Wednesday, June 16, 2010

"S-Chipped" (Reprise) 2010

The latest Fujian Zhenyun saga is a saddening reprise of the many blow-ups which occured in the S-Chip space in early 2009. FerroChina, Fibrechem, Beauty China, Sino-Environment, Oriental Century, Celestial Nutrifoods, China Milk and China Sun are just some of the troubled companies which have run into trouble, and have since been suspended (or are pending delisting).

Earlier in 2009, S-Chips fell like flies, succumbing to a mix of fraud/accounting irregularities, an inability to meet liabilities or in several cases, the forced sale of shares which had earlier been pledged by a major shareholder of the company (and yet, not disclosed to the Exchange).

An Early Warning in September 2008
In what was to be one of the most timely warnings issued by a brokerage, JP Morgan actually released a report dated 18 September 2008 where 21 S-Shares with a market cap of over US$200 million were screened for potential warning signs - just eight passed without any warning bells (Cosco Corp, Yanlord Land, Delong Holdings, People's Food, China Fishery, Hsu Fu Chi, China Aviation Oil and Epure Intl). Interestingly, all eight are "alive" and relatively healthy today (Delong Holdings appears to be doing the worst, but it was never a great business to begin with, in our opinion).

A 30% hit rate!
The other stocks flagged by JPM were Yangzijiang, China Hongxing, Li Heng Chemical, Centraland Ltd, FerroChina, Synear Food, China Sky Chem, China XLX Fertiliser, Fibrechem Tech, China Milk, Pacific Andes Hldg, Celestial Nutrifoods, Midas Holdings. While some of these 13 stocks have not done too poorly since (YZJ, XLX, Midas), it is shocking that JPM's simple analysis of potential warning bells managed to spot 4 troubled companies (FerroChina, Fibrechem, China Milk and Celestial Nutrifoods), a "hit rate" of over 30%! FerroChina shares were actually suspended in October 2008, less than a month after the report emerged.

DBS Vickers states the obvious
As S-chips continued to implode in early 2009, owning S-chips was akin to stomping around a minefield. If you were lucky (and your company wasn't the one in trouble for any particular day), you merely had to suffer collateral damange as investors fled from the sector (and who can blame them!). A (largely redundant)12 March 2009 report by DBS Vickers ("Navigating a Chinese minefield") only served to rub salt into bleeding wounds; the damage had already been done! Former market darlings like Beauty China, Fibrechem Tech and Sino-Env had already run into trouble by then, while the Celestial's inabiltiy to meet impending liabilities from its putable convertibles was already well-documented by then.

Avoiding the S-Chip space
Our familiarity with most of the S-chip names comes from having actually being invested in a handful (yes, a handful!) of them at some point of time. Naively, we took balance sheets and accounting statements at face value. Low single-digit PEs, net cash exceeding market capitalisation, book values exceeding market value by several multiples - we interpreted this as a buying opportunity of a lifetime. It was indeed a tremendous buying opportunity, but not in S-Chips.

When one is unable to trust financial statements and the management's integrity is suspect, we see absolutely no reason to seek out opportunities in the S-Chip space. While we scrutinise balance sheets to assess financial integrity of companies we invest in, we remain cognizant of our limitations (little or no accessbility to company management). Therefore, most of our investments are in larger-cap established companies where corporate governance is not an issue. For our smaller-cap investments, we prefer to avoid the S-Chip space completely, and prefer to choose companies incorporated in Singapore.

"CONFESSIONS of a S-Chip CEO" is lengthty, but essential reading for those who still seek investments where many fear to tread. Whether the letter is real or a fake is a moot point, but it serves as a warning that in the financial world, money can be made in zero-sum games of financial innovation, and investors will do well to avoid being the patsy in the poker game.


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