But my favorite part of the interchange between auditor and client company was still to come. On May 20, the chairman of Longtop called Deloitte's Eastern region managing partner. In the course of that conversation, Deloitte's letter of resignation says, Longtop Chairman Jia Xaio Gong informed the Deloitte partner that, "there were fake revenue in the past so there were fake cash recorded on the books."
Not surprisingly, Jia didn't answer when Deloitte asked how long this had been going on and how large the discrepancies might be. Surprisingly, Jia did answer when asked who was involved. "Senior management," he said.
What we can learn from this debacle
The first lesson is that the rules governing Chinese companies that list on U.S. exchanges have a huge loophole. In many cases local accounting firms that are affiliated with the Big Four accounting companies do the actual audits in China. These inspections are required in the case of accounting companies that audit companies that trade on U.S. markets as part of the Sarbanes-Oxley Act. But China has refused to allow inspections of the audits conducted by these affiliated companies. Investors have no idea of how closely their work conforms to international audit standards.
Second, the Chinese companies intent on tricking investors understand the reliance of many overseas investors on big names. On April 28, when short-sellers were questioning why Longtop needed $332 million in cash and asking if it even existed, Derek Palaschuk, a former audit manager with PricewaterhouseCoopers (another Big Four accounting company) in Hong Kong and Beijing, assured Wall Street that the claims were unfounded. Short-sellers were "criticizing the integrity of one of the top accounting firms in the world," he said.
Third, we shouldn't forget one of the lessons of the mortgage crisis and the technology bust of 2000 -- Wall Street is awash in conflicts of interest that can potentially warp judgments. Wall Street companies make money when they take a company public or manage an offering of additional shares. As part of the process for winning that business, investment bankers make all kinds of promises to cover the stock after the offering. The implication is that this coverage will be positive and help support the company's share price.
On May 4, an analyst for Morgan Stanley, which managed Longtop's secondary offering, defended Longtop against allegations of fraud. "Our analysis of margins and cash flow give us confidence in its accounting methods. We believe market misconceptions provide a good entry point for long-term investors."
Fourth, China's banks should never, ever be thought of as a bulwark against misrepresentation or fraud. Investors are safer thinking of them as enablers -- at least at this stage. Longtop would not have been able to pull off its deception without the active participation of bank employees. In April, Deloitte resigned as the auditor for China Media Express over, in part, similar questions about bank confirmations. That same month, another Big Four accounting company, KPMG, resigned from ShengdaTech, a Chinese chemical company, over serious discrepancies in bank balances and false bank confirmation letters.
Fifth, let's give the bears their due in this case -- and on China's stocks in general, given China's current financial regulations. Right now, bears provide a critical check on the claims of China's companies. Investors shouldn't take the charges of investors who will profit if stock prices fall on face value any more than they should take the claims of investors who will profit if stock prices climb.
But it seems likely that if the bears hadn't gone after Longtop, Deloitte wouldn't have decided to double-check Longtop's cash balances. After all, the accountants had signed off on Longtop's financials for six years.
A safer way to invest in Chinese stocks
First, don't abandon the big-name theory. While they are far from perfect, Wall Street's big names -- accounting firms, institutional investors and investment banks -- do have a financial interest in getting it right. Yes, they have conflicts of interest and institutional blind spots, but at least investors have a sense of what those problems are. Do you really want to add another level of uncertainty to the uncertainties of investing in a Chinese company by, for example, going with an accounting firm that you've never heard of -- and that might not even exist?
Second, extend the big-name theory to include China bears. Some investors are in it for the short term and will pass around any rumor that might help their cause.
But some bears believe in making their money the old-fashioned way -- by finding real problems that make a stock worth less than most investors think. Get used to including an Internet search for bearish opinions on any Chinese company before you buy as part of your due diligence. (Check out Citron Research, for example.)
More useful than the generic bears predicting a China collapse are those contrarians who see problems in individual Chinese companies. If you do a lot of investing in emerging markets in general and China in particular, and can afford the $910 subscription, check out Grant's Interest Rate Observer. If the price is too high, I think you'll still find it valuable to read the free teasers on Grant's home page.
Third, don't let the big-name theory replace your own accounting due diligence. You won't catch all the bad stuff just by reading the financials filed by Chinese companies that trade in the United States. But sometimes the red flags will be obvious.
In the case of Longtop, what was a company with total assets of $606 million doing with $332 million in cash? Companies that cook their books typically start with "improving" their accounts receivables by either booking fictional sales or inflating the price and size of sales. But if that "improvement" escapes detection for a while it starts to become so large that it draws attention and a company may then start to manipulate its cash balances.
Try to double-check a company's financial claims with those of its competitors. If its growth rate, profit margin or market share is out of line with similar companies, make sure you understand why. And check a company's balance sheet, income statement and cash-flow statement. The combined movements of cash should make sense.
Fourth, understand the basic story about the way a company makes its money. Where does growth come from? Why are profit margins what they are? China is an amazing growth story, but nobody has repealed the rules of business. A company's story should make sense to you.
Fifth, be willing to walk away. China is still in the early stages of its growth story. All the great success stories of China's stock market won't be snapped up by the end of next month. Remember, you would still have had a pretty good run in U.S. stocks if you'd missed all of 1896.
At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund's portfolio here.
Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.
Click here to find Jubak's most recent articles, blog posts and stock picks.
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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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