Janus Henderson: China investing part 3 - financial ratios

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Marktausblick

To help inform investors about risk in China, Janus Henderson presents this wide-ranging educational series – China investing: Signals and Smokescreens. This is based on an in-depth study of China stocks that underwent periods of intense financial stress in recent years.

09.07.2018 | 12:25 Uhr

​‘Even a tower a hundred yards tall, still has foundations on earth.’

Don’t suspend disbelief in extraordinary circumstances;
everything should have a basis in reality
- Chinese proverb  

Given the high-growth environment of China’s economy, certain companies have been experiencing rapid expansion on a scale not evident in the West and this is expected to continue in the medium term. A result of this is that investors are sometimes inclined to accept figures that appear ‘too good to be true’ as a result of their desire to ride the wave of China’s growing success. However, this suspension of disbelief sometimes means investors refrain from assessing whether changes on a given Chinese company’s financial statements stand up to reason.

The starting point for all of the ‘Signals and Smokescreens’ case studies has been an analytical review of the balance sheet, cash flow and profit/loss of the Chinese companies in our data set that were subjected to a short attack*. This helped us to look for signs of anomalies in the reporting on the underlying business and for indications that the controlling shareholder(s) might have manipulated the accounts in an effort to inflate the share price which, in turn, could have provided the short sellers with a reason to initiate coverage.The purpose of this review was not to identify cases of manipulation ‘after-the-fact’, but to determine whether key financial ratios, in conjunction with a thorough examination of the company’s governance and other external factors, might have made it possible for investors to anticipate turbulence in the share price and thus avoid losses.

Beyond the numbers

Lupe

As is the case in more mature markets, in our view some form of quantitative screening should be the starting point of the investment process in Chinese equities. However, in light of the high-growth nature of China’s emerging market, more importance needs to be placed on contextualising and cross-checking a company’s financial statements in order to determine their veracity.

Evidence of any outliers or inconsistencies in financial figures and ratios should act as a strong prompt to look ‘beyond the numbers’ into a given company’s governance and internal controls to identify the real causes of anomalies.

Moreover, a comparison of a company’s financial statements with external factors, such as global industry norms or relationships with suppliers and customers, can help to highlight cases where reported profits and growth are just not credible.

Key figures and ratios

We examined absolute changes in values, such as rapid increases in receivables days or short-term debt, in addition to relative changes, such as widening divergence between net income and cash flow. Some of the key figures and ratios that we found particularly useful in evaluating a given company’s financial position included the following:

  • Increasing receivables days – this could suggest aggressive revenue recognition and/or an inability to collect funds from customers, which is a common problem in China;
  • Inventory days – rapid increases might indicate that sales growth is slowing, whereas rapid decreases could indicate the flooding of distribution channels, which might not reflect actual sales by distributors;
  • Large increases in asset growth – some companies occasionally use intense M&A activity over short periods as an opportunity to book large gains, particularly in intangible assets such as goodwill or assets evidenced by paper documentation rather than physical existence;
  • Increases in short-term debt – this might indicate that a company is struggling to generate free cash flow from operations;
  • Increases in deferred assets – this can indicate an attempt to manipulate profits by delaying the recognition of costs;
  • Increases in margins – large jumps in margins can indicate that a company might be understating its expenses or overstating its revenue and profit;
  • Increasing divergence between net income and cash flow – this could suggest, among others things,  delays in receiving cash settlement for sales already booked, aggressive recognition of revenue or the flooding of distribution channels to maximise profit;
  • Increasing divergence between cash holdings and interest income – if there is a negative correlation between cash holdings and interest income, or if interest income is inordinately small, this can suggest that a company has exaggerated its cash holdings;
  • Divergence between depreciation and fixed assets – falling depreciation relative to fixed assets can indicate the exaggeration of the useful life of assets.

Financial ratios – risks in practice

The above examples are by no means exhaustive but by looking at the these figures and ratios, amongst others, we found some rather striking warning signals in the financial statements of foreign-listed Chinese companies, which strongly indicated aggressive application of accounting standards in order to drive up share prices or, in the most egregious cases, to manufacture the results:

  • Inaccurate imports - A scrap metal recycling company that was reporting revenue growth and outputs of processed recycled metal that far exceeded its nearest competitor, despite the fact that its capital expenditure was comparatively low. In trying to determine the plausibility of these numbers we noticed that, in order for the company to actually be producing its reported output, it would have had to have been importing more scrap metal in a single month than the Chinese Ministry of Environmental Protection permitted in a whole year. This information was readily available from the Chinese internet and suggested that many of the company’s figures had been fabricated.
  • Manipulated margins - A mining company that manufactured and distributed coking coal with EBITDA margins of between 60%-68%, which were stratospheric in comparison with those of its fellow industry peers, which ranged from anywhere between 10% to 45%. Moreover, these margins remained eerily consistent despite the company operating in a cyclical industry in the middle of a recession. For example, in one year, the EBITDA margin increased despite its sales declining 6%, its production costs per ton increasing by 13% and its average selling price declining by 18%. Thus the reported results could not possibly be squared with any objective reality.
  • Soaring shares - A manufacturer of capital equipment for the production of photovoltaic cells used in solar panels, which claimed gross margins of 85% and 55% profit-before-tax margins, figures which were vastly superior from its competing capex equipment manufacturers in China. Further investigation revealed ballooning ‘days-in-receivables’ from a customer under common management. This strongly implied that the management was manipulating margins and effectively funding the privately-held, onshore related party with publicly raised cash from shareholders of the listed entity. These events coincided with an increase in the listed company’s share price of 600% in a single year. Not long after this information was disclosed in the annual report, the stock price suffered a decline of 47% and trading was suspended after the Securities and Futures Commission launched an investigation. At the date of writing three years later, the shares remain suspended.
  • Trees that fell themselves - A forestry company which claimed to harvest over one million metric tons of woodchips in a given year, but which only had just over US$200,000 of depreciating fixed assets, as the balance was still ‘under construction’. Further inspection showed that the only fixed assets which were depreciating were vehicles; this logging company had no logging equipment. There was another forestry company which saw vast increases in its revenues and net income over multiple accounting periods without anything like a proportionate increase in its capex spending, thus implying that the company was somehow able to double its logging capacity without investing in more logging equipment. Further inspection of the profit and loss account revealed that almost all of the company’s profits had been derived from arbitrary revaluations of forestry assets rather than the sale of timber.
  • Inverse correlations - A Chinese valve manufacturer claimed that their margins were directly related to their R&D spending. However, the company then reported significant decreases in R&D spending from an already miniscule 0.3% to 0.1% of revenues in the same year as they posted increases in margins from 6.4% to 24.5%.
  • Dubious assets - A leading Chinese e-commerce business showed that the level of intangible non-current assets held in the balance sheet had grown from around 25% of net assets to almost 60% in the first three years after the IPO. Most of these increases derived from write-ups in goodwill during an intense acquisition spree plus revaluations of ‘investments in equity investees,’ despite these investees showing consistent losses and with book values that no longer accurately reflected their market value. This company has a corporate structure with over 500 hundred subsidiaries, which in turn raises the risk of misstatements remaining undetected by the external auditors.

Green flag indicators and balance

We found that there was a clear correlation between companies with strong governance and balance sheets comprised mainly of well described, recognisable tangible assets where certain key ratios and figures appeared rational and consistent with similar businesses outside China. Or, where they were inconsistent, there were plausible and independently verifiable reasons provided to believe that such inconsistency was genuine. So for example, if the identification of a red flag consisted in the divergence between fixed assets and depreciation, the corresponding green flag could be the company providing verifiable evidence that the fixed assets had only recently been purchased and were therefore at the early stages of their useful lives. Alternatively, if a red flag consisted in a rapid increase in inventory in a company whose products are paid for at the point of sale, the corresponding green flag might consist in the company demonstrating that it operates in a seasonal industry and that it is more economical to focus on production in the low season in order to allocate funds to distribution when the demand is higher.This being said, even where the numbers appear to stack up, it is important to maintain a sceptical approach to uncover further reasons to believe that those figures accurately portray the true state of the underlying business.

Summary

The table below shows the flags that were most instructive in our analysis.

Red flags Green flags
Increasing receivables days – this could suggest aggressive revenue recognition and/or an inability to collect funds from customers. Explained increasing receivables days – a positive if reflective of industry trends or a change in customer mix that alters payment terms.
Abnormal inventory days - rapid increases might indicate that sales growth is slowing; rapid decreases could indicate the flooding of distribution channels, which might not reflect actual sales by distributors. Key ratios and figures that appear rational and consistent with similar businesses, reflect seasonal trends or mark a change of strategy that is clearly articulated by management.
Large increases in asset growth – some companies occasionally use intense M&A activity over short periods as an opportunity to book large gains or mask organic shortfalls. Well-articulated acquisition or expansion strategy, which enhances the company’s growth prospects.
Increases in short-term debt – this might indicate that a company is struggling to generate free cash flow from operations; Explainable increases in short-term debt – could be in conjunction with rising receivables and increased inventories
Changes in margins that don’t reflect industry trends – this could suggest a deferral or understatement of costs or an overstatement of revenue. Economies of scale and gains in efficiency could result in industry-leading profitability
Divergence between net income and cash flow could suggest problems with cash collection or aggressive recognition of sales. Slower than average cash collection may well be a sector norm but should be seen alongside the ability of management to mitigate the effect.

Investment team perspective

Mike Kerley, Director of Pan-Asian Equities and Portfolio Manager at Janus Henderson Investors:
“Although the numbers are always a good starting point for making an informed and successful investment decision they must be analysed in  conjunction with a full understanding of the industry in which the company operates. Behind the numbers may lay an opportunity or a risk – only in-depth analysis will determine which it is for investors.”


Note:
*In a short attack, firms conduct extensive desk analysis and on-the-ground due diligence of a listed company that they suspect of being either fraudulent or of manipulating their share price. After gathering their evidence, these firms take large short positions before publically releasing negative reports on the company in question in an effort to depress its share price and profit from their short positions.

Part 1: Janus Henderson: China investing - China-specific risk
Part 2: Janus Henderson: Risk, with Chinese characteristics
Part 4: 
Janus Henderson: China investing - board oversight
Part 5: Janus Henderson - China investing - material and related-party transactions


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