I Don't Understand China Stocks

In January this year, I received my share certificate from Hongwei Technologies Ltd. This is not something to rejoice, for it means that the shares are now officially delisted from the Singapore Exchange and worth nothing. The main cause of the company failing was accounting irregularities at one of its subsidiaries. What are the lessons that I learnt from this episode?

I first invested in this stock in Apr 2009 during the Global Financial Crisis (GFC) at a price of $0.125. Then, I liked it as it was an undervalued stock. It had earnings per share (EPS) of 28.9 Renminbi (RMB) cents in Financial Year (FY) 2008, making its Price/ Earning (P/E) Ratio a mere 2.2 times. Its net asset value was 145 RMB cents, making its Price/ Book (P/B) ratio only 0.43 times.

With the passage of the GFC, it recovered to a price of $0.285, allowing me to post a paper profit of 128%. I continued to hold on to it, believing that the stock was still undervalued. The last available financial results before its suspension in Feb 2011 showed it had EPS of 26.9 RMB cents in FY2009, making its P/E ratio only 4.8 times. Possibilities of accounting irregularities did not occur to me. The only concern I had was that a significant portion (24%) of its pre-tax profit were trading profits, and in trading, you could make profits as well as losses. It was probably a matter of time before the company reported a trading loss or a smaller trading profit. Nevertheless, I continued to hold on to the stock.

In Feb 2011, the company announced that the auditors had problems confirming the cash balance of one of its subsidiaries. The stock promptly fell from $0.26 to $0.19 and was suspended. Upon deeper inspection of its financial statements post-suspension, I realised that while the group had healthy cash balance of RMB112 million, the holding company itself had only cash balance of RMB71,000. All the cash balances were with the subsidiaries. This was a red flag that I should have picked up but did not. Other indicators were healthy: it paid dividends continuously for 5 years since 2006, although the dividends had declined from a peak of 7.58 RMB cents in 2007 to 1 RMB cents in 2010. From the cashflow statement, it paid income tax of RMB12.7 million in FY2009, approximately in line with its pre-tax profit of RMB76.7 million and Chinese tax rate of about 20%. So, what I learnt from this episode is that if the group is making profits, cash should also accumulate on the holding company's balance sheet. The holding company's balance sheet is something I always overlook, choosing to concentrate only on the group's balance sheet. After all, it is the group that we buy into effectively, even though it is the holding company that we own nominally.

Armed with this fact, I reviewed the balance sheets of all the China stocks and stocks with exposure to the China market in my holding. In total (as at now), I have 6 such stocks, namely, China Aviation Oil, Fung Choi, Karin, Midas, Valuetronics and Yangzijiang. In 3 of them, the holding company's cash balance is less than $1 million in the functional currency (either RMB or Hong Kong dollar). These 3 companies are Fung Choi, Karin and Valuetronics. So, are these 3 companies likely to have accounting irregularities like Hongwei? My guess is probably not. I can only say "I don't understand China stocks".


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