“To his credit, out of all the major figures, [Alan Greenspan] was the only one who promptly said ‘I was a horse’s ass’ [...] I think we need more of that sort of thing” — Charlie Munger

To begin, I want to provide a bit of background to this article, because it’s a radical shift from what I have previously published. Over the course of the past two years, I have not only been buying and recommending Chinese companies to other investors, but I have also had a substantial amount of my own portfolio invested in Chinese companies listed on the U.S. markets.

Many of these companies seemed like an investment opportunity of a lifetime, so I set out on a trip to China in an effort to understand them better and confirm that they were indeed excellent investment opportunities, run by honest, capable Buffet-type managers. Instead, my trip had the opposite result.

After spending two months in China visiting 50 publicly-traded companies listed on the U.S. markets, my thoughts on investing in China have changed drastically. It’s tough to admit when you’ve been a “horse’s ass,” but I believe that my own investing in China, and recommendations of Chinese stocks, have made me exactly that.

As a value investor, I only invest when I feel that I have a solid understanding of the company, and that the company is worth substantially more than its current market cap. Before my visit, I knew that I did not understand the Chinese companies as well as I would U.S. companies, but I felt that the valuation of the Chinese companies, as well as a basket approach to ownership, would more than compensate for this risk.  I now feel that this investment approach is deeply flawed.

I discovered that American investors generally have little to no understanding of what is actually happening in the Chinese companies that they own for two main, interconnected reasons:  Not only is business in China more likely to be fraudulent — as most native Chinese citizens will tell you — but American professionals are also not protecting U.S. shareholders the way they should be.

In China, I visited company after company that had substantial problems in their business models or had completely unpredictable future cash flows, which was not what American investors had been led to believe. These problems were compounded by the fact that there are fraud accusations against a number of these companies that seem to be well researched with sound logic and reasoning.

For example, I visited a company that was supposed to generate $20 million in revenues for the most recent fiscal year but, when I saw their physical tax statement from the Chinese provincial government, it stated they had made only $100,000. That’s more than a 99% discrepancy.

In another instance, one well-known Chinese company raised $75 million based on the value of their retail stores; but a private investigator later verified that a vast majority of these stores did not exist. A friend of mine in China told me that he had visited a company that had a fully operational factory the day he visited, but when he drove by the next day, the factory was shut down and padlocked. He asked some of the locals what they knew about the factory, and they told him it was always closed. This case certainly serves as a warning to investors, though I think it is unusual.  All of the companies I visited definitely had operating entities, so I do not believe that any of these companies are complete frauds.

In most cases, if a company is a fraud, it is exaggerating the size or profitability of its operations, like in the first two examples above. Clearly, China can be a dangerous place to invest. Not only are Chinese companies intentionally misleading American investors, but the American professionals who collect their hefty fees on offerings like these clearly do not conduct proper due diligence.

Unfortunately, we cannot always trust in the “due diligence” that auditors, investment bankers, investor relations firms, and lawyers perform on these companies. Some auditors have proven very unreliable, since an analyst who is thousands of miles away from a Chinese company can find glaring inconsistencies in financial reporting that auditors were not able to find on site in China, like in the case of the retail stores.

Because these professionals make a living from the proliferation of Chinese companies on the U.S. markets, they have a strong incentive to believe, and convince others, that these companies are all honest. Behind closed doors, many of these professionals admit that they will never invest their own money in these companies, yet they’re willing to allow thousands of other investors to do so. This is not to say that all professionals intentionally mislead their clients; there are plenty of trustworthy professionals in the industry. Unfortunately, a few bad apples mean that the onus is on you to know and trust the professionals with whom you work.

Additionally, American shareholders may even lose the money that they invest in a legitimate Chinese company. Recently, the Chinese management of a company that I used to follow attempted to throw out the American board members and delist their company, in which case the value of the company for American shareholders would go to zero. If the Chinese board members succeed, they will essentially steal the Chinese company from U.S. shareholders. Even though this particular company was not a fraud and, in fact, has substantial and impressive modern operations, American shareholders may still lose their entire investment. I strongly recommend reading Tim Clissold’s Mr. China, in which he details several similar experiences of American investors losing their money in legitimate Chinese companies.

After my trip to China, I have sold off nearly all of my China holdings, though I still hold a few positions that I researched and trust, including Emerald Dairy (OTC BB: EMDY), ChinaCast Education Corp. (NASDAQ GS: CAST), and Sino Gas International Holdings (OCT BB: SGAS). There are legitimate companies and great investments in China, but it is so difficult to distinguish between the legitimate businesses and the frauds, that I’m not interested in playing the game. Since I have been so bullish in the past, I want to make it clear that I may begin to short some companies that I find to be potentially fraudulent.  I think it is less risky to make money shorting these Chinese companies.

I changed my investment approach because, even after I conducted my own due diligence by visiting these companies, meeting with the management, and touring the facilities, I still feel that I do not have a strong enough understanding of these companies, nor do I feel comfortable with most of the businesses that I was previously buying.  I would caution investors not to overestimate your understanding of these companies, as I did in the past. Reading the SEC filings and taking them at face value is not adequate due diligence.

Buffett is famously quoted as saying “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” In China, countless frauds have proven consistently that American investors are the patsies in the investment game. As a poker player myself, I know when I am the patsy in a game, and that the best decision for my money at that point is simply to leave the game. During my trip in China, I realized that I was the patsy investing in these companies, and so I’m quitting this game. 

When researching a company, I look at similar criteria to what Buffett searches for — a company with honest and intelligent management, and one that has strong economics, an understandable business, and a price that makes sense. I believe that I’ve found one.

Introduction

BYD Company Limited (BYDDY.PK) fits the above criteria. Charlie Munger said BYD is the best company in the world and the most amazing company he’s ever seen.

BYD currently has three primary parts — their auto segment, the rechargeable battery business, and the mobile handset components. The future of the company is primarily in their auto segment and renewable energy divisions.

They don’t have substantial revenue from their renewable energy segment, but they have several competitive advantages.  First, they have vital access to low cost raw materials. They just built a factory in an area rich in silica and other raw materials that are essential for solar technology.  Second, their partnership with Midamerican of Berkshire could help them with future distribution, development, and marketing in the United States.  Lastly, they have a low-cost skilled and unskilled labor advantage because they’re in China.

At the same time, BYD is trading for $17 billion and should earn around $1 billion in earnings this year. It’s trading for around 18 times earnings.  While this is not cheap, the company seems to deserve this valuation.  It already produces the number one selling car in China. All the potential upside of their electric cars and solar panels are priced in for free.

Management

“It’s our company’s long-term target, to be China’s No. 1 automaker
by 2015 and to be the world’s leading car maker by 2025.”
–Wang Chuanfu, Chairman/Founder, BYD

Warren Buffet has called Wang Chuanfu the Thomas Edison of our time, combined with the Bill Gates of China. “This guy,” Munger tells Fortune, “is a combination of Thomas Edison and Jack Welch — something like Edison in solving technical problems, and something like Welch in getting done what he needs to do.”

One more thing reassured Buffett. Berkshire Hathaway first tried to buy 25% of BYD, but Wang turned down the offer. He wanted to be in business with Buffett — to enhance his brand and open doors in the U.S., he says — but he would not let go of more than 10% of BYD’s stock.

“This was a man who didn’t want to sell his company,” Buffett says. “That was a good sign.”

What about accumulating wealth?

“I’m not interested in it,” claims Chuanfu.

He certainly doesn’t live a very lavish lifestyle. He was paid about $265,000 in 2008, and he lives in a BYD-owned apartment complex with other engineers. His only indulgences are a Mercedes and a Lexus, and they have a practical purpose: He takes their engines apart to see how they work. On a trip to the U.S., he once tried to disassemble the seat of a Toyota owned by Fred Ni, an executive who was driving him around.

Shortly after BYD went public, Wang did something extraordinary — he took approximately 15% of his holdings in BYD and distributed the shares to about 20 other executives and engineers at the company. He still owns roughly 28% of the shares, making him one of the richest men in China.

Wang entered the automobile business in 2003 by buying a Chinese state-owned car company that was all but defunct. He knew very little about making cars, but proved to be a quick study. In October, a BYD sedan called the F3 became the bestselling sedan in China, topping well-known brands like the Volkswagen Jetta and Toyota (TM) Corolla.  This is only seven years after he got into the business.

Business Economics

The business economics of BYD are impressive. They are potentially tapping into two of the largest business segments in the world, solar power technology and electric-powered cars.  BYD has already established itself as being the forerunner in battery technology for cars, a powerful position to be in given the future potential market of electric cars worldwide. Their technology makes their current model superior in both price and function in comparison to the other models available, such as the Chevy Volt.

Information gathered from press releases:

–BYD’s management thinks the company has a shot at becoming the world’s largest automaker — primarily by selling electric cars — as well as a leader in the fast-growing solar power industry.

–Daimler CEO Dieter Zetsche laid out the harsh reality for the Chinese auto market, stating that petroleum-powered vehicles are not sustainable due to the massive demand, and that electric vehicles are imperative. BYD is the forerunner in this market.

–BYD, the Chinese maker of cars, batteries, electronics, and solar power equipment, earns the No. 1 spot on Bloomberg Businessweek’s annual Tech 100 ranking of tech’s top performing companies. BYD (which stands for Build Your Dreams) has more than flourished — it outperformed the hottest tech outfit around — No. 2 Apple.

–Mr. Sokol also said MidAmerican hopes to boost its BYD stake if the chance arises. “If in the future there is an opportunity for us to continue to invest in BYD, we will be happy to increase our stake over time, but we will do it in cooperation with BYD,” he said. Mr. Wang said an increase is “negotiable.”

–Bill Gates gets a royalty on computers. BYD will be a complete energy producer, thus getting a royalty on energy usage in China.

On Jun 6th, Premier Wen Jiabao went to Xi’an Industrial zone of BYD Company Ltd. and took a test drive of the F3DM, a dual mode electric vehicle developed by BYD.  It’s clear the Chinese government is behind electrics vehicles, but this shows that the Chinese government is also in contact with BYD, a good sign for the company. In China, it’s vital to have government support in order to run a successful business.

There have been many rumors about how Chinese entrepreneurs have recently been ripping off American investors. I think this is no doubt true. While I don’t know which accusations will pan out to be true among Orient Paper, Inc. (ONP), China-Biotics,Inc. (CHBT), Fuqi International (FUQI) and others, I do believe that some of these companies will be found to have committed fraud.

I think this is a terrible thing for U.S. investors, and has caused many, including myself, to lose confidence in putting money into the Chinese markets. If the financial statements for Chinese-listed U.S. companies were reliable, it would be the investment opportunity of a decade. If the one for China MediaExpress Holdings, Inc. (CCME), for example, is truly real, the company is incredibly undervalued. But there are serious doubts as to its legitimacy.

This has all been extremely bothersome and costly for me as an investor. I empathize with the pain of American investors who have lost money and are angry with the Chinese. We call them heartless for their uncaring ways of ripping us off, but there’s one psychological principle that I want to point out: We relate better to those who we have more in common with, which makes it easier for Chinese companies to be fraudulent and steal money from us.

More importantly, I want to flip the coin to look at both sides of this issue. What about all the U.S. investment banks that have ripped off Chinese entrepreneurs?  I have spoken with Chinese Chairmen and CEOs who should probably be put on suicide watch for what has been done to their companies and their wealth. They have worked hard their entire lives, only to have their money ripped away by American bankers, lawyers, hedge funds, and accountants.

Are they getting paid? Yes, ultimately they are, but they’re getting much less than they deserve. They’re getting terms that they don’t understand, and only later do they find out how horrible those terms are.

Why does this happen? Essentially, it’s because they’re not used to dealing with U.S. capital markets, and they’re from a different culture, so it’s easier for the transactional parties to rip them off, just as they’re trying to do to U.S. investors.

I’m not condoning all the money that U.S. investors have lost because of Chinese fraud. I’m simply looking at this issue from both sides. It’s possible that Chinese entrepreneurs have lost more money from the U.S. capital markets taking advantage of them than American investors have lost from Chinese fraud. Even though it’s not technically fraud in the way that they’ve lost their money, it is taking advantage of these entrepreneurs in the same way.

I think that, ultimately, this is a cultural issue.  It started long ago — when the British couldn’t trade with the Chinese fairly, they got them addicted to opium so they had something to trade them. While technological and economic sophistication have advanced since that time, the cultural divide has yet to be fully bridged.

Last week, I presented you with Part 1 about the cultural differences in China. Today, I’ll start by asking an important question — is it worth the risk?

I’ve concluded not to avoid investing in China, but to question every investment that I make to a greater extent. My list of good companies continually gets shorter and shorter, which gives me great confidence in the companies that I still own. The list is beginning to narrow down to a point where, despite the cultural differences in China, I have strong confidence in the low risk, high reward companies that I’m buying. When you can buy a company at five
times operating cash flow or less, when owner’s earnings are expanding at rates of 30% or more, the sector should not be avoided.

The uncertainty in the sector creates great opportunity. We can’t simply rely on the auditors of these firms, however. I worry about U.S. investors just blindly investing in Chinese companies based on the numbers. There are several companies that I originally invested in because they looked cheap, but now I would never touch them because the network of people I have developed has visited or heard about the illegitimacy of those companies or the promoters associated with them.

An example of what I consider one of my biggest mistakes was Biostar Pharmaceuticals (BSPM). From a growth and earnings standpoint, the stock looks incredibly cheap, but I don’t think it is. Unfortunately, BSPM is a very questionable company. They essentially promote a product that’s ineffective, and only promote their product in primarily rural areas where people are less educated and more likely to believe the advertisements.

In China, it’s illegal to claim that you can cure hepatitis B, yet BSPM walks a fine line around that rule, and essentially claims, while staying within the law, that its product can cure the disease. This is why in April, the government chastised BSPM for its advertising hype.

The other issue with BSPM is that they don’t even produce their product — they are merely a middleman who encapsulates the raw materials. They simply buy from a manufacturer. Their competitive advantage is that they have a license that only two other companies have. The two other companies did not enter the business because they viewed it as being unethical. The reason the chairman gave me was that the other companies did not realize the size of the market. Supposedly, hepatitis B affects 100,000,000 people, so I find that hard to believe.

I don’t blame myself for buying BSPM. When looking at the financial statements, it looks incredibly cheap and appears to have a competitive advantage because they’re the only company with a license to sell their product. The filings don’t mention the sketchy aspects that I learned while visiting; they make the company sound great. It’s a mistake to invest just on the numbers in China. A greater level of due diligence is required that involves visiting the companies, and talking to competitors, customers, and suppliers.

Unfortunately, most U.S. investors still invest in China after conducting inadequate due diligence. They attend one or two high-priced investor conferences in fancy hotels in New York that assure them that investing in China is a sure thing. They confidently look at the financial statements that show extremely low earnings multiples with unbelievable growth, and they assume that everyone else is stupid for not investing. But they haven’t visited factories or attempted to understand Chinese business culture, which is vital for understanding businesses in China. There are many sophisticated investors who have looked at these companies and passed. You should always question if the person you are buying or selling your shares from is more or less informed than you are.

Circle of confidence
Warren Buffett has always said the key to investing is having a circle of competence. It’s not important how wide that circle is, but how well it is defined.  I fear that many U.S. investors who put money in China are investing confidently based on numbers alone, without realizing that they are far outside their circle of competence.

As I wrote earlier, I’m not on a high chair pretending to be a know-it-all, but I’m beginning to define the boundaries of my circle of competence.  I’m creating a longer list of companies that I
would not touch, and developing a network of Chinese executives and bilingual investors with whom I can test my ideas.  I would never have learned of the troubles with BSPM had I not met another investor who had visited the company, and then visited it myself.

Going forward, I need to have incredible faith in the owner of the business and the economics of the business itself.  It’s not enough to use Joel Greenblatt’s magic formula of purchasing companies with the lowest earnings multiples and the highest returns on capital. In China, there’s a saying: Yi ren zhi xia. Wan ren zhi Shang. It means one on top, and 10,000 beneath him. That owner on top better have great integrity, the same interest as you, and a fantastic business with great economics, a low price, and high returns on capital before it is worth being included in your portfolio.

“Invert, Always Invert”
–Famous Algebraist Jacobi

My experiences visiting companies have shed light on the incomplete research that U.S. investors conduct on Chinese companies, myself included. There are many cultural differences that we fail to understand, which are vital to the operations of the Chinese companies that are listed in the U.S. I’m not saying that I know it all. Actually, in contrast, I think that the trip that I’m currently on has taught me that I need to increase my network of people and understanding of the cultural effects of business here. That’s why I‘ve been focusing on creating a network of sophisticated investors and Chinese executives to help me make more informed decisions.

Yesterday, I visited a manufacturing plant that was three-and-a-half hours outside of Harbin, a harsh city near the Russian border into Siberia, where even beer freezes in the winter. The drive to Harbin was full of unique experiences. Lanes on the road seemed to be a mere suggestion, as there were several times when we drove into oncoming traffic. Among the things that we nearly collided with were very large cows, chickens, goats, and ancient trucks pouring out dense pollution. While this may sound horrific, it’s quite common in China, just as driving in your own lane is common in the U.S.

We passed dilapidated homes and horse-pulled carts while we experienced comfortable, air-conditioned travel in a spacious minivan. The inequality in China dwarfs that of the U.S.

Upon arrival, I was able to tour the factory. It was vast, with brand new machinery that was spotless. I was impressed with the efficiency of the operation. The chairman who built this one is responsible for designing over 80% of the factories in China in his industry.

Eat, drink, and learn
My next learning experience occurred at lunch. I don’t smoke – actually, I hate smoke. It’s a pet peeve of mine, so I was less than excited when all five of the managers lit up cigarettes in a small room, with 50 more to follow.

As I choked to death, I was informed that I would be drinking Baijiu — a strong 53% alcohol distilled from sorghum, starch, and rice — with the managers. Luckily, our Baijiu was the most expensive kind in China, around $200 per 750 ML bottle. I was informed that this would lead to no hangover, stomachache, or headache, unlike many of the cheaper forms of Baijiu. Unfortunately, I have since been able to verify that truth. I have to admit, it was the best 53% alcohol I have ever had, but that’s not saying much. I noticed that after a few drinks of Baijiu, the victim smells like a gasoline tank.

I’m not a heavy drinker so, to my dismay, I was required to drink copious amounts of Baijiu while eating food that looked like it was from a different planet. Every few minutes one of the managers would make a new toast, requiring more drinking, with me chasing the shot of Baijiu with more green tea and smelling more like gasoline.

The large quantities of Baijiu were complemented with food that I was less than comfortable eating. Some strange meat was circulating the table. I asked the Chairman about a particularly odd piece that resembled some sort of meat sashimi, and he told me it was pork, so I tried some. It had the crunchy quality of a combination of joints and skin with very little meat. After I had finished my piece, he told me it was pig ear. His timing was perfect.

After stumbling drunkenly out of lunch – yes, this was lunch and is quite standard in China — we toured the rest of the factory offices. In the bathroom, as the Chairman and I peed side by side at the urinals, he let out a loud, prolonged fart that solidified my understanding that the cultural differences between the U.S. and China were vast.

In fact, the Chairman must undergo very similar meals on a weekly basis. At this lunch, he was able to skip the excessive amounts of Baijiu because it is his own company. But he has been out having similar meals with some of the heads of the provincial and local government for the past four nights. This way of doing business is standard in Chinese culture. He was not able to get to bed until 5:30 AM Friday night, as he was up late drinking Baijiu and eating excessive amounts of food. He was exhausted from similar endeavors from the past four nights in a row.

This is part of what is required to run a successful Chinese company. While I don’t understand the inner cultural differences in China, I’m deeply impressed with the Chairman and his ability to run his business and get things done. His factory was extremely impressive and efficient. In China, achieving this requires more than what we are required to do in the west. The things that must come together at his factory are power, water, environmental permits, wastewater treatment, raw materials, labor, and appropriate technological machines. In general, this requires several nights of Baijiu drinking with government officials from those various departments.

The dissemination of information about Chinese companies is so asymmetrical, that it allows informed investors a large edge. I’m not talking about obtaining insider information; I’m simply conveying the need for greater due diligence. Another American investor in Chinese companies experienced similar circumstances to mine, except that, after the large amounts of food and Baijiu, he got naked with the Chairman, mayor, head of the water department, and other important government officials in a nearby bathhouse. Only then, through a drunken state and clouds of cigarette smoke, were the various members willing to talk serious business. He was not being told inside information, but he was getting the most accurate picture of the company’s business model.

…To be continued next week.

Last week, I brought you part 1 of my interview with the President-International of the first and only U.S. publicly-listed post-secondary education company that owns accredited universities in China.

Here’s part 2 of my interview with Michael Santos, President-International of Chinacast Education Corporation (CAST).

Zack Buckley: Why is the company undervalued?

Michael Santos: I think a lot has to do with the history of how we got listed on the NASDAQ. The other U.S.-listed, PRC education companies all did traditional bulge bracket bank IPOs with the likes of Goldman Sachs, Citibank, Merrill-Lynch, Deutsche Bank, etc., where we did a reverse merger with a special purchase acquisition company (SPAC). We didn’t have any research or liquidity — we only traded about 10k-20k shares per day — to speak of, and our shareholder base looked totally different than these other companies. In addition, the SPAC capital structure left our balance sheet with a huge 9 million warrant overhang that kept investors wary about buying our stock.

Luckily, over the past three years, we’ve managed to transition our shareholder base, increase liquidity — we now trade roughly 400,000 shares a day — and have five research analysts covering the company. Although we still have a ways to go, we’ve surpassed all the other PRC education companies in terms of liquidity and market cap except New Oriental, who currently trade at over 25x EV/EBITDA and has a market cap of $3.5 billion. They’re generating about $90 million in EBITDA per year, so we’re not too far behind.

In addition, we were part of the Russell 2000 Index rebalancing in the second quarter of this year, so there was a lot of selling pressure on the stock that had nothing to do with the fundamentals of the company. For instance, at the end of March, our stock hit $8.55, close to our historical high of $8.61, and yet three months later, our stock slumped to $5.65, close to our 52-week low. We had over 5 million shares traded on June 25, the last day of the rebalancing. The Russell 2000 rebalancing probably knocked down our stock price at least 20% over the past quarter.

Regarding valuation, the Street consensus 2010 GAAP EPS for our company is $0.42, but if you back out the non-cash charges, amortization of intangibles, and stock-based compensation, our cash EPS is $0.55, which makes the stock much cheaper. On an EV/EBITDA basis, we are currently trading at less than 5x FY2010 EV/EBITDA versus the PRC education average of 10x-12x EV/EBITDA. Thus, we believe our stock presents an investor with not only an excellent long-term growth story, but also a great value investment.

In addition, Deloitte Touche has been our auditor for the past 10 years. This is a key point in that probably less than 15% of all PRC small-cap companies listed in the U.S. have a Big 4 auditor. and there have been some high profile auditing fraud cases from PRC small-cap companies over the past year. Now I’m not saying that just because you don’t have a Big 4 auditor you’re not a good company, or that if you have a Big 4 auditor there won’t be any problems.  In most all cases of accounting fraud by PRC small-cap companies, none had a Big 4 auditor. It typically costs a company over $1 million dollars in fees annually for a Big 4 auditor, Sarbanes Oxley, and IR communications, but it’s the minimum you have to pay to be taken seriously by U.S. investors.

Another important issue to consider is that we are a very professionally-managed company, and have an excellent track record of corporate governance and creating shareholder value. All our key executives and board members have worked for multinational companies, have brought companies public in Hong Kong, Singapore, and the U.S., and communicate frequently and articulately with investors and analysts.

ZB: Why the $43 million raise in Dec. 09?

MS: When we did the raise, we had two strategic university acquisitions in mind, and needed the incremental capital. If you look at the very profitable business and strong cash flow generated by the newly-acquired university, the significant assets added to our balance sheet, the long-term investors added to our shareholder list, and the increased liquidity to our stock, then we believe we’ve created good, long-term shareholder value.

With this acquisition, we have provided guidance of up to $47 million in EBITDA this year, and will have north of $60 million in EBITDA next year. We’re now in as strong a position as ever in the history of the company in terms of cash flow and assets, and believe we can organically grow EPS 20% to 25%, even without acquisitions. In addition, we’ve now crossed a major strategic inflection point in the company’s history that, due to our strong balance sheet and cash flow, we believe we can make at least one acquisition a year without ever having to come back to the market and thus accelerate EPS growth.

ZB: What was the price paid for the universities in terms of EBITDA?

MS: We purchased the university for $66 million, and the expected trailing EBITDA is $7.5 million, so we’re paying a bit less than 9x trailing EBITDA, or about 7.5x forward EBITDA. You must look at the underlying assets of the universities and the potential for growth in the future. It can’t just be analyzed on an accretion dilution basis only looking at cash in terms of the valuation. For instance, for this university, the government has allowed us to rezone 30 acres of the land for commercial purposes, and we plan to monetize this, which will greatly lower the total acquisition cost. This is what we discuss at the board level constantly — when we look at the whole discounted DCF analysis, the potential for growth makes sense. We do exercise strict financial discipline in approaching our M&A opportunities.

ZB: What type of insider buying has occurred recently?

MS: The management team and Board of Directors have collectively bought approximately $6.5 million in stock this year. To show our willingness to co-invest with our shareholders and our strong belief in the long term value creation potential of the company, our CEO, CFO, and I bought $5 million worth of stock at $7.22, and two of our board members also recently purchased an additional $1.5 million of stock just last month.

ZB: How do you feel about top tier firm auditors vs. lesser auditors in the China space?

MS: As mentioned above, for your company to be taken seriously by U.S. investors, having a Big 4 auditor like Deloitte is mandatory, especially in light of some high profile auditing fraud that has happened to some PRC small-cap companies over the past several years. The only reason not to have a Big 4 firm is either that a company cannot afford it — as mentioned above it will cost at least $1 million annually — or they’re not comfortable having someone fully scrutinize their financials and operations.

Since most PRC companies are reporting high profitability, then it is probably the latter in most cases. I would like to suggest to all the research analysts covering PRC small-cap companies that they disclose at their conferences and in their research reports which companies have a Big 4 auditor and which do not — like a ratings agency list. This will protect them, as well as the investors.

ZB: How would you avoid fraud as an investor in China?

MS: If a company doesn’t have at least a high tier 2 auditor, has had high turnover in their management team or professional firm relationships, has a lot of receivables, or if they don’t have much in terms of tangible assets, then these should be some red flags to address, even before you get into the fundamentals. I would also strongly suggest serious investors to do a company site visit, since what you see at investor conferences and read in research reports in some cases have little in common with what you will encounter in China.

ZB: Are there any companies that you think are interesting in China from an investment standpoint?

MS: I believe in looking at key long-term macroeconomic trends, such as the rise in consumer spending power and the appreciation of the Yuan. Health and education are usually the two largest consumer sectors, and both are in the early stages of privatization in China. Thus, companies in those sectors will do well. In addition, travel, hotels, food service providers, and advertising also fall within that category. Using the investment guidelines mentioned above, try to find the top one to two companies in each of those segments that have strong, predictable cash flow and stable, experienced management teams. Hopefully, ChinaCast Education will be one of your portfolio companies that fit that profile.

I had the opportunity to interview the President-International of the first — and currently only — United States publicly-listed post-secondary education company that owns accredited universities in China. The company hopes to create a Chinese version of the University of Phoenix and Devry University — for-profit, post-secondary education models in the U.S. — to address the huge demand for post-secondary education in China.

ChinaCast Education Corporation (CAST) is currently trading at an enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA) of about 5, which is a significant discount to its PRC education peers, which trade at about an average of 10-12x EV/EBITDA. Here is my interview with Michael Santos, President-International CAST.

Zack Buckley: Can you give me some background for the company?

Michael Santos: We’re the largest, U.S. publicly-listed, PRC for-profit, post-secondary education company in China. We have approximately 30,000 on-campus university students studying at our universities located in Chongqing, Guilin, and Wuhan, and 141,000 E-Learning students in partnership with 15 state-owned universities.

China is now the largest post-secondary education market in the world, with 22 million students, and is growing at a much faster rate than the U.S. market. But still only 5% of the Chinese population has a four-year university degree versus over 25% in the U.S. and most western countries. By 2020, the Chinese government has announced that it has a target to have over 40 million university students, and thus has opened the sector to private universities and E-Learning to assist in addressing this ambitious growth target. Thus, we believe that our business is a good, visible, long term growth story to track the rise of the consumer spending power in China.

ChinaCast started as a VC-funded internet dot com company back in 2000 to provide broadband internet services in China using satellite technology from Hughes Network Systems. We were able to secure a nationwide satellite and Internet license from the Ministry of Information Industry (the FCC of China), raised US$17 million in venture capital from Hughes, Intel Capital and Sunevision (Hong Kong) in October 2000, and went into the business of providing broadband Internet services to corporate and government customers. As a dot com startup, we needed to focus on getting profitable before we ran out of venture capital, so we decided to focus on the E-Learning segment, since our broadband satellite technology gave us an advantage over the government-owned fixed line telecom carriers.

At that time, our PRC university customers told us that there were over 100 million students who wanted to go to college, but there were only about five million physical seats in the PRC universities, which presented a great growth opportunity. The Ministry of Education granted these state universities distance learning licenses to recruit students off-campus for the first time to address the supply-demand imbalance. The universities turned to us to provide the hardware, software, and telecommunications services to allow them to connect all their remote distance learning centers around the country back to their main campuses that were located in the major cities. We developed a business model whereby our company would invest in the equipment and software, and would get paid by the university by taking a revenue share of each student’s tuition. This is a win-win situation for both the university and our company.

We became profitable after 18 months, and did a $30 million IPO on the Singapore Stock Exchange in May 2004. In 2005, a U.S.-listed Special Purpose Acquisition Company (SPAC) called Great Wall Acquisition Corporation (OTC: GWAQ) made a public tender offer for our Singapore listed company. Our Singapore shareholders accepted the tender offer, and we completed the reverse merger in December 2006, de-listed from the Singapore Stock Exchange, and were the first PRC education company to be listed on NASDAQ in October 2007. After we got on the NASDAQ, we embarked on a strategy to augment our B2B nationwide e-learning platform by acquiring universities. We could now own our own degree programs and students, thus becoming a fully-fledged, B2C for-profit, post-secondary education company.

One strong feature of our business model is that we receive our revenue 100% in cash one year in advance of the service. Thus, we have great visibility in earnings — we provide annual guidance — no bad debt or receivables, and strong cash flow. The customer acquisition cost is very low — less than 2% of revenue versus over 20% of revenue for most U.S. for-profit education companies — because of the large supply and demand imbalance. The government currently doesn’t tax profits, although we do take a 15% non-cash tax provision that provides very attractive net profit, EBITDA, and free cash flow margins. In addition, we have a strong balance sheet with over 180 acres of land, and 6 million square feet in our buildings, which translate to about $4.88 in book value per share.

ZB: Who are your main competitors?

MS: On the E-Learning services side, we compete mainly with other telecom service providers such as China Telecom (CHA), China Netcom (CN), and China Satcom (CHU), and distance learning service providers such as Orient Satellite and ChinaEdu (CEDU). On the university M&A side, we compete mainly with domestic and international private equity firms, and global education players like Apollo, Laureate, and Raffles Education. Apollo Global has a US$1 billion private equity fund with Carlyle that’s actively looking at international education acquisition opportunities.

Although the competition is heating up, we still think the profitability in the PRC post-secondary sector will remain reasonably high in comparison to the other education segments, like English training, test preparation, after school tutoring, or vocational training, due to the high barriers to entry. Our goal is to build China’s largest network of university campuses and have the largest online learning network before these global education companies can gain traction in the PRC market.

ZB: Where do you see the company in the next five years?

MS: If we can continue to acquire more universities at attractive valuations, five years from now, we would hope to have 10 universities with 20,000 students, each for a total of 200,000 on-campus students. We’re also targeting to expand our E-Learning network to over 350,000 students over the next five years. Thus, it’s conceivable that in five years, ChinaCast could reach about US$400-$500 million in revenue, and about $200-$250 million of EBITDA annually, especially if the Ministry of Education allows private universities in China to sell their accredited degree programs online. At an industry average of about 10x EV/EBITDA, ChinaCast could possibly have a $2.5 billion enterprise value.

Part 2 of my interview will be posted next Monday. Stay tuned.

Last week, we began a look at the possibility of fraud when investing in China. The first three factors to examine are the firm’s auditors, their transparency through financial statements and investor relations, and the quality and independence of the management team and board of directors. Here are numbers 4, 5 and 6.

4. Inside Ownership

Insider ownership is a vital factor for investors to consider. With a high amount of insider ownership comes less risk of fraud in a company. At Tsinghua University, the most prestigious university in China, the accounting department conducted studies showing that lower insider ownership in Chinese companies leads to higher incidents of fraud.

At Weikang Bio-Technology Group (WKBT), a pharmaceutical company in Northern China that specializes in Traditional Chinese Medicine, insiders own 88% of their company. If they decide to defraud the other 12% of shareholders, they’re only hurting themselves. As a result, shareholders’ goals will be aligned with WKBT management’s goals.

Conversely, the insiders of New Dragon Asia Corp (NWD), a company engaged in the sale of instant noodles and soybean-derived products, own only 20% of the company. While this might seem high in comparison to U.S. companies, it’s actually quite low in comparison to the other small cap Chinese companies.  Not surprisingly, NWD has been horribly mismanaged. They have issues with five of the six fraud factors I look for in companies – the only thing they missed is not raising additional capital from equity markets.

5. Raising Money through Equity Markets

Companies that are constantly raising capital from equity markets are more likely to be fraudulent, because they could be keeping the money themselves. If a company isn’t raising capital through the equity or debt markets, it has less incentive to be fraudulent.  There are smaller ways to defraud investors, such as paying high salaries or doing deals with friends, but the big payoff for a fraudulent company is raising capital, because they can pocket the large proceeds.

The first step when looking at a company that’s raising capital is to determine how the company becomes public. If they do an IPO instead of a reverse merger, there is a much more rigorous investigative process for verifying the financials. This doesn’t mean that reverse mergers are all frauds, but the probability is higher because the due diligence process is less extensive.

The other important aspect I look for when a company is raising capital is whether it is doing it continually, or doing so at low prices when they don’t seem cash poor.

China Marine Food Group (CMFO), a company engaged in the sale of processed seafood snacks, has recently come under scrutiny for raising capital through a secondary offering for its Hi Power acquisition. They raised $30 million in order to complete the acquisition. While CMFO has been investigated and appears honest, I can imagine situations where a company could falsify an acquisition, raise $30 million from U.S. investors, and then put $25 million in the Chairman’s pocket. China is very ethnocentric, so it’s easier for local businessmen to steal from foreigners with a clear conscience.

6.  High Accounts Receivable Balances

Chinese companies are notorious for having high accounts receivable (A/R) balances, and investors should be careful to determine their quality. Orsus Xelent Technologies (ORS), a company who distributes cellular phones in China, went from $5.36/share to $.22/share in the past few years, as investors realized they would never collect on their ballooning A/R balances.

While ORS has only a $6.5-million market cap, they have an $85-million A/R balance. They used the old “shove it down the distributor and book it” method to give the appearance of strong sales and net income.  Unfortunately for investors, the phantom income never was realized – they still haven’t received payment from their distributors.

Chinacast (CAST), on the other hand, has 180-day receivables because they run private universities that collect cash up front before every semester begins.  This is great for investors because there is no receivables risk.

In conclusion, the probability of fraud in Chinese companies is generally higher than in U.S. companies. As a result, many investors have applied a blanket to completely avoid China, or invest only at very low multiples. As a result, there are many companies trading below their cash balances. China Agri Business (CHBU) is one example. Another company trading at P/OCF of less than 5 with annual growth rates of 30% or higher is China MediaExpress Holdings (CCME).

This type of opportunity leads me to apply a basket approach to investing in China. I don’t allocate my entire portfolio to China, and the percentage I do is spread among 1% to 3% positions with low fraud risks and very high rewards. This limits my risk if I happen to be wrong, while also giving me the upside of companies that appear extremely undervalued.

Investing in China is like walking across a minefield with a pot of gold at the end of the field. If you’re able to sidestep the mines, you’ll have the pot of gold. But if you walk across too many mines, you’re likely to blow up.

“The 19th century belonged to England, the 20th century belonged to
the U.S., and the 21st century belongs to China. Invest accordingly.” – Warren Buffett

Over the next five years, investors who put their money in China and avoid fraudulent companies will almost certainly be successful. It’s easy to find cheap companies in China when you look at them on a PE ratio basis, but high-quality companies that generate real earnings that are not fraudulent are more difficult to find. I spend most of my time studying ways to avoid fraud in China. Key factors to consider are:

1. The firm’s auditors.

2. The transparency of the firm through financial statements and investor relations.

3. The quality and independence of the management team and board of directors.

4.  Inside ownership of management.

5. If the company has been raising money through equity markets.

6. High balances on accounts receivables.

Let’s examine each factor.

1. Auditors

The importance of auditors is very simple; some auditing firms do extreme due diligence and are very careful to protect their reputation.

On the positive side, Yongye International (YONG), a company engaged in manufacturing and distributing its own fulvic acid-based plant nutrient, has auditors from the big four accounting firm KPMG practically living in the factory for several months of the year. Before KPMG even accepted Yongye as a client, they visited the factory, and talked with distributors and customers. Using top-ranked KPMG costs the company much more — between $1 and $1.5 million — but the extra annual cost is worth it, as it will give them investor respect and potentially higher earnings.

On the other hand, a company can be cheap and use a low-quality firm that charges $100,000 to $250,000 for a similar size audit as Yongye’s. In some cases, there are low-quality audit firms that fly from California to China and spend only a week to conduct an entire annual audit. This isn’t enough time — it takes KPMG’s highly-trained auditors months to perform a similar service.

The head partner of another auditing firm, ZYCPA, was in court for defrauding European investors of $110 million HKD ($14 million USD). Whether or not the court finds him guilty, a public company doesn’t want to be associated with this type of auditing firm, yet several Chinese companies, including Agrisolar Solutions (AGSO), China Marine Food Group (CMFO), and NF Energy Saving (NFEC), use them. If the quality of the audit firm is high, there’s a greater level of assurance that you’ll get accurate and transparent financial statements. This is vital for avoiding fraud in China.

2. Transparency

A firm’s transparency, which is determined through investor relations and financial statements, helps investors determine the likelihood of fraud. If a company doesn’t communicate with shareholders and has confusing financial statements, it should be avoided. If a company has an internal investor relations department, or uses large investor relation (IR) firms such as Crocker Coulson IR, HC International, or RedChip, they are easy to contact. These IR firms help ensure that the most relevant information about the company is promptly communicated to investors. They also help with investor conferences, conference calls and press releases.

Most firms use IR companies that communicate with shareholders. On the other hand, there are companies that I have been unable to contact, like China Growth Development Inc. (CGDI), which owns shopping malls in central China and leases the units to commercial tenants. CGDI does not go to investor conferences, has no conference calls, and no press releases to keep shareholders updated on the company. The phone number on their website for an investor relations contact doesn’t work, and my emails are never returned.

Another common red flag is vagueness in financial statements. Songzai International Holding Group (SZGH), a coal company that’s engaged in exploration and development of coal mines, had an 80% decrease in revenue in the fourth quarter. On their 10-k, they explained that they had to shut down their factory for the month of July.  But July should have no effect on the 80% decrease in the 4th quarter, since that month is part of the third quarter. They completely avoided addressing the main decrease in revenue.

Investors wanted to know what happened in the fourth quarter, not the third quarter, but the company never addressed the issue. The lack of transparency with investors in this case is a red flag to stay away from this company. Most businesses that have a well-trained management team and board of directors have transparent financial statements.

3. Management and Board Quality

The board of directors can tell you a lot about a company’s quality and investment safety. The Chinese business practice of Guanxi, or relationship-based business practices, can lead to higher levels of fraud. Essentially, Guanxi means that if I do something for you today, you must return the favor for me in the future. You can imagine the fraud implications that this common business practice creates. If management has been educated in the West, the odds are that Guanxi would play less of a role in how the company is run and decrease the likelihood of fraud.

Consider the Chairman of Chinacast (CAST), a post-secondary education company looking to develop four-year degree programs online in China.  He has been CEO for 11 years, and was educated in Montreal. Other directors of Chinacast were educated at Harvard, Princeton, and Cambridge and come from a variety of backgrounds. The entire management team and board of directors are English speaking.

In contrast to the sound practices of Chinacast is Gold Horse International (GHII), a company that’s engaged in three sectors: construction, residential and commercial real estate development, and management and operation of the Inner Mongolia Jin Ma Hotel. Currently, the board members of GHII include the Chairman, his wife, and his daughter. The CFO of the company does not respond to emails, and only visits the operations a few times a year. There are other board members that could be considered independent from GHII, but the company states in its filings that “it does not have a member that is ‘independent’ as the term is used in the Securities Exchange Act.” GHII has several potential fraud factors, including rapid selling from insiders. Although the company is extremely cheap, I would urge investors to avoid this value trap.

Next week, we’ll look at numbers four through six.