6/2/2011 8:34 PM ET|
The big fraud in Chinese stocks
Investors can learn a lot from the scandal at Longtop Financial. Jim Jubak offers 5 lessons, plus 5 tips for safer investing in China.
Whom can a poor investor in Chinese stocks believe?
For years, investors in Chinese companies have used the reputations of outside auditors, institutional investors and global investment banks as a proxy for reliable financial reporting. Maybe the disclosed data wasn't always easily understood, transparent or accurate but if a Big Four international accounting firm like Deloitte Touche Tohmatsu signed off on the audit, a big institutional investor like JPMorgan Chase (JPM, news) owned a couple of million shares and an investment bank like Goldman Sachs Group (GS, news) had underwritten the company's initial public offering, the financials had to be OK, right?
That's what's so depressing, disturbing and disorienting about the fraud recently uncovered at Longtop Financial Technologies (LFT, news). The company's books were audited by Deloitte, and Longtop still managed to lie about the $332 million in cash it claimed on its balance sheet.
This was no penny stock that duped only unsophisticated individual investors. JPMorgan Chase owned almost 2 million shares that were worth $62 million as of March 31. FMR, which owns the Fidelity mutual fund family, had $261 million invested. Maverick Capital, a hedge fund with $20 billion under management, owned $177 million of Longtop Financial Technologies shares. The lead underwriters on Longtop's 2007 IPO had been Goldman Sachs and Deutsche Bank (DB, news). In 2009, Morgan Stanley (MS, news) was the lead manager of a sale of more shares.
Longtop, which had been valued at $2.4 billion at its high last November, was valued at $1.1 billion when trading in New York was halted in the stock on May 17.
And it gets worse. Since March, more than two dozen companies based in China have disclosed auditor resignations or accounting problems, according to the U.S. Securities and Exchange Commission. The SEC has launched a task force charged with examining accounting at overseas companies listed in the United States.
In other words, Longtop Financial Technologies isn't a bad apple in a barrel of otherwise sound fruit. Instead, it's symptomatic of a big problem that has tainted an entire sector. And because China is too big an economy and too promising a stock market to simply ignore, investors need to figure out how to deal with the problem.
What happened at Longtop
Longtop's finances started to unravel when its accountants decided to double-check the accuracy of the cash balances the company claimed to have in the bank. Deloitte had statements from the company's banks showing the accuracy of the cash balances that the company claimed. But it's a good accounting practice to at least spot-check paper claims. If a company claims $100 million in inventory, the accounting firm will look at the paper trail for that inventory. Can the company show that it bought what it now claims to own? The accounting firm will do spot checks to actually eyeball the inventory that the company claims to have purchased. This practice doesn't stop all fraud, but it does make it harder to execute.
In this case Deloitte decided to go to some of Longtop's banks to find a paper trail and records that validated management's cash balances. And what did the accountants find? Let me quote from Deloitte's letter of resignation as Longtop's accounting firm. They found:
"Statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by bank staff compared with the amounts identified in previously received confirmations;...and significant bank borrowing reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group."
In light of what looked like an effort to inflate cash on hand, Deloitte tried to conduct a second round of bank confirmations on May 17. "Tried" is the key word. Longtop intervened to stop the process. According to Deloitte's resignation letter, management's actions included calls to banks "asserting that Deloitte was not their auditor, seizure by the company's staff of second round bank confirmation documentation on bank premises; threats to stop our (Deloitte's) staff leaving the company premises unless they allowed the company to retain our audit files then on the premises; and then seizure by the company of certain of our working papers."
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DJ, you forgot to mention tainted pet food, toys with lead based paint, drywall that ruins homes, no respect at all for intellictual property, child labor, currency value manipulation, bribes of government officials as accepted business practice, and keeping thier own market relatively closed to foreign trade. The Chinese do not play fair.
Slave labor, a totalitarian oppressive regime abusive of human freedoms, economic fraud, inequitable trade restrictions enforced by the World Trade Organization, and unspeakable environmental and ecological pollution killing 400,000 people a day. Sounds like the perfect stew for an investor to dine on with their hard-earned savings.
Oh, and I am particularly fond of that steel they manufactured a few years ago and sold to France to make refrigerators that was laced with radioactive strontium.
Oh, yeah, the economic miracle of this millenium.
What more could you expect out of atheistic, totalitarian, communistic regime?
Whenever I have a choice, I boycott Chinese products. They are inferior, break on first use, unsafe or harmful, and patronize injustice.
I wouldn't trust the Chinese as far as I can throw them underwater
they would cheat their own grandmother if they could
The last I checked China was a Communist regime. Why would anyone trust these people? I remember a time when this country fought to eliminate Communism but now we get comfy with them because the labors cheap and they treat our kids right with lead based paint. If we want cheap labor let's go to Africa. They can use the money there and they are no threat to our boarders. If we continue to fuel the Chinese economy we will only hurt ourselves.
This is beautiful, like it takes a financial genius to figure out that the Chinese are not to be trusted. I mean there have been clues dropped like a trail of breadcrumbs for those with eyes open to follow. Clues like the lead paint in toys, cadmium in cheap jewelry, melamine in children's formula, ect,ect.
My wife bought a dinnerware set that she just had to have that was made in China. I made her take it back because there is lead in the glaze they use, unlike American made dinnerware like Coors produces. I want nothing from the Chinese.
the chinese are simply taking lessons from america on how to cook to books or pervert the audit trail..
they simply haven't learned to successfully get away with it yet.
FMR, which owns the Fidelity mutual fund family, had $261 million invested.
Aren’t these the same folks who advertise that investing is as easy as walking down a green line? I always suspected that arrow might be pointed towards the edge of a cliff somewhere.
I believe that when your profession begins to find legitimate, enforceable methods for accounting the true economic and social costs attributable to an enterprise, and hence its products and services, then the authentic price of Chinese exports will be more fairly aligned with their fairly competing counterparts in the Free World.
Can FASB or other accounting arbiters undertake discussions or considerations of the real costs of Chinese production, not at the macro-economic level, but at the level of the enterprise and its individual financial statements?
Until accounting standards are made more equitable and production is balanced with economic and social costs, the Free World will always have to compete at a disadvantage with China that we will never overcome.
Remember Buffett's rule about greed and fear: be fearful when everyone is greedy and be greedy when everyone is fearful.
I am actually getting more greedy about small Chinese companies these days. Of course, due diligence is important, and Jim has listed quite a few of them. I also have quite a few of my defensive and cautious rules: like investing in smaller amount than I usually do in each company, and checking whehter local government officials have skin in the company, etc.
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