Chinese Con Companies – A Warning

REVERSE MERGER RULES TO TIGHTEN

Back in June, The Frost Report wrote about the sorry state of Chinese companies listed on North American exchanges.  Namely, that many such companies are rife with fraud (The Sick Man of Asia).  This week, both Canadian and American securities regulators began exacting their revenge.

The best way to understand this story is from the perspective of a Chinese con-artist/short-term entrepreneur, whom the new rules are designed to thwart.  And so, both the initial problem and the solutions are presented here in letter form:

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Dear North American Securities Regulators,

A few years ago, I had it made.  Through reverse mergers (buying out American companies listed on stock exchanges), I had a quick and easy way to become rich - fast!

Merely by listing on a North American exchange, putting together an impressive website, and manufacturing some nice accounting numbers, it was easy to get investors excited.  Most of them thought that because my company was listed on a North American exchange, it must be legitimate - the idiots!  Ha ha.  It was easy money.

Then the problems started. 

Savvy North American investors started questioning things - like my receipts and accounts that don't match, the ridiculously spectacular sales numbers, and the head office that doesn't exist (I didn't think anyone would go to Central China to check)!  And, I certainly didn't think anyone would check my resume to see that I actually did graduate from business school.  In China, buying a degree is no big deal: everyone does it - it only costs a few bucks for a degree from Harvard.

So now, it's all going to hell.

This week in the US, the Securities and Exchange Commission (SEC) announced stricter requirements for foreign companies that become listed on American stock exchanges through reverse mergers (buying out listed American companies).  Under the new rules, foreign companies like mine will be traded on the “over-the-counter” (highly risky, restricted) market for a full year before being allowed to trade on a larger exchange.  How am I supposed to make my fortune?  I need to have investors trust me immediately.  I need to take my cash and buy an overpriced house in Vancouver or Sydney right away, before I get arrested.  One year is too long.

Then I heard that in Canada, the Ontario Securities Commission (OSC) accused Zungui Haixi Corp and two of its executives of failing to cooperate with their special investigation.  The company’s auditor, Ernst & Young LLP, suspended audit of the company’s financial statements just because of a few “inconsistencies” in bank documents, assets and invoices.  How dare they!

Now, the OSC is saying it will be unveiling “a number of cases” in the coming months.  My friends are all worried that this is the end of the easy life.

So, I am asking you - the employees of the securities exchanges - to please back off.  If you do, there is a nice fat red envelope full of cash waiting for you in locker number 6 at the local train station.

Sincerely,
"Entrepreneur"

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Certainly, the vast majority of Chinese companies are legitimate business enterprises.

However, small-cap Chinese companies must be investigated fiercely before being bought as investments - fantastic sales numbers and low debt levels don’t mean much if the numbers are simply fabricated.  For the majority of investors, your best bet is to simply stay away.

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Goldman Sachs - Buy or Sell?

GS has taken a beating recently, both with the public flogging its members have taken from Congress as well as its stock price. Just how much is Goldman’s image damaged? Is it the same company it was? For my opinion, I refer you to the MS Outlook note I scheduled for myself next week:

"Buy more Goldman Sachs if share price has stabilized."

Goldman is a company of sharks, whose ambition is to make money no matter what the circumstances: usually, this is one of their selling points. Goldman taking bets against its own large clients is similar to college girls flashing their breasts during spring break: shocking, but not surprising.

In a large financial institution it’s common for one arm to take a position opposite to another, sometimes without either side knowing. For example, in one bank I know, the brokerage arm was recommending natural gas stocks to clients, as well as taking long positions in its own portfolio. The trading arm of the same firm was shorting natural gas futures. Traders for large firms are given significant independence.

Salespeople at brokerages generally have to go with the recommendations of their analysts, even if the salespeople themselves think the investments are garbage. As strange as this may sound, it is a necessity. Investing is an art, not a science, and it is highly unlikely that all brokers at a firm would agree whether a stock is a “buy” or a “sell.” For obvious reasons, a firm can’t have one broker advising clients to buy a stock while the broker at the next desk is advising them to sell it. In addition, if a broker sells something they personally recommend (but analysts of the firm don’t), they can be sued if that investment turns sour. For all these reasons, brokers must sell whatever their company’s “squawk box” is touting. Yet, when investigators find evidence of a broker selling stock that they personally hate, it’s presented in the media as “proof” that the company is corrupt.

Goldman is the same company that it was two weeks ago, only a) it could owe a large fine and face criminal charges, and b) its stock price is 27% lower. Unless Goldman is fined 20 billion dollars (the approx. market capitalization it has lost since 2 weeks ago) its stock is now a bargain.

Goldman Sachs is no angel, and never has been. It is still a company of sharks, intent on making money. It is still the firm that every broker wants to work for. And its P/E ratio is 6.1.

Goldman is a buy.



Price (at time of writing): $145.20

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“As a public company, Goldman Sachs will have the financial strength and strategic flexibility to continue to serve our clients effectively as well as to respond thoughtfully to the business and competitive environment over the long term.”
Henry (Hank) Paulson, former U.S. Treasury Secretary, during his time as Goldman Sachs CEO, June 1998.
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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.