Cabot Editor Goodwin Does Chinese Stock Due Diligence at NYC Forum

Paul Goodwin, editor of Cabot China & Emerging Markets Report, attended the Wall Street China Forum on May 6 in New York. The purpose of the Forum was to examine practices for assessing Chinese companies for U.S. investment. At the conference, found that both the SEC and U.S. stock exchanges are actively committed to improving transparency and the reliability of financial reporting. Goodwin confirmed his belief that investors who understand the essence of these Chinese stocks and apply the appropriate due diligence will be able to maximize returns with minimum risk.

Goodwin discussed the conference in the May 12, 2011 issue of Cabot China & Emerging Markets Report:

"The community of investors in China is skewed toward the professional end of the spectrum, with a heavy weighting of hedge funds, private equity firms and institutional funds.

"People at that level are used to positive results, and when they see their investments taking a hit, they tend to take action.

"One recent example of that action was the 2011 Wall Street China Forum that we attended in New York City on May 6. The topic was “Assessing U.S. Listed Chinese Companies,” and the discussions had some real urgency to them.

"There were two negative events on the minds of attendees.

"First, people were still digesting the fallout from the reverse takeover (RTO) dustup of a few months ago. That mini-crisis resulted from an article in Barron’s that detailed how a number of Chinese companies had achieved their listings on U.S. exchanges by buying moribund companies that already owned a listing.

"These RTOs were usually accompanied by a substantial private placement of stock with a hedge fund. Chinese companies would then change the company name and listing symbol to their own and happily go about the business of selling stock.

"There’s nothing inherently wrong with RTOs. After all, the New York Stock Exchange itself is the product of a reverse merger, as is Berkshire Hathaway.

"But the wave of RTOs facilitated by one or two shady advisors was unusually high in companies that were shaky at best, and outright frauds at worst. (Two of these companies—China Integrated Energy (CBEH) and RINO International (RINO)—were included in the Cabot China & Emerging Markets Report’s portfolio in 2010 and one—Deer Consumer Products (DEER)—was on our Watch List, but was never actually bought.) Our system, however, got us out well before these stocks truly hit the skids.

"The second negative event that concerned conference attendees was the recent short attack on Sky-Mobi (MOBI) by a company called Citron Research. Citron specializes in shorting stocks, and had short positions in MOBI, so their motivations aren’t hard to discern.

"But that doesn’t mean Citron is wrong, either. So one huge theme at last Friday’s conference was the practice of due diligence in assessing Chinese stocks.

"At the same time, there was also a recognition that Chinese stocks are always vulnerable to rumors and false accusations, and the consensus was that the SEC (or even criminal investigation agencies) would have to take a close look at any source of negative stock information where the publisher has a financial stake in the outcome.

"For the Big Dog China investors (hedge funds and private equity firms) who are looking to sink significant money into individual firms, the lessons of the conference have mostly to do with old-fashioned due diligence. With big wodges of cash on the line, these people make multiple visits to China to kick the tires, look the CEO and CFO in the face, talk to suppliers and customers, go through the books with a magnifying glass and, in one memorable anecdote, even park outside the factory gate to count the number of trucks entering and leaving.

"For Cabot China & Emerging Markets Report, the lesson is to piggyback on the due diligence of the Big Dogs and decline to recommend any stock that doesn’t have a decent measure of quality institutional support for its shares.

"The reputation of the target company’s accounting firm is also valuable, and one consistent conference theme was the thoroughness of the vetting process that Big Four accounting firms put potential clients through. If Deloitte Touche Tohmatsu, PwC, Ernst & Young or KPMG take responsibility for a firm’s accounting, you can be confident in putting your money to work in its stock.

"We’ve always taken care to use all the resources available to us to evaluate the stock we recommend. The really hopeful message of the Wall Street China Forum is that these practices are becoming more widely accepted. And this will continue the process of lowering the risk of investing in Chinese stocks."

As editor of Cabot China & Emerging Markets Report, Goodwin focuses on stocks in China, India, Brazil and other emerging Markets. The Report was named one of the top ten investment letters for five-year performance 24 times by Hulbert Financial Digest.

Paul Goodwin at China Forum NYC 2011
Pictured: Cabot China & Emerging Markets Report Editor Paul Goodwin, right, at the 2011 Wall Street China Forum with Robert H. McCooey, Jr., Senior Vice President of New Listings and Capital Markets, The Nasdaq Stock Market, Inc. 

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