China Trading Stocks

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China Finance: What makes a company short-selling resistant? Link

After a couple of years of short-seller attacks, we’ve seen a number of stocks crash under the pressure of allegations. However, we’ve also seen companies take the initial hit, respond with strength and bounce right back perhaps, if nothing else, demonstrating the inherent bias that can flavour a short-seller report.

Finding the companies that are short-resistant is all about doing your own due diligence in the same manner as a shortseller would, and that starts with looking through the financial statements.

This is where shortsellers would start, and it’s where you should start as well. What you’re looking for is usually not something entirely specific - most shortsellers talk about claims made by companies that simply defy reason. What they claim has happened is that investors have been duped by the “China” tag on the company into believing that impossible claims are actually credible. At times these claims have been substantiated, at others they haven’t, but the starting point always appears to be the same.

Now, looking for gravity-defying claims in general isn’t very useful as a strategy for the regular investor, especially if you lack the experience that the shortsellers have on their side. So we’ll be creating a bit of a shortlist, based largely on what claims shortsellers have been making in the past. None of these are proof of fraud or irregularities, but they are common red flags with a proven track record.

Margins
Top of the list for early signs are incredible margins. Some companies have been reporting margins well above what any of their competitors are able to achieve. This case becomes especially strong when we look at smaller companies operating in commodities businesses.

For instance we’ve seen companies operating in the oil business and agriculture showing margins well above the norm, even when logic would suggest they should be under considerable pressure from their bigger competitors. The big questions here is if the story for how these margins are achieved is believable, and by extension if there’s any way for investors to check the credibility of these claims.

Accounts receivables
Accounts receivables is one of the true classics of the red flags. It’s been used a lot and has shown itself to be pretty open to manipulation, especially as you can hide things for years in overdue accounts, or try to roll the whole thing over. There are a couple of things to look for here that can guide your further work.

If the growth in AR outpaces the growth in sales, we could be looking at something worrying. This implies one of two things, either there is an aggressive sales pattern of giving your clients more credit to increase your sales, or it’s being used to beef up sales figures.

While the first one certainly does happen in the normal course of business, giving extra lines of credit especially to SMEs in China comes with a good amount of risk at present, and there have been claims of things bought on credit being used to secure other loans as well, so even this is a worrying development. Interesting examples I’ve seen in some companies along these lines have been the entire increase in sales being exceeded by the increase in AR dollar for dollar, which while not proving anything would seem very aggressive.

A second thing to look out for is allowance for doubtful accounts, or more specifically lack thereof. Firstly, this is a very aggressive accounting policy that seems ill advised for getting an accurate picture of the company’s finances. More importantly a lack of write-downs means your potentially non-existent AR accounts don’t disappear, thus potentially perpetually beefing up your balance sheet.

Cash
So, if you have extraordinary margins created by AR that doesn’t exist, you will also normally have a big cash position that might not actually exist. Looking at a cash position, the big question is really if it’s outsized, and if it’s outsized, why isn’t it being used.

Cash is normally a safe position because it’s relatively easy to audit, but as we saw with long top financial, it isn’t always quite as straightforward in China. Faked cash confirmations have happened, and it’s actually considered relatively tricky to audit.

As I’ve stated previously, one of the hallmarks of a fake cash position is that fake cash is notoriously hard to spend. So a huge cash position just sitting there, while the company is securing loan financing for expansion should raise questions.

Acquisitions
One way that seems to have been used to get rid of non-existent cash has been M&A transactions, especially if the acquired party has some link to the company or its owners. What essentially happens here is that the company “overpays” for the acquisition, thus getting faked money off the balance sheet.

A series of relatively small acquisitions containing a lot of goodwill is a red flag, and something which leads us to our next topic.

Goodwill
Goodwill and other soft positions on the balance sheet are always open to interpretation, so it’s sometimes hard to just say that something is wrong. But because it is a bit of a wild card, companies should also be aware that it raises red flags, especially when you saw an explosion of goodwill and AR bolstering a balance sheet, as we did in the China Minzhong case. While China Minzhong may have many good reasons as to why this happened, it certainly shouldn’t be surprised that it will have raised some eyebrows.

The problem with short reports that focus mostly on these positions is that they’re almost as hard to judge as the position itself. Sure you can argue the value of an acquisition or a patent, but unless you can offer up a strong case based on other evidence you’re really peddling opinion and conjecture.

Insider dealings
Finally, a good thing to look at is what the owners of the company are doing. Are they selling off shares, or not participating in a new issuance of shares? Are they starting, or involved in competing businesses? These are issues that should be looked into.

If the company has a VIE, these issues take on a new importance, as the alignment of interest between the VIE equity holders and the listed company could be jeopardised from any of these disruptions. The potential negative results from it could also be far worse.

However, in the more general sense, what we’re looking at here is if management is staying committed to the company, and if its shareholding is decreasing we would certainly want to know why. This is especially true if it's involved in a lot of companies who are in business with the listed company, so checking related party transactions is also key in this.

Conclusions
If we’re investing in smaller Chinese companies we want to make sure that we check out all of our investments to make sure they're short-report resilient. Checking these key tenets, that have been the starting point of many short reports is a good place to start, although it’s not conclusive.

If there are no issues in these areas with a company, hopefully it looks pretty sound, even to shortsellers, and as such we might feel more secure in these investments. If there are issues here, that doesn’t mean we have to stay away, it simply means we need to look deeper to find out if it’s a viable option.