HuaBao International (0336.HK) a fool's gold? Part 2

While there are many dos and don'ts that you can find online.  This is a quick and dirty checklist on Asian stocks you can use to raise red flags.  It is not meant to replace detailed due diligence.

(1) How did this stock obtain a listing?  Plenty of articles about fraudulent companies coming to the market through a Back Door Listing (i.e. reverse merger / takeover) of a listed shell.  Just Google it to learn more.  They have less onerous listing requirements.

(2) Watch out for the market capitalization sweet spot.  Market cap will likely to run into billions.  I would say between HK$$5bn and HK$$20bn. The pay off has to be big for such an elaborate stunt.  Do not forget there is a whole list of bureaucrats, politicians, business associates to pay off.

(3) Look at Insider and Substantial Shareholders.  You want them to have skin in the game, but you also want to look at their exits. You want to at least understand the complex company structures that they use to hold their shares.  The chain of companies that they use is usually because there are shadow shareholders.  You also to do a quick name search on Google / Baidu.

(4) If it is too good to be true, it generally is.  Doing business in China is hard.  So when a business seem to have very good margins, you bet it will attract many new entrants and the margins will quickly evaporate.  So at least try to do some high level industry analysis.  Porters Five Forces is a good place to start.

(5) Be careful when you see the company is very much dependent state owned enterprises for business.  The legal system is not straight forward and doing business in China is not simple and direct.  So unless the head person has a lot of GUANXI its difficult to operate.

(6) Read the MD&A.  No you are not stupid if you do not understand it, it is because translators have a hard time deciphering these complex statements that are meant to confuse and portray the business as complex and well run.

(7) Acquisitions.  While this is not new, many people just assume that the fraud occurs thorough the Income Statement only (e.g. overstated expenses, inventory manipulation, fraudulent invoices etc.).  Well although not new, it is good to remind investors of this simple accounting entry: DR: Goodwill CR: Cash.

(8) Elaborate fraud takes time.  One thing Chinese people have is patience.  So if you think the company you bought into is a Ponzi scheme but have no proof, do not be alarmed, stay close, do a lot of digging.  Corroborate evidence and withdraw in stages as your doubt increases.

(9) Use Google.  Punch in key words like 'short selling', 'fraud', 'management fraud', 'customer complaints' etc. 

(10) Misdemeanours, sloppy websites, funny transactions and explanations that do not make sense.  If you read the annual reports for a number of years; Hua Bao's annual reports are littered with inconsistencies and confusing statements.  There are also stock exchange filings that look weird (e.g. management having a derivative transaction on its own stock such as in Hua Bao, Auditor resignations, Non-Exec or Exec resignations - particularly one after another)

(11) Overpaid investment bankers and stock analysts are, to be polite, cannot be trusted.  These guys do not have your interest at heart. In any case its not their money and they'd have already collected their pay cheques courtesy of you paying for fund management fees.  I'll explain in a later post.

Lastly, do not be deterred, although Chinese frauds are getting more sophisticated, access to online resources is getting easier and there are still good managers in China / HK.  Part of the fun of investing is learning how to avoid these problem companies.  You will gain confidence as you increase your knowledge of such a fascinating country.