Here There Be Dragons

There has been plenty on the wires over the past few days of the powers being wielded by blogs in bringing various companies share prices to their knees. The response of the companies involved is to SUE. Which is of concern to TMM, not because we feel we are in the same camp as the litigants, but because it seems an asymmetric response to risk and a sign of regulation entering the webosphere.

The asymmetry of response is clear as we have never heard of a company suing an information source for publishing things that result in their share price going UP. The risk of regulation on the web does worry us much more. Not because we feel that it would be a slight on free speech and all the normal moralistic things, but more that we strongly feel that it is vital for the web to contain huge amounts of made up nonsense and complete and utter twaddle. As long as it does, and everyone knows it does, the reader is forced to make judgment calls on the validity of what he reads and take responsibility for the actions he takes based upon it.

Regulation works as long as it is impervious and leak free but partial regulation is much like trying to store water in a net. You only have to look at the fall out from the financial crisis to see how it doesn’t work with all casualties blaming all other parties for their own lack of risk management. Whether it was banks blaming regulators funds blaming banks for the toxic paper, the borrower for being allowed to borrow and depositors who thought 7% in an Icelandic bank was risk free. Profit will drive resources to bypass the restrictions whether by developing new products or moving jurisdictions. Where would the fields of finance and law be without regulatory arbitrage?

This is all the more topical as Giethner is warning on the front page of the FT on “light-touch” oversight, which will no doubt lead to “heavy petting” oversight which will lead to the destruction of the remaining financial Himalayan Pink Salt mines.

As we have mentioned many times we feel the importance of doing your own research and taking responsibility for your own actions is paramount, especially in the Thunderdomes of the East. This lesson is being particularly sorely learned by investors in Chinese companies with ADR listings of which a good number appear to be frauds of one sort or another. Just how fraudulent they are is a subject of some debate – as one expert on the matter, John Hempton of Bronte Capital noted “sin has morphology” and just whether these guys have done something along the lines of “aggressive accounting” or listing businesses that entirely do not exist is up for some debate, though TMM are leaning towards the latter.

The problem with these ADRs goes beyond that of most EM investing: you have companies listed in a country where transparency at the best of times is awful and whose managers generally live in that country. That’s not ideal – just look at the shenanigans in Asian equities listed in Asia – but it is hardly catastrophic because ultimately if the managers are exposed as frauds they have lost local retail money and that retail money will go completely buts trying to get square. Just look at the Hong Kong minibond scandal.

Equities listed abroad whose managers sit in the local country and cannot be extradited are a whole other ball of wax and have serious adverse selection problems. If you were fraud, would you list domestically? No. Would you get a dumbass whiteboy CFO to legitimize you? Yes. Would you overpay him and let him live in Vancouver / Beijing / etc away from the main city? Sure. It isn’t hard to see that Chinese companies that list abroad need to answer one question first and foremost: what are you doing here? Well, probably the same thing Bre-X was.

With all that in mind, you would think the great and the good of long/short, private equity and the like would be halfway competent at avoiding these land mines, right? Oh no they aren’t. Just look at the holders list of Longtop Financial before it was suspended and it reads like a grade A list of hedge funds – or perhaps a litter of tiger cubs. To be fair TMM understand the local bank branch colluded with Longtop to fabricate financial statements which is pretty mind blowing to think of in a western context. Kind of like finding a fraud manufacturer having JP Morgan tell them they’d print whatever they liked as their cash balances. Nonetheless, if a couple of funds including one guy sitting by the beach in Sydney can figure you out then what are these guys doing wrong?

TMM think they know why it seems a ragtag group of shortsellers, distressed debt traders and the like are doing better than most on this: skepticism and having to take responsibility for all their research. The China law blog has a good guide on how to actually do diligence on Chinese companies and it comes down to this: assume anything too good to be true is a fraud and work from there with a keen eye to people’s incentives. Money apparently does not grow on trees. It seems that people who are doing their own work are working out what makes these businesses tick rather than to work out next quarters earnings (they’re in the dock) and continue to win this game. TMM think this may be because they are cutting out the conga line of institutional investing ass-covering that seeks to ensure no one is responsible for anything:

Fund of Funds guys: “The consultant said they were good! I didn’t do nuffin’!”
Equity Analyst: “The GLG guy said everyone uses their products and are awesome! Whocudanone?”
PM: “The equity analyst put together a bajillion powerpoint slides and talked me into it! It wasn’t me!”

Save the money on GLG consultants and spend some time working out a business’ supply chain, how they bill customers and the like. Or, even do something as simple as compare revenue per student at TAL Education (XRS) and New Oriental Education (EDU) per student and compare it to GDP per capita. Sometimes this stuff really is painfully obvious – and if your equity analyst does not pick up on this stuff he’s a goose.

Looking across some equity research on our desk, TMM can’t help but feel that short selling is likely to stay lucrative simply because the whole structure of the broker dealer industry makes it easy. Analysts are so petrified of not getting next quarter’s earnings they completely ignore primary drivers of businesses to the extent that they miss out on the business being a fraud. Similarly, no one likes the boy who cries wolf, especially downstairs in the investment banking division.

For those not dedicated to the intricacies of corporate investing TMM can only say that if you aren’t doing the work stick to your knitting – trading baskets, ETFs and the like – rather than picking single names and if you do stick to larger cap liquid stocks. Sure every now and then you get an Enron, but most of the frauds we are seeing are thoroughly mid or small cap. Caveat emptor for those not well versed in the black arts of due diligence or forensic accounting.

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