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Like many investors we have always been always been a touch suspicious of any company that prefers to list outside of its home market. This issue has recently cropped up again in the London market with the Kazakh miner, Eurasian Natural Resources Corp, dismissing two senior independent directors seen as ‘heavyweight figures‘ in the City. But the real ‘sex & violence’ of late has been in the US listed mainland Chinese companies. The Securities and Exchange Commission (SEC) is now investigating accounting and disclosure issues at a number of Chinese companies listed on US exchanges. These problems have escalated as we have moved from the accounting scandals and potential frauds at the small and largely insignificant Rino International and China Media Express Holdings to the bigger and more concerning problems at Longtop Financial Technologies and (Canadian listed) Sino Forest. Given the likes of Fidelity (Longtop) and Paulson (Sino Forest) are reported to be major shareholders in these companies their plight has attracted a fair bit of US media attention. Recent market movements highlight these recent events have brought Chinese stocks listed elsewhere under greater scrutiny.

The early pioneers in this trend to list in the US – namely the China internet companies – the likes of Baidu, Sina, NetEase, Sohu, etc have been a phenomenal success. Baidu (the ‘Google of China’) has been a 46 bagger (split adjusted) for the investors fortunate enough to participate in its IPO during 2005. These companies had pretty valid reasons for listing in the US in preference to closer to home given the US market’s greater familiarity with the sector, and the larger pool of liquidity that followed the internet stocks in the US market at the time. The theory that the US market and US investors were more capable of properly valuing (at a richer price) these companies was also reasonably valid. Over more recent times the process of listing China shares in the US has been subverted by companies carrying out reverse takeovers of US ‘shell’ companies whereby they could avoid the more onerous disclosure requirements of a primary listing. As a result, they were able to do things like appoint compliant auditors at small firms without attracting much notice. Until this year this did not matter as the companies were all largely ridden up by investors keen to play the ‘China story’. With the recent accounting scandals this has now turned into a nasty pain trade as can most obviously be seen in the Bloomberg Chinese Reverse Mergers Index (CHINARTO INDEX <GO> if you have access to Bloomberg) which is now down over -40% year-to-date.

However, the problems of Chinese offshore listings have not been confined to the US as some Chinese companies have always had a penchant for listing outside of their de-facto home market, Hong Kong. For example, the ‘S Chips‘, Chinese companies listed in Singapore have had a similarly chequered history. Who could forget China Aviation Oil? CAO was China’s monopoly jet-fuel importer that in 2005 lost a bundle on oil derivatives trades something you would think (and hope) it would know a fair bit about. And China Milk, China’s largest manufacturer of bull semen which was also listed in Singapore and remains suspended. This is a personal favourite of ours for some of the photos in its old investor presentations (circa 2006). Even a few HK listings have also been caught up in recent events. China Forestry Holdings (backed by Carlyle Group) is another forestry stock that might not have much in the way of forests. Likewise, Chaoda Modern Agriculture, a vegetable producer is alleged to have overstated the size of some farms in China.

Therefore, this is not a new phenomenon and nor is it confined to any particular exchange. As a result, it highlights lessons for investors as though history might not repeat itself to use a cliché it does tend to rhyme. There are some common themes or ‘red flags’ that investors can look for in any of these investments, but particularly when they are listed a long way from home. These include the following:

• Short track record and years of listed history (a common problem across nearly all listed Chinese companies).
• High levels of cash and high levels of debt.
• Frequent tapping of the capital markets to raise additional funds (across equity, convertibles and debt).
• Frequent M&A activity often designed to obscure underlying trends in the business.
• High and deteriorating working capital requirements. Things can be seen in the cash flow that are not always in the P&L.
• High management / director turnover – particularly worrying is turnover in important roles like the CFO.
• Resignation of auditors and / or frequent changes in auditors (particularly worrying if outside the ‘big four’ firms).
• Opaque background to and the actions of the controlling shareholders.

Whilst this is not intended to be an exhaustive list, and each case is somewhat different it does highlight that investors without a lot of time investors can find some common red flags. The starting point should be it pays to start sceptical particularly if the listing is far from home.

A final point to note is that whilst these frauds might look obvious in hindsight none of this is easy to research before the event even with established red flags. For example, both Longtop (Deloittes), and Sino Forest (Ernst & Young) had been audited by big four firms (and of course Enron was audited by Arthur Andersen when there was a ‘Big 5′). Mistakes get made by analysts even with the best of intentions, and often investors have to rely on a company’s word (or integrity) as well as their audited financial statements to reach their investment conclusions. All investors to some extent regardless of their level of due diligence have to decide whether to trust (or not) management’s word as well as their financial statements. The level of due diligence required to research these stocks is high with or without relying on management’s integrity. On a company like Sino Forest it is not easy for any individual institution to marshal enough resources or time to independently validate their acreage and land title against their word. For example, Muddy Waters  reportedly had 12 analysts researching Sino Forest  for over two months to carry out its ‘detailed forensic accounting and legal work’. Whether you believe their research findings are right or wrong this is a huge resource commitment to research just one stock. Even very well resourced fund managers in the Asian region typically have a team of 6-12 analysts looking at portfolios of 50-100 companies. Clearly on each portfolio holding most houses cannot do the same level of due diligence that Muddy Waters are reported to have done on Sino Forest.  But, as highlighted above there are at least some mechanisms and common checklists and templates which all investors who try to follow a fundamental investment process can use to guard themselves against too many blow ups even if they are far from fool proof and cannot lead to a complete avoidance of problems, especially in a market like China.

Naturally investors need to tread carefully particularly the further away they step from home. However, this is also leading to opportunities in some of the US listed Chinese companies that are being tarred with the same short selling brush that do not have any of the aforementioned red flags. However, a sceptical outlook on listings a long way from their home base is not a bad place to start. But, this applies to listings in HK by Russian and Italian companies (or dare we say English football clubs) as much as it does to Chinese companies listing in the US.