Waving the white flag on Chinese small caps

I'm officially tossing them into the "too hard" pile.

By Motley Fool Pick of the Day May 26, 2011 11:45AM

By Matt Koppenheffer

 

Am I a flip-flopper?

I had been seriously skeptical of Chinese small caps before the worst of the meltdown began. But then, as the short "hit" pieces flooded the Web and the group's stock prices got absolutely clobbered, the value investor in me started to get intrigued.

 

But now it's time to finally throw up my hands, pull out the ol' white flag, and simply say, "I give up!" And I can thank Longtop Financial (LFT) for bringing me to this conclusion.

 

Longtop's shares were halted last week, and earlier this week the company filed with the SEC that its accountant (Deloitte Touche Tohmatsu) is walking away and its CFO has offered his letter of resignation. That all sounds bad enough, but it gets much worse. Check out the reasons that Deloitte told Longtop to talk to the hand:

[the resignation was] as the result of, among other things (1) the recently identified falsity of the Company's financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT's audit process; and (3) the unlawful detention of DTT's audit files. DTT further stated that DTT was no longer able to rely on management's representations in relation to prior period financial reports, that continued reliance should no longer be placed on DTT's audit reports on the previous financial statements, and DTT declined to be associated with any of the Company's financial communications in 2010 and 2011.

And did I mention that the SEC is also investigating the company? Yeah, it's really bad.

 

Not your average Chinese flop
There has been a seemingly endless parade of Chinese companies battered by fraud accusations in recent months. China Agritech (CAGC) and China MediaExpress (CCME) were recently delisted from the Nasdaq after long trading halts and serious fraud allegations. It's hard to forget Rino International (RINO), which was one of the first ships sunk in the battle. And there's a legion of other companies including China Sky One Medical (CSKI), China-Biotics (CHBT), Advanced Battery Technologies (ABAT), and Motley Fool Global Gains recommendation Yongye International (YONG) that have continued trying to fend off nay-sayers.

 

Every one of the companies above, however, was either a reverse-merger or "blank check" company -- which essentially means that they took a back-door route to reach the public markets. Not so with Longtop, which went through a full IPO process back in 2007 -- an IPO that, I might add, was managed by Goldman Sachs.

 

It's also obviously notable that Longtop wasn't using some no-name auditor -- Deloitte is a major global brand. Finally, Longtop barely qualifies as being considered a small cap as its pre-trading-halt price puts its market cap at more than $1 billion, and just six months ago, its stock price was nearly double what it currently is.

 

Whom indeed...
Back in April, I asked "Whom can you trust?" when it comes to Chinese small caps. The picture was dim then, and it's significantly dimmer now.

 

Last week, a commenter on an article of mine lamented that by not declaring all-out war I was giving many suspect Chinese small caps the benefit of the doubt when there is no reason to. Perhaps there is some merit to that accusation.

 

Of course my goal isn't to defend one side or the other here -- I'm primarily interested in figuring out if there are investable opportunities. And there may still be. But as I said in the beginning, I'm now firmly of the belief that the juice just isn't worth the squeeze. Not convinced? Here are my top three reasons why it's better to steer clear of this group.

 

1) What do you know?
Major global auditors have been taken for a ride. Not once, not twice, but a handful of times. If you want to be on the long side of one of these small Chinese companies, you better have something very compelling that makes you believe the company is on the up and up. And that compelling evidence can no longer be that Deloitte or Ernst & Young signed off on the financials or even that the company had a proper IPO.

 

2) Even on the upside, it's been unimpressive.
One possible strategy I've mentioned a few times is buying a basket of beaten-up Chinese stocks and assuming that the ones that were cleared of fraud would deliver returns that make up for the ones that end up folding. This is now out the window. For one thing, the fraud seems frightfully pervasive, and an investor could run the risk of having a hefty chunk of their basket go belly up.

 

Past that, the companies that have circumvented short sellers by going private haven't offered high enough returns. I wrote about this when China Security & Surveillance went private, and China Fire & Security (CFSG) just recently underscored this point.

 

China Fire is being bought out for $9 per share by Bain Capital. While that's a nice 39% premium to China Fire's 90-day average trading price, it's not nearly enough of a gain for an investor that's hoping it'll offset a company that loses 80% or more because of fraud.

 

3) What exactly are you buying anyway?
What shouldn't be lost in all of this is what the companies involved actually do (or supposedly do at least). Most of my personal investing focuses on finding companies with great businesses that have some sort of competitive advantage that will allow them to produce outsized returns well into the future.

 

It's seems tough to say that the businesses of many of the under-fire Chinese companies have much in the way of a sustainable moat. In many cases, the products appear to be commodities, while in others, the companies are simply first movers in low-barrier-to-entry businesses. There's nothing inherently wrong with businesses like these, but it's difficult to expect them to continue to deliver outsized returns on capital over an extended period of time.

 

"Too hard pile"
Warren Buffett supposedly has a "too hard pile" where he metaphorically tosses stocks that are just too tough to figure out. For me, Chinese small caps are getting the heave-ho to this pile. Forecasting the future -- which is what we have to do to analyze any investment -- is hard enough. Trying to figure out whether facts about the present and past hold water makes the process a dangerous quagmire.

 

Besides, with attractive risk-adjusted returns available from world-class companies like Apple and Chevron, why get mired in this muck?

 

To tell me why I'm crazy for passing up Chinese small caps, just scroll on down to the comments section.

 

Fool contributor Matt Koppenheffer owns shares of Chevron, but does not have a financial interest in any of the other companies mentioned. The Motley Fool owns shares of Yongye International and Apple. Motley Fool newsletter services have recommended buying shares of Chevron, Apple, and Yongye International, as well as creating a bull call spread position in Apple. The Fool has a disclosure policy.

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