Investor Q&A

A hard sell

Meet the man recommending small, illiquid China stocks to investors

“For my sins, I’ve been around far too long,” jokes old China hand, John Mulcahy. In his extensive and varied career Mulcahy has edited the South China Morning Post’s business section and run a brokerage that only those with the memory of a pachyderm will recall (WI Carr). His latest venture (headed by David Williamson) is a boutique research and advisory firm, AM Capital, of which he is a shareholder and head of research. One year old, the company aims to find small and often illiquid Chinese companies that should interest value investors. AM’s strategy is to look for small caps that are not covered by other research analysts. “We prefer to cover companies that have been ignored,” Mulcahy says.

You might imagine his timing is far from ideal. After all, Muddy Waters and other short-sellers have been trashing the stock prices of a slew of China firms. Just the rumour of a Muddy Waters report was enough to see pork giant Yurun’s stock fall 20% in a single day last week. So surely small and little known China stocks must be a tough sell? Mulcahy tells WiC why he’s still bullish.

How do you vet Chinese firms?

We have some basic quantitative criteria when judging companies. For example, we look at the ratio of executive compensation to profitability. Obviously the higher it is, the more concerned we would be – especially if the CEO is also the founder and a substantial shareholder. We think that an owner should mainly benefit from dividends along with all the other shareholders. But if they are still taking substantial cash remuneration, that would be a black mark.

We also try and do some back channel checking. We ask people in the vicinity that we know. We’ll try and ferret out information.

Likewise we look at statements from management and see whether they’ve held true to their word. Are they doing what they said they would do? Have they moved from their core industrial business into property development? That’s not something we like.

Sometimes it’s just a case of counting pallets, so to speak. We went to see a company in Fujian that had introduced a new product line. It was supposed to be the fastest growing bit of their business and we wanted to validate the sales data. There was a spanking new glass and chrome factory. But my colleague and I noticed there didn’t seem to be a lot of workers around. It all seemed dull and lifeless. We were told there had been a power failure that morning, but it looked to us like the workers were accustomed to moving around slowly.

It made beverages and we asked questions about throughput in units and crates per day. How much inventory did they keep in their warehouse? We were told they’d keep a minimum seven days’ output. But we couldn’t find more than half a day’s production in their warehouse. So we asked if this was the only plant. They replied that they did outsource, but 60% of the output was from this plant. So we just couldn’t reconcile the sales figures with what we saw in the warehouse. That company didn’t make it onto our coverage list.

So you must have visited companies all over China?

Yes. Typically the sort of companies that our filtering process throws up are not based in Beijing and Shanghai. So we have traipsed around quite a bit – in places like Henan province, Fujian, Shanxi, Hebei and Hubei. We are also planning trips to Heilongjiang and Inner Mongolia.

Short-sellers like Muddy Waters have exposed corporate governance failings with Chinese stocks. And even the legendary investor John Paulson was burned by his holding in Sino-Forest recently. Is this good or bad for your firm?

It’s good and it’s bad. One can question the ethics of selling short and then telling everyone. But the reality is: if the companies don’t have anything to hide, there shouldn’t be a problem. Truth be told, the short-sellers seem to have exposed some shortcomings in Chinese firms.

But thousands of companies from China have listed in the public markets in the last 20 years. There are going to be some bad eggs – you’d be naïve not to expect that.

Does it mean you cannot trust any Chinese company? Of course not. Does it mean you mistrust any Chinese company listed in the US? No. For example, there are some very good renewable energy firms that listed in America because they got better valuations there.

The current scandals have dented the appetite for China stocks. There are some in the investment community who are paranoid about China anyway and all this has done is validate their anxiety. So the rating of China as a global asset class has been reduced. Every company with a China connection will now be looked at very carefully.

Having said all of that, it is good for people like us. We do go and kick the tyres. We do get to know the companies and try to understand whether the owners’ ambitions are aligned with our clients’ expectations.

That’s not easy to do: it requires more than one visit. I have a Chinese fund manager friend who told me how he picks companies. He says he visits the chairman, visits him again, and then visits him again. After the third or fourth visit, if he trusts him, he may open the annual report and start looking at the numbers. That’s quite sensible. What’s the point of doing a discounted cashflow model if you think the owners are crooks?

You need to figure that out early and, if you don’t think the company is legitimate, just move on.

Muddy Waters was not the first to realise you have to be careful in China. Anyone who has ever invested in China knows that financial reporting isn’t the same as elsewhere. Sometimes there are vested interests that are not evident on the share register. So it’s very important to understand what is motivating the owners of the business. Generally, if they are passionate about the industry they are in, and want to be the best and biggest, then lots of things fall into line – because they will tend to manage the business to reach those goals.

Do you remain upbeat about China?

In our view this is an industrial revolution happening in real time. You go to the capital of almost any province and you’ll see rapid growth – they’re building a subway system, a new CBD, a high-speed rail terminus, a special export zone. Those stories are repeated almost ad infinitum. So is China on the edge of a cliff? I don’t think so. To quote Thomas Friedman: it’s very dangerous to short a country with $3 trillion in reserves.

Muddy Waters has done us all a service: there are cautionary lessons to learn about China and things that must be improved. But is it time to abandon investing in China? No.


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