Chinese Companies' Dodgy Accounts Deter Investors

Published in Investing on 9 February 2012

But non-Chinese companies who operate in the country offer a way in.

Chinese companies have featured strongly in the list of accounting scandals in recent months, and many investors have discovered to their cost that Chinese accounting practices can be somewhat fast and loose.

One of the biggest cases is the Toronto-quoted forestry company Sino-Forest, almost all of whose assets are in China, which stands accused of having falsified its accounts. Unfortunately, an independent fraud investigation has failed to resolve the situation, leaving the authorities with a host of unanswered questions.

Then there's Longtop Financial Technologies, which was delisted from the New York Stock Exchange last year for numerous violations covering four years' worth of accounts. The investigation hit a brick wall recently after its accountants in Shanghai refused to release any documents, claiming that this would violate Chinese state secrecy laws...

It's enough to put you off the country.

Strong economy, but…

Every time I consider investing in China, the negatives -- such as the Sino-Forest case -- put me off. Among the things that weigh against China are its lax approach to property rights, a legal system that routinely judges cases according to the parties' political connections rather than the facts, and that corruption in China appears rife.

Then there are serious corporate governance concerns, in particular the treatment of minority shareholders and the often highly opaque nature of Chinese ownership. Though, in these matters, China is a paragon of virtue compared to Russia, where minority shareholders are often openly defrauded yet the authorities do nothing about it.

So, for me, the best way to invest in China is indirectly through other companies.

Invest in China by investing outside China

One way I do so is via companies that sell a lot of stuff to China, such as the multinational mining giants BHP Billiton (LSE: BLT), Rio Tinto (LSE: RIO) and Xstrata (LSE: XTA).

Hong Kong and Taiwanese companies and investment funds are another way into China, given the strong commercial ties between these countries and the mainland. Companies like Foxconn, the world's biggest manufacturer of electronic components, have huge Chinese interests as most of their production has been outsourced to there.

The American company that feeds China

Another way to get a piece of the Chinese action is to invest in large non-Chinese companies that operate in China.

While companies like Unilever (LSE: ULVR) do a reasonable amount of business in China, for me the pick of the bunch is America's Yum! Brands (NYSE: YUM.US). You may not know the name, but you've almost certainly heard of its fast food restaurants KFC, Pizza Hut and Taco Bell

That's because just over 50% of Yum!'s sales come from China, having grown by 34% in 2011, where the company intends to triple its number of restaurants during the next decade.

A crucial part of Yum!'s success is that the vast majority of its managers in China are Chinese, so they know the culture and how to do business the Chinese way. And since Yum! is a $30 billion company, I reckon that it has sufficient political clout to cope with the vagaries of the Chinese legal system.

A few numbers

The problem for prospective investors is that Yum!'s shares are quite expensive. They're $64.44 as I type this, close to their all-time high, so with earnings per share for 2011 of $2.87 (up 14%), this put them a historic price-to-earnings (P/E) ratio of 22.5 where they yield 1.5% net of US withholding tax.

That said, Yum! has been on a very high P/E ratio for many years (I've owned shares for quite some time and can't remember them ever being 'cheap') and it keeps on delivering the goods for its shareholders. Furthermore, given the popularity of KFC in China, I don't see things slowing down there until the mid-2020s at the earliest.

Yum! also sees plenty of scope for growth in many other developing markets. It's just started a major expansion programme in India, where it expects to quadruple its number of outlets in the next three to four years. Yum! is also doing rather well in Russia, but that's another story!

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> Tony owns shares in BHP Billiton, Unilever and Yum! Brands. The Motley Fool owns shares in BHP Billiton and Unilever.

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Comments

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theRealGrinch 09 Feb 2012 , 2:12pm

I would never buy chinese shares directly. just dont trust that. agree best way is to invest in companies which do business with china but report according to UK GAAP.

BrnzDrgn 09 Feb 2012 , 4:35pm

I've heard of Yum brands, definitely will be researching that company.

Hallucigenia 10 Feb 2012 , 1:37am

Err - HK isn't another country, have you heard of "one country, two systems"? And I wouldn't say that HK companies are some kind of gold standard either - I strongly suggest you read up a bit about the demise of Akai Holdings. This was an HK listed company with a $5bn turnover and audited by Ernst & Young.

Sounds exemplary no? But there was massive fiddling of the accounts, apparently with the connivance of the local branch of E&Y. Thing is that at least historically, the HK branch of a Big Four firm was effectively little better than a local auditor with a fancy logo. You might think the logo means you're getting London levels of auditing but you're not by a long shot.

Things have got a little better since then - paying out $200m concentrates the mind wonderfully - but they still have problems just getting the staff when China is expanding so rapidly, and fierce competition on fees doesn't help either. So the Big Four are no guarantee of reliable accounts - Deloitte did Longtop and China Media Express, E&Y did Sino Forest, KPMG did China Forestry, don't think PWC have been badly caught out yet in China but have elsewhere in Asia - Kanebo, Satyam, DSQ, Global Trust Bank etc.

TonyTwoTimes 10 Feb 2012 , 7:20am

Hi Hallucigenia,

In many ways Hong Kong is a very different country (something to do with having a very different legal system and culture).

You could apply the same reasoning re. Akai to avoid investing in the USA given cases like Enron and WorldCom.

TonyL

TonyTwoTimes 10 Feb 2012 , 8:12am

Hi BrnzDrgn,

A pretty good read about Yum!'s expansion in China (and business in China) is "KFC in China: Secret Recipe for Success" by Warren Liu.

Yum!'s boss David Novak's autobiography "The Education of an Accidental CEO" is also worth a look. There's a lot of stuff in there about marketing and sales and it doesn't read like most business leaders' books

e.g. in the section where he's talks about when they were looking for a name for the company when it was spun out of PepsiCo. He wanted Yum but was overruled with "Tricon Global".

Novak says that Tricon "sounded more like the name of an industrial dry-cleaning company" whereas "Tricon Global sounded like an evil conglomerate from a James Bond movie"

Cheers,

TonyL

Hallucigenia 10 Feb 2012 , 1:25pm

@Tony - sure, but it's still a fact that it's one country. And talking to people who are intimately acquainted with the work of auditors in HK and are in a position to take a professional view from a global perspective - they are scathing about the quality of auditing in HK, even by the Big Four.

That's why Akai was so much worse than Enron - at least with Enron there were hints that things were going wrong in the public accounts, that some outsiders picked up on. The difference with Akai was that the audit process was way more corrupt than Enron or some of the other big Western failures. This was a company that would have been in the FTSE if it was listed in London, its turnover was comparable to Reckitts or SSE - yet as of the IPO the 1994 accounts were signed off by someone who didn't work for E&Y until 1998!

The records of the court case have plenty more examples in that line, it really was shocking.

So no, I would only invest in a company audited in Hong Kong on the assumption that the accounts are in effect unaudited.

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