The most recent scandal around Sino-Forest (ticker symbol TRE.TO) has once more
dented the reputation of Chinese companies on global stock markets. Besides
playing on the generic fears of corporate governance in Chinese companies, the
company's volatility may also have longer-term consequences on capital raising
by Chinese companies on their home turfs of Shanghai and Hong Kong, let alone
mulling overseas listings in Canada and the United States.
If the issue actually steamrolls into a market-wide shutdown, that would leave
Chinese companies over-reliant on borrowing from corrupt banks in their local
market, in turn accentuating the negative spiral that appears to have taken
hold over the past 10 years.
The rum thing in all of this is the exceedingly large amounts of
capital that are available in China and Hong Kong: many global companies
ranging from Glencore to Prada and Samsonite have listed their shares in Hong
Kong recently to benefit from the local capital depth. The fact that Chinese
companies cannot tap into the same pool of capital is quite a statement in
As the graph from Yahoo! Finance makes clear, this has been a roller coaster
ride for a few weeks. The main reason for the prominence of the story was two
stories: firstly the publication of a damning research report by a firm called
Muddy Waters, and secondly the revelation in the Wall Street Journal that
Paulson & Co, one of the world's biggest hedge funds, had lost over $550
Million in its holding.
The circumstances of the stunning volatility in the stock are explained below
but before delving into that aspect it is also sensible to consider the
volatility of Chinese stocks relative to the US. The chart below shows the two
sides of the Chinese reserve management quandary - rate rises have pushed down
the value of Chinese stocks, while the maintenance of US Treasury holdings that
have kept US interest rates low have helped promulgate market rallies.
But is it possible that a corporate governance premium has been affecting the
performance of Chinese stocks in addition to the rate actions of the People's
Bank of China?
Coming back to the Sino-Forest story, the key development was the publication
of an extremely negative research report on June 2, 2011. The opening
paragraphs hardly pulled any punches:
Like Madoff, TRE is one of the
rare frauds that is committed by an established institution. In TRE's case, its
early start as an RTO [reverse takeover] fraud, luck, and deft navigation
enabled it to grow into an institution whose "quality management" consistently
delivered on earnings growth. TRE, which was probably conceived as another
short-lived Canadian-listed resources pump and dump, was aggressively
committing fraud since its RTO in 1995. The foundation of TRE's fraud is its
convoluted structure whereby it runs most of its revenues through "authorized
intermediaries" ("AI"). AIs supposedly process TRE's tax payments, which
ensures that TRE leaves its auditors far less of a paper trail.
From that point, the report goes steadily more activist, taking pains to
explain the genesis and progress of what it calls a significant fraud in terms
of actual forestry holdings, essentially painting a story of good old-fashioned
asset diversion for the benefit of management. I have no idea if any of the
allegations contained in the research report are true - but it does read like a
great economic thriller novel.
There are many other twists and turns in the Sino-Forest story, including the
revelation that another major US investment firm (Wellington Asset) accumulated
a large stake in the company after its sharp decline. Meanwhile last week, the
company which had been issuing various counter-claims to the Muddy Waters
research itself postponed a planned trip by equity analysts to its forestry
concessions in China (designed to show that the Muddy Waters claim on the
company's inflated holdings was wrong) - sending shares down 20% on the day
before recovering later.
The fact though is the price, or more importantly the volatility. The mere fact
that the Muddy Waters research was considered plausible immediately on
publication - and by contrast the official statement of Sino-Forest was simply
dismissed out of hand by the market - itself highlights the lack of confidence
in the Chinese (and wider, Asian) corporate sector. The area of focus - below
the global Fortune 100 - is where 95% of Chinese and Asian companies operate.
Hence a lack of confidence is not just representative but also "sticky".
Surely Asia has enough well-rated analysts and people capable of doing a good
job in pushing through higher standards of corporate governance? That may be a
claim that cities like Hong Kong can make. As one goes through the research, a
paragraph about the amount of effort expended by Muddy Waters stands out like a
giant middle finger to the Asian establishment:
Were Muddy Waters not
to have come along, it is likely that this fraud could have continued for a few
more years and billions of dollars more. Solving this fraud was not easy. In
order to conduct our research, we utilized a team of 10 persons who dedicated
most to all of their time over two months to analyzing TRE. The team included
professionals who focus on China from the disciplines of accounting, law,
finance, and manufacturing. Our team read over 10,000 pages of documents in
Chinese pertaining to the company. We deployed professional investigators to
five cities. We retained four law firms as outside counsel to assist with our
analysis. We are confident that we have brought more expertise, time, and money
to bear in analyzing TRE than has any investor or bank - by a substantial
In Hong Kong, the bugbear of the city's corporate elite
is a mild-mannered, former merchant banker by the name of David Webb, who
writes some excellent corporate governance exposes in a site called
www.webb-site.com. That website though is a lonely outpost; the rest of the
coverage on Chinese companies - for example that on the Chinese banks that is
released by the investment banks and rating agencies - is depressingly familiar
in the general failure to spot anything at all wrong despite writing reports
about a sector where senior managers often get arrested (and sometimes even
shot) for corruption.
Genesis of a discount
As mentioned above, this article isn't about Sino-Forest, but rather what the
volatility represents. For a global investor looking to expand investments into
China, the key danger simply remains that purchasing even a well-regarded stock
is fraught with the danger of fraud. The simple fact that one of the world's
largest hedge funds (suggesting an institution with a deep capability to
properly conduct due diligence on its purchase, unlike say an index-following
mutual fund) dropped a bundle on its Chinese stock pick only serves to
highlight the risks.
Looking at history, one doesn't need to panic. The evolution of most of the
world's greatest economies has been accompanied by patterns of deceit and
fraud. For example, a century ago the US economy was positively festering with
robber barons and casual fraud. The difference though was that even a century
ago there were instruments of law available to the common investor that are
simply not available in China today. The significant role of local governments
and banks in the fortunes of Chinese companies simply means that objectively it
is quite difficult for an investor to determine where his stock rights start
and where the stakeholder rights of the state end.
The second aspect that Chinese companies could well do with would be greater
openness to criticism. A thin skin towards analyst criticism is usually
justifiable by the sheer growth discernible in the Chinese economy and in
competitiveness against most foreign companies in many sectors. However, it is
now seen as a sign of unwanted defensiveness that may be hiding some serious
bad news : better in that case to focus on openness with respect to facts.
The third area of improvement possible in China (and the rest of Asia, to be
sure) is to expand the professional cadre of accountants, lawyers and analysts.
Put simply, there is a gross shortage of such people in Asia, and quite often
excessive workload is blamed for shoddy work. Banks and brokers have steadily
expanded their staffing in Hong Kong and Singapore, but progress is thus far
slower within China itself. That needs a concerted effort on the part of
companies and their brokers to ensure that good quality information is
disseminated promptly to the markets.
Bosses of Chinese companies looking to list but being told by their brokers
that the process is too difficult should not look so much at the Sino-Forest
scandal as a sign of fickle equity markets but rather look at the success of
foreign companies listing in their back yard (like Prada) as a sign of the
opportunity set that is available to them.
If people prefer to invest their savings with foreign companies because of
greater trust, that in the long term would cause the same foreign companies to
purchase their Chinese competitors on the cheap - despite the economic value of
the latter being likely superior to that of the Western companies. It is really
up to Chinese companies to figure out a way forward to avoid backdoor
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