current environment favors a more private equity-like approach – to thoroughly understand the management team, where unlocked value may lie, and the catalysts that will drive value actualization.
AI
