To help inform investors about risk in China, Janus Henderson presents this wide-ranging educational series – China investing: Signals and Smokescreens. This is based on an in-depth study of China stocks that underwent periods of intense financial stress in recent years.
09.07.2018 | 12:25 Uhr
‘Even a tower a hundred yards tall, still has foundations on earth.’
Don’t suspend disbelief in extraordinary circumstances;
everything should have a basis in reality
- Chinese proverb
Given the high-growth environment of China’s economy, certain companies have been experiencing rapid expansion on a scale not evident in the West and this is expected to continue in the medium term. A result of this is that investors are sometimes inclined to accept figures that appear ‘too good to be true’ as a result of their desire to ride the wave of China’s growing success. However, this suspension of disbelief sometimes means investors refrain from assessing whether changes on a given Chinese company’s financial statements stand up to reason.
The starting point for all of the ‘Signals and Smokescreens’ case studies has been an analytical review of the balance sheet, cash flow and profit/loss of the Chinese companies in our data set that were subjected to a short attack*. This helped us to look for signs of anomalies in the reporting on the underlying business and for indications that the controlling shareholder(s) might have manipulated the accounts in an effort to inflate the share price which, in turn, could have provided the short sellers with a reason to initiate coverage.The purpose of this review was not to identify cases of manipulation ‘after-the-fact’, but to determine whether key financial ratios, in conjunction with a thorough examination of the company’s governance and other external factors, might have made it possible for investors to anticipate turbulence in the share price and thus avoid losses.
As is the case in more mature markets, in our view some form of quantitative screening should be the starting point of the investment process in Chinese equities. However, in light of the high-growth nature of China’s emerging market, more importance needs to be placed on contextualising and cross-checking a company’s financial statements in order to determine their veracity.
Evidence of any outliers or inconsistencies in financial figures and ratios should act as a strong prompt to look ‘beyond the numbers’ into a given company’s governance and internal controls to identify the real causes of anomalies.
Moreover, a comparison of a company’s financial statements with external factors, such as global industry norms or relationships with suppliers and customers, can help to highlight cases where reported profits and growth are just not credible.
We examined absolute changes in values, such as rapid increases in receivables days or short-term debt, in addition to relative changes, such as widening divergence between net income and cash flow. Some of the key figures and ratios that we found particularly useful in evaluating a given company’s financial position included the following:
The above examples are by no means exhaustive but by looking at the these figures and ratios, amongst others, we found some rather striking warning signals in the financial statements of foreign-listed Chinese companies, which strongly indicated aggressive application of accounting standards in order to drive up share prices or, in the most egregious cases, to manufacture the results:
We found that there was a clear correlation between companies with strong governance and balance sheets comprised mainly of well described, recognisable tangible assets where certain key ratios and figures appeared rational and consistent with similar businesses outside China. Or, where they were inconsistent, there were plausible and independently verifiable reasons provided to believe that such inconsistency was genuine. So for example, if the identification of a red flag consisted in the divergence between fixed assets and depreciation, the corresponding green flag could be the company providing verifiable evidence that the fixed assets had only recently been purchased and were therefore at the early stages of their useful lives. Alternatively, if a red flag consisted in a rapid increase in inventory in a company whose products are paid for at the point of sale, the corresponding green flag might consist in the company demonstrating that it operates in a seasonal industry and that it is more economical to focus on production in the low season in order to allocate funds to distribution when the demand is higher.This being said, even where the numbers appear to stack up, it is important to maintain a sceptical approach to uncover further reasons to believe that those figures accurately portray the true state of the underlying business.
The table below shows the flags that were most instructive in our analysis.
Red flags | Green flags |
---|---|
Increasing receivables days – this could suggest aggressive revenue recognition and/or an inability to collect funds from customers. | Explained increasing receivables days – a positive if reflective of industry trends or a change in customer mix that alters payment terms. |
Abnormal inventory days - rapid increases might indicate that sales growth is slowing; rapid decreases could indicate the flooding of distribution channels, which might not reflect actual sales by distributors. | Key ratios and figures that appear rational and consistent with similar businesses, reflect seasonal trends or mark a change of strategy that is clearly articulated by management. |
Large increases in asset growth – some companies occasionally use intense M&A activity over short periods as an opportunity to book large gains or mask organic shortfalls. | Well-articulated acquisition or expansion strategy, which enhances the company’s growth prospects. |
Increases in short-term debt – this might indicate that a company is struggling to generate free cash flow from operations; | Explainable increases in short-term debt – could be in conjunction with rising receivables and increased inventories |
Changes in margins that don’t reflect industry trends – this could suggest a deferral or understatement of costs or an overstatement of revenue. | Economies of scale and gains in efficiency could result in industry-leading profitability |
Divergence between net income and cash flow could suggest problems with cash collection or aggressive recognition of sales. | Slower than average cash collection may well be a sector norm but should be seen alongside the ability of management to mitigate the effect. |
Mike Kerley, Director of Pan-Asian Equities and Portfolio Manager at Janus Henderson Investors:
“Although the numbers are always a good starting point for making an informed and successful investment decision they must be analysed in conjunction with a full understanding of the industry in which the company operates. Behind the numbers may lay an opportunity or a risk – only in-depth analysis will determine which it is for investors.”
Note:
*In a short attack, firms conduct extensive desk analysis and on-the-ground due diligence of a listed company that they suspect of being either fraudulent or of manipulating their share price. After gathering their evidence, these firms take large short positions before publically releasing negative reports on the company in question in an effort to depress its share price and profit from their short positions.
Part 1: Janus Henderson: China investing - China-specific risk
Part 2: Janus Henderson: Risk, with Chinese characteristics
Part 4: Janus Henderson: China investing - board oversight
Part 5: Janus Henderson - China investing - material and related-party transactions
Diesen Beitrag teilen: