As I write this, Sino-Forest Corp. continues to be investigated for fraud by the Ontario Securities Commission and its shares remain the subject of a cease trade order on the Toronto Stock Exchange. While I do not know whether Sino-Forest is a fraud or not, I readily admit that it doesn’t look good based on what has been uncovered thus far. So why do we care? We don’t own any Sino-Forest shares. However, we do own approximately 2% of the outstanding shares of Hanfeng Evergreen Inc., a Chinese slow and controlled release fertilizer manufacturer, which is listed on the Toronto Stock Exchange. Hanfeng shares have performed poorly since the Sino Forest fraud allegations first surfaced and it is fair to state that it has become subject to a severe case of Sino Taint as have other Chinese companies that are listed in North America.
How do we at Stacey Muirhead ensure that the investments we make with the capital you have entrusted to our care are not frauds? The simple answer is that we can never be absolutely certain. While I am sure this will make regulators cringe, I really believe that any dishonest CEO intently focused on enriching himself or herself at the expense of shareholders can be successful to at least some degree. While the current situation unfolding at Sino Forest is shining the spotlight on North American listed Chinese companies, the investor fraud Hall of Fame is both long and well represented by every geographic area of global capitalism. Recall Enron and Adelphia in the United States. Nortel and Bre-X in Canada, Polly Peck in the United Kingdom and Parmalat in Italy to name just a few of the biggest investor blow-ups over the last two decades that resulted from fraudulent activity.
Thus far, we have successfully avoided any of these spectacular wealth destroying frauds by adhering to a few simple principles during our investment research process. These principles coalesce around two main areas. The first area is what might generally be thought of as traditional governance considerations. Our checklist includes the following:
- Are there any past regulatory transgressions by the company or senior management?
- Who are the auditors, bankers and other advisors involved with the company?
- Who is on the board of directors and what is their ability to represent all shareholders effectively?
- Does the company provide a detailed and timely annual report which gives a transparent and candid account of its operations and outlook for the future without excessive jargon and impossible to decipher notes to the financial statements?
These traditional governance guideposts are obviously important in determining whether a company may be a potential fraud. However, most investors stop with these governance items when considering a company for investment.
There is another area of inquiry that is equally if not more important. This second area can be described as attempting to establish whether or not the CEO is economically aligned with shareholders to such a significant degree as to render committing fraud against his or her own economic self interest. Simply put we try to follow the money. We look at how many shares in the company are owned by the CEO and try to establish whether that investment represents a majority of their net worth. We consider any past sales of shares. While we accept that everyone is entitled to sell some shares from time to time, any pattern of recurring sales or a particularly large sale is a red flag to us which requires further investigation at a minimum. While options can form a part of a well designed compensation plan, we view the granting and exercise of excessive options and the subsequent sale of shares to be a real turn off. We also look at the company itself and its financial structure. If we see continual share offerings to raise capital, we view that as a potential warning sign. Likewise, if a company has an excessive amount of debt, the temptation to commit fraud increases.
So what is the situation at Hanfeng Evergreen when you follow the money? The score card is quite good actually. Xinduo Yu, the CEO, owns 12 million shares representing approximately 20% of the shares outstanding. He takes no options and has never sold a share. Other than the strategic alliance with Agrium in 2007, Hanfeng has issued no shares to the public since 2004. The company also has over $50 million in net cash after all debt. Not bad! Clearly, these are not the usual warning signs for a likely fraud.
Over the long term, this bout of Sino Taint will help us. The current Hanfeng Evergreen valuation has reached absurdly cheap levels. I feel like the character Marty McFly in the movie “Back to the Future”, who experiences time travel and goes back to the period where his parents were dating in high school. It has been about 25 years since investors have been able to buy stocks below their net net working capital value. This approach was popularized by Benjamin Graham in his epic tome “Security Analysis” which was first published in 1933. Although he passed away in 1973, he remains the intellectual mentor to many of the best value investors operating today. I started my investment career doing net net working capital analysis and consider Benjamin Graham’s writings to be one of the bedrocks of our investment approach at Stacey Muirhead. At the risk of bogging down this discussion, a net net working capital situation occurs where you can buy shares in a company at a price below the current assets less all liabilities while getting all the fixed assets such as land, plant and equipment for free. That is the case today with Hanfeng Evergreen. That is just too cheap! It should not surprise you to learn that we have recently added to our Hanfeng holdings.
Finally, let me just say that a CEO intent on committing fraud will usually be a polished and persuasive individual. All investors would be well served to heed the timeless advice that says that if something seems too good to be true, it probably is!
“Above the Fray” is a regular blog written by Jeffrey Stacey, Chairman and CEO of Stacey Muirhead Capital Management Ltd., which discusses items of interest related to investing, finance and business. This is not a solicitation.