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How to Invest in China Stocks

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China’s economy has grown exponentially over the last century. Although recent headwinds have seemingly slowed it down, China is poised to continue its growth story in the coming decades. 

The China stock markets offer a totally different investing game which caught many growth investors off-guard in 2021 when China stocks took at hit due to a nationwide regulatory crackdown.

In this guide, I hope to provide an introduction to the China stock markets and an applicable framework which you can use to find growth opportunities.

Guide to Investing in China

Psst… No time to read the full guide right now? Download the PDF version here!

Why China?

1) 2nd Largest Economy in the World

  • Poised to surpass the US to become the largest economy in the world
  • Growth by consumption (much more sustainable) than by trade
  • China’s expected GDP growth rates are at 4.2% through 2025 and 3.5% until 2030

2) Opening Up of Capital Markets in China

  • Foreign ownership restrictions gradually being lifted
  • China is 2nd largest stock and bond market globally
  • Shares starting to be included in global indices
  • Many pricing inefficiencies due to a non-mature stock market (which will mature with time)

3) Rising Global Dominance of Chinese Companies

  • China companies are some of the popular and most valuable companies in the world including Tencent, Ping An, Haidilao, Alibaba, Xiaomi, Tencent, Baidu
  • Huge potential to capture multibaggers on the next cycle.

Understanding China as an Investor

The Lay of the Land

China is home to 1.4 billion people – making it the most populous country on the planet. This huge country in Asia is divided into 34 parts – with the majority of them being provinces.

While it is not as pertinent to know each province and city in detail, you should note that the coastal provinces (found on the East of China) are much more urbanized, wealthy, and population-dense as compared to the inner Western parts of China.

Click here to see a map of this distinction.

Tier 1 cities (and provinces) are the most well-developed areas of China. Herein resides many consumers with a lot of spending power, and is home to many businesses and MNCs. You can expect to find cities like Shanghai (29.9 million people), Guangzhou and Beijing here.

Subsequent tiers are less well-developed and get increasingly rural.

🤨 “Why do I need to know this?”

As an investor, it is useful to note the demographics of the customers of the company you’re analysing. 

  • Are they differentiating their product mix and marketing methods in a Tier 1 or Tier 2 city versus in a Tier 4 city?
  • Are their expansion plans into rural cities logical?
  • Should they have chosen a more urban city?

A little understanding of these differences will help you better evaluate whether growth plans of Chinese companies will be successful. 

The One-Party Rule

Even though the Chinese government is known as the Communist Party of China (CPC) and has its roots in communism, modern China has evolved significantly in both ideology and government control. 

The incumbent president and General Secretary is Xi Jinping, who has been Head of State since 2012. President Xi has been a pivotal figure in China’s urbanization and economic growth – starting his presidency with the announcement of a large-scale project known as the Belt & Road Initiative (一带一路).

His other notable directives include the “China Dream” as well as “Made in China 2025”. He is also the man navigating China through the COVID-19 pandemic with a dual pronged zero-COVID policy and economic growth at all cost approach.

🤨 “So what?”

As an investor, it is critical that you understand how the CPC works and the thoughts of President Xi. Chinese companies are, in one way or another, controlled by the CPC and it makes sense to know the plans or initiatives the CPC has. This could effectively foreshadow the level of growth or even survival of a company.

For instance, we at Dr Wealth have long identified that ESG themes such as environmental protection have been one of CPC’s key focuses over the last 5 years. Companies which were manufacturing goods harmful to the environment had subsequently been forced to convert their factories and operations to meet environmental standards.

Companies which were not financially strong in the first place had to take on unsustainable amounts of debt to sufficiently comply or be forced to shut down. 

The Truth behind China’s infamous Regulatory Crackdowns

There have been multiple regulatory crackdowns across the years and industries. While each crackdown looks like a repeat of the past, each has its own agenda and objective. Some companies will inevitably survive and grow stronger from each crackdown, while some will not.

Thus it is not entirely true that policy in China is “unpredictable”.

Yes, policy may be hard-handed and surprising at times – but many times, you can trace it back to what the Chinese government is trying to achieve from their public official missives.

Alternatively, you may enjoy reading President Xi’s thoughts on his “socialism with Chinese characteristics” form of governance in his book – The Governance of China. 

In it, Xi highlights ideas that you can see were defining themes of CPC’s policies. These include scientific innovation, having open and shared development, energy conservation and environmental protection, strengthening national security and so forth.

The People of China

The language of Chinese people is Mandarin (Putonghua). However, if you visit different parts of China, they may speak different Chinese dialects and engage in markedly different customs and cultures. 

This is another key factor that may make or break Chinese companies’ expansions into different cities. Thus, even business growth within China itself has very uncertain outcomes.

China’s population is quickly aging – as with many other fully-developed nations. 

You can see from the chart below that China is in the middle of an exponential curve in growth of the elderly population. It is also forecasted that China’s percentage of elderly may even exceed that of US and UK by 2050.

China’s birth rates have been declining with an average of 10.645 births per 1,000 people in 2023, nearly half of the birth rate just a decade ago. 

Moreover, longer life expectancy also has exacerbated this problem – the median age a Chinese person can be expected to live is at 77.1 years (2021 figure). This is in line with the life expectancy of developed nations like US (77 years), but not as problematic as countries like South Korea (83.2 years) or Japan (84.8 years).

This presents both problems and opportunities for us investors looking into China. We fear that China’s economic growth may be harder to sustain because of lesser productive workers in the economy. This will not become problematic within the next 10 years, but there is a risk if the CPC does not adjust policies for population growth and if forecasts prove to be accurate.

On the other hand, there are opportunities investors may wish to seek – especially in the healthcare and medical space.

The Chinese Growth Story

It is important to understand how China has grown to become the global superpower it is today. Below, we have identified 4 key drivers that we think have contributed tremendous growth for China – and that we believe will continue doing so for the next decade or two:

Belt & Road Initiative (BRI) 

BRI (一带一路) is a global infrastructure project aimed to help improve China’s connectivity along key trade routes and improve its cooperation among countries.

BRI has undoubtedly generated enormous benefits for China (aside from its beneficiary countries). At this stage of development, domestic construction demand has been boosted as well as lending activity.

We think that once the new trade routes have been fully completed, China also stands to benefit from growth in exports, lower cost of imports, RMB appreciation, and larger investment flows.

As China’s domestic growth slows, we believe BRI will become a huge contributor for its future growth.

Consumption Upgrades & A Rising Middle Class

I’ve done a good amount of analysis on Chinese companies thus far – and with most these, growth is almost always attributed to consumption upgrades and a rising middle class.

Since opening its economy more than 40 years ago in 1978, China has undergone rapid industrialisation and urbanisation – resulting in many Chinese getting higher-paying, higher-skilled jobs. This also led to a fast growth in household incomes among the middle class.

It is estimated that by 2030, more than half of urban households would fall under the upper-middle class group – earning between US$16K – US$34K per year.

By 2030, China’s private consumption is set to reach US$12.7 trillion, about the same amount that American consumers currently spend. This figure is more than double the US$5.6 trillion Chinese consumers spent in 2019. Disposable income per capita will likely double from US$6,000 a year to US$12,000 in 2030.

As such, we can see more people from the rural areas coming to live in urban cities like Shanghai and Shenzhen, and eventually migrating there.

As disposable incomes grow, spending habits become more sophisticated. For instance, Chinese parents would be in a better position to focus on their kids’ education and spend more on extra curricular activities like piano lessons or dance classes. Due to the focus on healthy living, a larger proportion of the population are now spending more on healthier food options and on exercise equipment. Such a phenomena is known as “consumption upgrades” in China.

For the younger generation of Chinese consumers, retail spending has grown (and is expected to continue at more than 10% growth rate).

We think that over the next 10-20 years, as the Chinese economy continues to shift to higher-value production and a services economy underpinned by technology, more rural areas will have to be redeveloped to meet this growth.

Many rural Chinese (over 40% of population) will start to enter the mass middle class and become key drivers of the economy in the future.

Liberalization of Financial and Capital Markets

We think this is the reason why it is time to look at China and Chinese stocks now.

China is home to the SECOND-largest bond and stock market in the world worth nearly US$20 trillion – yet it is still almost entirely funded by domestic investors.

In the last decade, China has accelerated the opening of capital markets – with the most notable one (we think) being the A-share inclusion into global indices like the S&P DJIA, MSCI and the FTSE Russell. Over time, this inclusion factor has increased as China’s stock market has increased in size.

With a larger global exposure, it has increased fund flows into China and makes markets (and stock valuations) more efficient.

Right now, China’s stock market is *still* heavily dominated by retail investors (~90%). By investing in Chinese stocks which are under-looked, undervalued, and have good growth potential now… investors can still take advantage of market inefficiencies and earn a respectable alpha (excess returns) on their holdings as the market matures and gives them the proper valuations they deserve.

China’s stock market is definitely not what it used to be 20-30 years ago.

Back then, Chinese companies were involved in scandal after scandal. Misappropriation of assets, fraudulent accounting, taking advantage of minority shareholders, reverse mergers…they had it all.

However, we believe over the years China has cleaned up its act and introduced financial reforms with strict regulations on par with those of international bodies.

While we cannot guarantee there wouldn’t be risk investing in China, we think the benefits of being IN China far outweighs any perceived risk associated with it.

At Dr Wealth, we dedicate an entire segment in our due diligence to looking for such red flags unique to China, before presenting our case studies to our members.

Digital Transformation

China is now a tech giant, deemed as second only to the United States. It is even a leader in certain segments, tapping on innovations like 5G, Blockchain and IoT (Internet of Things) a lot faster than most other nations.

This focus, plus a unitary-state structure, allows China to quickly adapt and essentially “leapfrog” the US in tech adoption.

For instance, China had been quick to transition from cash to mobile payments (through Alipay and WePay) when the technology was available, bypassing credit and debit cards.

In 2015, China announced a ‘Made in China 2025’ project that aimed to move the country from being “the world’s factory”… to producing high-value products and services – especially in high-tech fields like pharmaceuticals, robotics and aerospace.

With MIC 2025, China is effectually developing EVEN MORE Chinese companies to become self-sustaining global powerhouses – besides the current BAT companies, Huawei, and a smattering of others.

According to the World IP Organisation, China has filed the most international patents overall in 2021, almost 20% more than that of the US at 2nd place!

New China powerhouses will emerge from this digital revolution – and this means investors have no lack of growth opportunities looking into China.

Five Year Plans

The CPC drafted its 14th five year plan for 2021 through 2025 against a backdrop of an uncertain global climate. The plans formulated usually includes strategies for reforms and economic development, and the setting of the country’s economic growth targets.

The 14th five year plan outlined priorities focusing on both the current issues and positioning the country for the longer term.

Examples of immediate term priorities revolve around making improvements to agricultural and rural development, public healthcare services and modernisation of its military strength.

Longer term priorities include significant investments on ESG and innovation themes such as a digital ecosystem. ESG themes that the government is allocating large investments to include clean energy and water purification while innovation themes are focused on cloud, blockchain and hardware resources such as chips.

How to Invest in Chinese Stocks in Singapore?

Being exposed to stocks in a new market can be scary, especially when it’s a market where the language and investing culture might be different.

I’ve been there before.

Here, I want to help you figure out the mechanics of how you can actually go about investing in Chinese stocks.

The Chinese Stock Market

There are 3 domestic stock exchanges in China:

  1. Shanghai Stock Exchange (SSE)
  2. Shenzhen Stock Exchange (SZSE)
  3. Hong Kong Stock Exchange (HKEX)

Most Chinese stocks (65%) are listed on these exchanges.

Companies incorporated in China can issue 3 different classes of shares (A, B, H):

  • Most Chinese stocks are A-shares and are quoted in the domestic currency, CNY. 
  • B-shares are similar to A-shares. They are listed on SSE or SZSE, but quoted in a foreign currency (ie. USD or HKD). We won’t be looking at these most of the time.
  • H-shares are Chinese companies listed on the HKEX and are traded in Hong Kong dollars (HKD). 

Read this for a detailed comparison of A shares vs H Shares vs ADRs

The Chinese stock market is still not as developed as other mature stock markets like the US or the UK.

You should expect this market to be very volatile and speculative as most (80-85%) of the stock market participants are retail investors or traders like you and me, rather than institutional investors.

That said, we should NOT be afraid of this volatility.

In fact – this presents long-term investors with multiple opportunities as we can buy stocks at irrationally attractive prices and ride the Growth Dragon!

Let’s now get into the technicality of buying Chinese shares…

4 Ways to Invest in China

Direct: Buying China A-shares (or B-shares)

Indirect: Buying China H-shares through Hong Kong

Buying Chinese ADRs on US Exchanges

1) Direct Buying A-Shares

To buy A-shares directly, you need to either:

  1. check if your existing broker has a SZSE or SSE service opened for you to trade; or 
  2. open a domestic brokerage account in China or Hong Kong.

We suggest opening with a broker in Hong Kong as it is relatively easier, with the whole process worded in English. 

With a Hong Kong broker, you are allowed to trade A-shares through their platform as a result of an initiative known as the Shenzhen-Shanghai-Hong Kong stock connect.

Note that for most brokerages, you will not hold the shares in your name – but in a custodian account managed by your broker.

Some of the more well-known brokers that provide custodial access to China are Interactive Brokers and Boom Securities (in Hong Kong). These two allow foreigners (including US citizens) to open accounts with relative ease.

Once you have access to Chinese markets, the first thing you’ll notice is that China-listed stocks have stock symbols with 6 numbers.

You’ll also find that many companies will list their origin province / city / county first (ie. “Jiangsu” city followed by rest of company name “Etern”).

Chinese shares are traded like how you would any other stock.

China Stock Market Trading Hours

  • For SSE, trading hours are 9.30am to 3pm (China Standard Time) with a 11.30am – 1pm lunch break.
  • For SZSE, trading hours are 9.30am to 3pm (China Standard Time) with a 12.30pm – 1pm lunch break.

2) Indirect Buying H-Shares through Hong Kong

Some well-known Chinese companies have bypassed SSE and SZSE and chosen to list on the Hong Kong stock exchange.

For instance, Alibaba (HKSE: 9988) and Xiaomi (HKSE: 1810).

To complicate things further, there are also Chinese companies that may be listed BOTH on the Chinese exchanges as well as the Hong Kong ones – with slight price differences.

Like PetroChina and the Bank of China.

If you’re looking to ONLY invest in Chinese stocks listed on the Hong Kong stock exchange, a wider range of brokers are available to you – including TD Ameritrade/Charles Schwab, Fidelity, and E*Trade.

However, we’d still strongly suggest opening a Hong Kong broker account (see above A-shares for broker recommendations) as many of our stock ideas will only be listed on the A-shares market.

Here’s why (it comes from a Chinese proverb)…

肥水不流外人田。

This (roughly) translates to “benefits are kept within the family, and not given to outsiders”.

The Chinese inherently believe that treasures that are coveted should be closely guarded.

It goes to reason that the best companies in China (especially those of national interest) are also geographically rooted within China – with the majority of its equity kept within the Chinese markets. 

3) Buying Chinese ADRs on US Exchanges

Some Chinese companies may list on overseas exchanges – such as in the US or UK – as ADRs (American Depository Receipts) or GDRs (Global Depository Receipts).

Companies like Alibaba (NYSE: BABA) and NetEase (NASDAQ: NTES).

Granted, these Depository Receipts (DRs) allow overseas investors to invest in the Chinese market easily…however, they are NOT stocks.

This means that DR holders do not have the same rights as traditional shareholders and cannot vote in meetings.

I generally do not recommend investors to own an ADR or GDR as it introduces more risk and complexity to the whole equation.

If you have the option, you should seek to directly own shares of the underlying company.

4) Buying Chinese ETFs (Exchange-Traded Funds)

This is the most convenient out of all the above methods – as there’s no stock picking involved and you can buy China-focused ETFs on most exchanges. 

If you’re interested, I’ve compiled a list of the Best China ETFs here.

For Singapore investors, these are the China ETFs available on SGX: 

Do note that some of these ETFs only represent segments of the China market. For instance, XT CSI300 only tracks the Top 300 A-shares listed in SSE/SZSE, while XT China50 only tracks the Top 50 Chinese companies listed in Hong Kong.

The ETF most representative of the overall China market would be XT MSCHINA – which tracks all large and mid cap Chinese companies (including H shares, B shares, Red Chips, P Chips and foreign listings).

If you are a foreign investor or have access to other markets, there are many more options to choose from. Popular market ETFs include Ishares China Large-Cap ETF (NYSEARCA: FXI), Vanguard Total China Index ETF (HKSE: 3169) and the iShares MSCI China ETF (NASDAQ: MCHI).

Besides that, there are also interesting thematic or sector ETFs if that is up your alley. Popular ones include KraneShares MSCI All China Health Care Index ETF (NYSE: KURE) which is focused on Chinese pharmaceutical companies, and KraneShares CSI China Internet ETF (NYSE: KWEB) if you’re bullish on China’s tech giants like Alibaba and Meituan Dianping.

ETF.com is a great resource to find an ETF you’re comfortable with.

As with any other ETF, make sure there is a good amount of trading volume and take note of expense ratios (as they will eat into any returns you have!).

China companies are Everywhere

If you’re living in Singapore, realize that Chinese companies are EVERYWHERE. You just got to look closely!

For instance, I noticed my new flat was built by China Construction (Rich Construction is its subsidiary).

You would also see many tunnelling and MRT projects have more Chinese companies involved, vying for market share from Singapore, Korean and Japanese companies.

You have companies like Shanghai Tunnel Engineering…

Even Jewel and Terminal 1 uses air conditioning from Chinese home appliance company, Midea!

There is little excuse not invest because we are unfamiliar with Chinese companies. It just takes a little more observation and reading to get comfortable with them!

Chinese Companies Are Not As Dangerous As You Think

The scandals regarding corporate mis-governance of Chinese companies back in 2000 has left a deep mistrust of Chinese companies for many investors.

Back then, there were many cases of misappropriation of assets, fraudulent accounting, taking advantage of minority shareholders, reverse mergers…

However, it has been 20 years on – and we believe China has cleaned up much of its act and introduced financial reforms with strict regulations on par with those of international bodies.

For instance, Chinese companies have been complying with China GAAP since 2007, and its reporting structure very similar to US GAAP. Over the years, China GAAP has been converging closer to the international reporting standard (IFRS) and is last reported to be 90% similar to IFRS.

China is even in negotiations with the US SEC to revise its audit rules and to open up Chinese ADRs for on-site audit inspections of Chinese companies listed on the NASDAQ and NYSE.

This gives us a lot of confidence that China’s capital markets is becoming increasingly transparent for retail investors like us.

But don’t take our word for it – the late Charlie Munger had been investing in China for over 15 years and he said this in a Forbes interview,

“the strongest companies in the world are not in America… I think Chinese companies are stronger than ours and are growing faster.”

That said, we don’t want to blindly believe what Chinese companies (or what any public company) report on their financial statements.

At Dr Wealth, we think it is important to do extra due diligence to check for any possible red flags with these companies in our analyses and case studies to members.

For instance, we check for things like the amount of dividends they have been paying out. Profits can easily be manipulated by companies – but when dividends are given (and if they distribute a sizeable >50% of profits as dividends), it signals that they have indeed generated enough cash on their hands.

Dividends are not the only things we look at. We also have our own set of proprietary checks that look for accounting irregularities and potential fraud.

Sometimes those are not enough. As retail investors – we do not have specialized tools or insider information and have to solely rely on the primary materials the company provides us (ie. Annual Reports, MD&A).

Thus, we cannot definitively know if top-line reporting items like revenues are being artificially inflated, or if income is actually coming from non-core operations or related-party transactions.

This is why we also rely on looking at short seller reports from companies like Bonitas and Muddy Waters. 

No system of checks can guarantee that we eliminate 100% of fraudulent companies. However, they should provide us with enough information to avoid investing in things like Hyflux or the exposé of Luckin Coffee.

Reliable Investing Resources for Chinese Companies

If you are investing in a Chinese company for the first time, you may not know where to look for certain pieces of information ie. Annual Report or company news.

Over the years, we have found Sina Finance to be very useful in terms of our research. Another great site is AAstocks. 

These sites provide a plethora of information (financial statements, ratio analysis, research, corporate announcements, stock-related news, etc.) on Chinese and Hong Kong stocks, but they are only displayed in Chinese.

Fret not, if you’re using Google Chrome, the page will automatically be translated to your commonly used language.

Although you should note that the translation is 100% accurately nor does it translate to proper (or coherent) English sentences all the time.

But if you can get the *gist* of what the text is trying to say, that’s good enough.

Oh, by the way – you can also use Google Translate if the company has published its Annual Reports or company announcements in Mandarin!

Simply copy and paste the text into Google Translate and let Google work its magic…

How to avoid Investing in Frauds in China?

The Fraud Triangle

The Fraud Triangle considers these 3 components when determining if a company is likely a fraud or not, and it’s a popular framework among analysts, risk managers, and auditors alike.

An easy way to remember this is “R.O.I.”, although its usage does not have to be in that order.

Although it is a Western-based framework, we will demonstrate how you can use it to avoid investing in fraudulent Chinese companies.

Intent

We first look at “intent” (once again, the order does not matter).

When considering intent, figure out if there are any motivations for that particular company to commit fraud.

The most common intent is to hide poor operating performance. This can be done in many ways such as:

  • fabricating sales invoices to boost revenues (ie. Luckin Coffee),
  • faking sales by round-tripping assets with related parties,
  • aggressively capitalizing expenses,
  • factoring receivables to generate cash flows,
  • “overpaying” for assets to hide nonexistent cash, etc…

Because there are so many ways a company can hide poor performance, there is no “definitive list” of items an investor can check against. Even if such a list exists, any company which intends to defraud investors will find more creatives ways to do so without getting caught.

Hence, investors need to figure out if there is a high likelihood for such intent.

Here are some things to look out for:

  • High or unsustainable debt levels (Debt/Assets, Debt/Equity)(studies have found fraudulent firms generally have higher leverage)
  • Earnings surprises are always expected by investors
  • C-level management remuneration policies and/or stock option plans are based on short-term or unsustainable results (ie. compensation based on a growing market cap; meeting EPS or revenue targets)
  • Low quality of earnings (Operating Cashflows/Net Income), an indicator of poor underlying business, leading to higher likelihood of accounting shenanigans taking place
  • An ambitious (unfeasible) “3/5-year plan” by company to grow, in a highly competitive industry with historically low margins
  • Aggressive historical growth by acquiring subsidiaries and doing joint ventures instead of growing organically

With this company, Quality of Earnings has been consistently very low for 2015, 2016, 2017. Therefore there is a higher likelihood that earnings may have been managed. Recently, a short seller report has been published against the company and their 2019 results have been delayed

As you can see, all of these requires you to dig deep to understand a business well vis-a-vis its competitors/stakeholders.

The red flags differ for each company, depending on its history and present situation. For example, numbers like “Quality of Earnings” may be revealing for some companies (like the example above) and yet be inconclusive for others.

Opportunity

In considering opportunity, find out where the weakest links are for the company. Where are the *opportunities* for fraud to happen?

Here are a couple of examples:

  • Weak internal control or accounting policies: read the ‘significant changes in accounting policies‘ section within the Annual Report, and see if the “tone” or language has changed over time.

Source: Spruce Point Capital Management (activist firm). The report highlights that management has removed the words “long-term” from its revenue recognition policies its 2018 Annual Report. The effect is that revenue can now be recognized more loosely – which helps the company boosts sales to meet earnings targets or in times where actual sales are low.

Ineffective Board of Directors or controlling shareholders:

These parties fail to perform checks and balances on management, allowing rogue practices to occur.

🚩Some Red Flags include:

  • Boards with few independent Directors and dominated by key management.
  • “Independent” directors with a history of being employed by the company.
  • Chairman of Audit committee is an executive of the company.
  • Chairman of the Board is also the CEO of the company. (Dual-key positions)
  • Controlling shareholders are management themselves.
  • Controlling shareholders are state-owned Venture Capital firms which do not actively influence management.

Complicated shareholding or organizational structures

Yeland Group (now HNA) was under scrutiny due to its opaque equity structure. The company also engaged in aggressive debt-laden acquisitions which it has trouble paying now due to the COVID-19 situation. Source: Finance Sina 2017.

  • Industry is not regulated much by the Chinese government as other industries (ie. industrial, mining, textiles)
  • Company has a small capitalization and/or has little to no coverage by analysts, media outlets, or industry news
  • Share prices are crazily overvaluedlike now, which can lead to insiders cashing out through stock option conversions or share pledges.
  • High number of joint ventures and subsidiaries (coupled with high amounts of related-party transactions)
  • Events out of the company’s control like a recession or COVID-19, where management may engage in “big bath” accounting. This is when assets, which may or may not be existent, are written down and large expenses are incurred, such that the significant decrease in net profit can be attributed to that ‘uncontrollable’ event.

Rationalizing

Firm-wide fraud does not simply occur out of nowhere. The offenders have to accept it as the norm within the company culture. (Sadly, this is usually perpetuated by higher management).

Outsiders wouldn’t be able to tell until the fraud gets too big and starts showing itself on the financial statements.

Fortunately, there are some “preemptive” tells we can look out for:

  • Use glassdoor.com (or the Chinese equivalent, kanzhun.com) to see how employees or past employees felt about working in the organization, and their views on the management.

Source: Spruce Point Capital Management (activist firm) issuing a strong sell. Insights from employees pre-empt management’s desire to meet numbers, which show up through aggressive revenue recognition practices within the financials

  • Analyse YouTube videos of top management personnel giving presentations or interviews.
    • What is your first impression of them? Humble? Braggy? Narcissistic?
    • Do they oversell the company’s growth plans without concrete numbers or facts?
    • Are they open to criticism and differing opinions? (Ie. similar to Wirecard, we found a Chinese company whose management booted an analyst from an earnings call after he wrote negative reports about the company – we subsequently found more red flags with the firm)
  • Analyze management’s tone in the Management Discussion and Analysis section of the Annual Report.
    • Is it overly optimistic?
    • Do they avoid talking about negative events?
    • Do they seem like they are focused on meeting certain financial numbers or do they care about customers/employees more?
  • Do they use language that confuse you or don’t mean anything?

What’s next?

Once you have looked at these 3 components of the Fraud Triangle, you would have begun to put pieces of the puzzle together. You should start to build a rough idea of the economic realities about your chosen company.

Now, you should be more confident about investing your money into the stock (or in some cases, decide to pull out).

A Caveat and A Conclusion

By now you’d have realized that avoiding frauds is actually not easy (that’s why they say investing is an art…). While this framework can surely help, it cannot guarantee that you’ll avoid 100% of frauds out there.

What it CAN do is help you be more critical when doing your own due diligence and reduce the likelihood of putting your money into a fraudulent company.

Frauds exist on a spectrum (overused phrase, but true).

On the extreme left, there is clear, blatant, outright fraud – everyone can see it. On the extreme right, there is zero fraud. The company in question is clean and economic reality is as reported.

As you navigate towards the middle, there are earnings management and management making selective choices in financial reporting (ie. classifying dividends paid as a financing activity rather than operating activity under IFRS leading to higher Operating Cash Flows). Now you’ll find yourself wondering if you should consider that as fraud…or maybe not?

Again, question the R.O.I. and it will tell you if management is trying to hide the business’ economic reality from you.

Finally, you’d also have realized that navigating the Chinese market is not dissimilar to other markets. Human behavior behind the acts of fraud is the same – only the methods of conducting fraud may be slightly different with Chinese firms.

Note that in this article, I did not go into specific details on the methods used by Chinese companies to carry out fraud (ie. related-party transactions, accounting maneuvers, options backdating, etc.). There are simply too many and too complex for investors without a proper financial background.

The beauty of the Fraud Triangle is that you don’t need to know these methods in order to understand if a company is highly likely a fraud or not. Let’s leave that to the short sellers and the auditors.

Try the Triangle out and stay safe investing!

Follow these 4 Short Sellers

We take short sellers’ reports very seriously, after all they have entire teams researching and digging out all the dirt on companies before putting out these reports. 

1 – Muddy Waters

Muddy Waters first came to fame in Singapore when they shorted Olam. The short seller was taking on our sovereign wealth fund, Temasek, whom the latter was a Olam shareholder. Eventually Temasek made an offer to buy more stake that it didn’t already own and Olam was saved as a result.

2 – Blue Orca (previously Glaucus Research)

Their track record is excellent at 82% success rate with an average return of 51% as of end Feb 2020:

3 – Bonitas Research (previously known as Glaucus Research)

Bonitas Research got well-known in Singapore when they attacked Best World (SGX:CGN) in 2019, which was a darling small cap among investors. Simply because it had an exceptional performance in an otherwise meek Singapore stock market – Best World’s share price had gone up by 140% in less than a year.

Best World has been suspended from trading since 9 May 2019.

4 – Iceberg Research

Iceberg Research was famous for the whistle blowing efforts against Noble Group, then an STI component and a giant in the commodities business.

The mysterious outfit claimed that Noble had over-inflated the value of an Australian investment for years. The battle ensued and it took 3 years to prove Iceberg Research was more right than wrong. Noble was suspended in Nov 2018 and had to do major debt restructuring subsequently.

Alvin shared how these short sellers report saved us from Luckin Coffee previously.

3Cs China Investing Framework

The China markets experience a euphoric run in 2020 but were quickly stifled in 2021 as the Chinese government issued a series of clampdowns. This is not uncommon for the China markets, however the impact was greater this round as more investors owned Chinese stocks.

Stop using an “American” lens to look at China

The biggest lesson we can learn from the current clampdowns is that we have to approach Chinese stocks differently – China’s political system and cultural values are different from the Americans’, which we have grown very used to.

1. Central Planning

Firstly, China is a central planning government and almost everything is shaped by the top. This is unlike the U.S. where if some politicians are unhappy want to change things, they need to go through a lot of bureaucracy. They have to get it passed at the Congress and government lawsuits are not sure win cases because of a separate judicial system. Just take Facebook’s case where the judge said that 48 U.S. states had no case against it.

In the U.S., even the President has no power to change the law by himself.

China is the direct opposite.

The Politburo dictates everything. They can change the policies anytime they like. They are the legislation, executive and judiciary rolled into one.

This absolute power also means that they will not allow any private businesses or leaders to be more powerful than the government. Such prominent individuals are fine as long as they follow the government orders and pledge loyalty.

Also, China government’s clampdowns are not new. China has been doing this all the time, just that less people cared in the past. More investors have observed the rise of China and want to bet on her future now, hence any big impact on the current stock prices are keenly felt. For example, clampdown on peer-2-peer lending as well as the pharmaceutical industry two-invoice policy change in 2017 were less talked about because not many foreign investors were vested.

So, get used to it.

The good thing about a centrally planned economy is that the Chinese Government often publicly announce which industries are going to be developed. Follow the government words carefully if you want to invest in China, and you might find yourself on the right side of the markets. 

The clues can lie in their 5-year plan and other initiatives such as Belt Road Initiative, Made In China 2025 and Greater Bay Area.

  • Greater Bay Area (GBA): The Chinese Government planned to amalgamate 11 cities such as Hong Kong, Shenzhen and Macau to form a megapolis.

GBA would have a population of around 70 million, larger than the under UK (66m) or Canada (36m). It will have 3 of world’s top 10 container ports. The area would be the 12th largest economy in the world.

  • Made in China 2025 (MIC 2025) plan: There are 10 key industries that the Government wants to develop and achieve a certain level of market penetration in the world.

IT, robotics, green energy and green vehicles, aerospace equipment, ocean engineering and high tech ships, railway equipment, power equipment, new materials, medicine and medical devices and agriculture machinery are the 10 industries mentioned. And its semiconductor industry will be key to provide the chips to these industries.

Investors who are interested in investing in China can think about which companies may benefit from these developments.

2. Communism

Secondly, China is a communist country. But the Soviet Union showed that pure communism wasn’t sustainable and hence Deng Xiaoping experimented with the market economy in the late 70s. That move allowed him to balance social organisation and economic growth, and soon proved pivotal to China’s wealth today and it is now ironic that the rich-poor gap in communist China is wider than of capitalistic U.S. (0.47 vs 0.41 Gini coefficient).

China knows that having billionaires is a result of the market economy and the government wants the wealth too because it makes her powerful on the world stage. But the great wealth of individuals should not be publicly celebrated in a communist country. Any loud-mouthed proud and rich individual will be silenced one way or another.

This is unlike the U.S. where wealth is celebrated. Greed is good. Anyone can live the American dream.

Having such a social organisation means that Chinese policies would tend to protect the man on the street. One example is the policy that monopolies are not acceptable. Why? Because monopolies would eventually have the ability to raise prices and make obscene profits, harming consumers and the man on the street.

Although we also have heard of antitrust movements in the U.S., they are fangless because of point number 1 – political bureaucracy. They are not effective in breaking up the U.S. big tech and these companies just get more powerful over time.

Hence, it is better to avoid investing in monopolies in China whereas U.S. monopolies will do just fine.

3. Confucianism principles

Thirdly, China is largely shaped by Confucianism for thousands of years. The Chinese believe in a law-abiding society and the preservation of social harmony. Authorities are meant to be obeyed and not defied.

Confucianism also plays an important role in academics and imperial examinations were held to identify smart individuals to become government officials. This is still true today in China (and to a large extent in Singapore too) with their Gaokao.

It is no surprise that Chinese parents are so kiasu about their child’s education. They are merely chasing the reward and it becomes a race of who can study harder. Singapore has this problem as well, but the competition in China is probably 10 times intense, due to their population size. And companies driven by the market economy will take advantage of this and charge an arm and a leg for tuition.

This is why the Chinese government has to intervene.

Xi Jinping believes in Confucianism and wants to shape Chinese society following those virtues more closely. Maybe it is time for investors to read the sacred texts to understand Confucianism – four books and five classics.



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