--FILE--A customer shows a cup of Luckin Coffee at a store of China's new coffee brand Luckin Coffee in Beijing, China, 22 December 2018.

Chinese startup Luckin Coffee is reportedly seeking to list on the Hong Kong stock exchange, according to research firm EqualOcean. Investment banks have begun to prepare listing materials for the IPO, EqualOcean said. Luckin was founded only 13 months ago, and quickly emerged as a fierce challenger to Starbucks in China. Luckin's estimated valuation is now $2.2 billion, after B-round funding of $200 million in December. It has opened 2,073 stores in China, aiming to launch another 2,500 in 2019. The company refused to comment on the IPO plan.

Avoid Investing in Frauds in China Using This Simple Framework

Ho Khinwai
Ho Khinwai

Luckin Coffee, TAL Education Group, Puda Coal, Kangmei Pharmaceuticals, Huishan Dairy, Sino-Forest…

Singapore investors would also remember the S-Chip debacle of 2009 with stocks like China Sun Bio-Chem and Eratat Lifestyle.

These are just some of the many scandals that have plagued Chinese stocks. Thanks to these black sheep, some investors avoid investing in China altogether.

More recently, the US Trump administration has also announced their intentions to delist Chinese stocks on US exchanges that do not comply with US accounting and listing standards.

While such news leave the impression that China is full of stock scandals, there are also great businesses that have doubled, tripled, 10x and even 50x their value for shareholders over the past 2 decades.

These are just some of them:

We should also point out that although it seems like “the wild, wild West East” in China (where frauds run prevalent without control), fraudulent companies can be found in any stock market or economy – with some markets possibly having even more frauds as a percentage of total firms…

Of course, we don’t hear about them because, well, they are not too prolific / too small / not media-worthy…

You’re likely to find quite a number of them in emerging or frontier markets where the economy is still fertile, the regulations are still premature, and the stock market is heavily dominated by retail traders and the state.

That said, what should you look out for if you want to invest in China while avoiding these frauds?

Use this simple framework…

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.” but 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
By the way, you can easily find Quality of Earnings for any A-Share or HK-listed Chinese firm on the Dr Wealth App! 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.
Source: own
  • 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 overvalued: like 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 preempt 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?

Now What?

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!