S chips

A couple of emails and messages from friends came in after another one of the S chips reported audit irregularities. It is not surprising, especially after I highlighted some companies during our discussions which later turn out to have problems.


I was disturbed by the various sell side research analyst, brokerage houses and some related forum writers (some of whom are trusted and appear on public frequently). They issued a constant flow of reports urging people to buy S chips and high yield dual listing counters without a concern for whom the target audience are and what are the effects. 


Let me set it here, most of the readers are mid to old age folks who are investing their nest eggs. True in that caveat emptor and it is their choice to invest, but seriously, you do not shun away from liability just by writing irresponsibly, unintelligently and covered by a disclaimer! 


As such, I think it is appropriate for me to share with readers some of my means to avoid these pitsfalls and elaborate which other counters I think is best avoided. (Not saying theres fraud or whatsoever, but to exercise more caution)


Firstly, S chips are cheap for a reason and we all know that. One has to not only dig deep into the numbers,read every single footnote carefully but also understand whats going on and take a step back and look at the big picture. Ask yourself "Does it all make sense"? If investing is like investigation, then investing in S chip, SMEs will have to be investigation on steriods.


There are many factors to look at it and I will draw a brief outline which is time tested and certainly effective across business cycles. Please look at the cases individually in entirety, it does not mean low PE, PB is good and neither does large cash position and no dividends means it is bad. Bear with me, it will be a little long winded. 


Framework 

1. Financials 
• Do the numbers in Income statement, balance sheet and cash flow all tie in?
• Look at balance sheet and cashflow and specifically track the uses and sources of funds and understand the rationale of the changes.
• Also look at operating assets and relationship to revenue and cashflows such as receivables, fixed assets etc
• Are there funky valuations or calculations? For example how China Milk uses fair value accounting for milk 
• Do not assume the numbers are right but try to understand the business before dissecting the numbers. 
• For example, for a certain industry and for firm X with a certain size, what should be an appropriate revenue and margins, what are the returns expected and requisite cash flows. If numbers differ vastly, attention is needed.
2. Management of the firm 
• Whats the background of the management? 
• Is the management heavily vested and does he sound vested? (Ex.Sinomem CEO sound disinterested in whats his expansion plans are - we shall see how the takeover turnsout)
• Any unusual transactions or details of the management? Example share sale.
3. Officers of the firm 
• Who are the auditors? were there discrepancies or multiple changes? especially if its due to disagreement to audit fees 
• Who are the sponsors? Are they of high quality?
• Are the independent directors relevant and are they related to the executive board?
4. Corporate action
• Dividend history? If no, see if retained earnings give rise to better profitability.
• Were there cases of raising capital even when firm is profitable and has hoardes of cash?
• Interpersonal or related party loans and transactions especially with offshore entities
• Dual listing simply means larger investor base at a higher than current cost of capital over time since there are listing fees and an overenthusiatic investor's expectations 
5. Business
• Understand the business cycles and find out why the firm is so profitable when others are not and vice versa. This is especially so for firms with no competitive advantage and/or no dominant market position
6. Logic 
• Many other considerations fall in this category where it is a combination or a factor not listed above.
• Look and the company and think about what it has done and if it is logical. For example;
• Did the firm issue equity at a large discount to market price even when their current valuations are cheap?
• does a firm invest heavily even when utilization rates are low?
• saying that it is hard to get loans in China thats why maintaining low loan amount simply doesnt make sense. Officers were essentially pushing loans in 2009/10

Below is a incomplete list of S chip firms which I have been tracking on and off and there may be a lot others out there which I may not have the time to go through such as Guanzhao Industrial forest. While such actions once carried has to be perpetuated, such constant actions can be spotted and reveal facts. Just as Erasmus mentioned, "A rolling loan gathers no loss", so is a fraud until the whole act breaks apart.


Hopefully this post will save some investors out there. Remember, look beyond the numbers!!!

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