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The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Sept. 28. With permission, we're reproducing it here in its original form.
"Desire to have things done quickly prevents their being done thoroughly."
"I've been here for more than 30 years, and I still have no real insight into how top-level decisions are made." My dinner partner that night in Beijing is a seasoned diplomat at the U.S. Embassy, speaks fluent Chinese, and has spent time in every corner of the Middle Kingdom. He knows China cold, yet this very basic fundament of Chinese commerce and civilization remains a mystery. This is a country that, for all of its strengths (and it has many), has yet to embrace the power of transparency in governance, corporate or national. This is something that any investor in China simply has to take into account.
I went to China this summer to look in on Zhongpin (Nasdaq: HOGS ) , a large Chinese pork processor that had at one point been one of our top holdings. When I returned to the U.S., we sold every last share in the company. I made the error of not doing so earlier, and it was somewhat costly for shareholders, but we bought into Zhongpin demanding the largest discount to intrinsic value of any company we have ever owned ... and I came to the conclusion that it still wasn't sufficient.
There is an open question in the market as to whether Zhongpin is a fraud. I visited the company's slaughterhouse and processing and logistics facilities and found them to be extremely impressive. This is a real business, with real products and infrastructure and real market opportunities. But I came away from my meeting with a profound feeling that the company, at a bare minimum, has a view toward shareholder capital that is out of step with how we believe it should be treated. Further, I was disheartened when company management expressed anger at short-sellers who have uncovered frauds at multiple Chinese companies. It's like being angry at a doctor who discovers a cancerous growth. He's part of the cure, not the problem.
We continue to evaluate Chinese companies and are happy to own them at the right price. But fraud in China is so rampant that the "right price" is almost universally quite low. In one shocking case, now-delisted Chinese company Longtop Financial's apparent fraud involved complicit behavior by its banks, without apparent penalty from the authorities. This is a level of fraud that auditors are nearly helpless to catch.
How China works
There are a few realities in China that foreign investors do not seem to have fully grasped. Financial statistics at every level are suspect. There is functionally no rule of law, since laws are written to support the Communist Party and are applied to benefit local party bosses. The banking system is in a shambles, since banks in China are organs of both political and economic policy. A recent UBS study places the potential for municipality debt default in China as high as US$450 billion.
Perhaps more worrying is the potential for a reckoning. Chinese banks are officially scared of one another, as evinced by the massive spreads they charge for overnight rates (currently in excess of 200 bps). China's municipal governments have borrowed somewhere between US$1.6 trillion and $2.2 trillion. UBS estimates well over $400 billion is at risk of default.
While Americans have felt the impact of defective Chinese products (toys with lead paint, tainted pet food, etc.), those who have been hurt the worst have been the Chinese. What's remarkable, and what wasn't technologically possible even five years ago, is that Chinese citizens by the tens of millions are talking publicly about it, using surprisingly uncensored channels like Weibo, a Twitter-like service operated by SINA (Nasdaq: SINA ) .
China's high-speed rail system, built at a cost of hundreds of billions of dollars, was meant to be a shining symbol of the technological ambition of the country. In early July, a Rail Ministry spokesman told The People's Daily that Japan's shinkansen "cannot be mentioned in the same breath, as many of the technological indicators used by China's high-speed railways are far better."
The land of the shortcut
July's deadly crash in Wenzhou has derailed this narrative with a competing one: that the government doesn't care about the people and is hopelessly corrupt, incompetent, and imperious. Even the positioning of the wrecked train was disastrous: Clearly visible in images of the wreckage is hexie, Chinese for "harmony," which some commentators altered to hexue, or "drink blood." The symbolism is simple: The rash of deadly incidents in China is the result of a government pursuing economic growth with neither care nor accountability to its population. I've often marveled at how quickly massive public-works projects are completed in China and wondered how this was possible without corners being cut. Confucius answered this question millennia ago: It isn't.
By late August, the Chinese government had launched salvos at several Internet providers, including SINA's Weibo, warning that they must do more to stop "the spread of false rumors." One can only assume that inconveniently true rumors are similarly suspect.
I've long decried the reverse merger as a backdoor route into the U.S. markets, since it eliminates the need for pesky (and expensive) processes that are requirements to go public via an initial public offering. I've noted this before, so I won't go over this same ground again, but I will say this: It is at least partially a testament to the strength of the U.S. stock markets that these frauds are being uncovered.
It's also a sign of the miserable failure of several institutions -- most notably the New York Stock Exchange and the Nasdaq -- to perform minimal due diligence prior to allowing these companies to list. Obviously, the U.S. has its Enrons and ZZZZ Bests in its past, so no one should expect perfection from our watchdogs. But the signposts were so clear that there was a money grab going on here, that their guards should have been up ... and they weren't.
I always play tourist when I travel -- it's part of my enduring fascination with cultures and countries around the globe. On my last day in China I toured the Forbidden City, as I have many times before. It was here that I was struck by the great paradox that is China. This palace could not have been built or maintained over the centuries without a great deal of care and foresight. It is a place where no small detail was overlooked: angles, vistas, sun positioning, nothing.
And yet in the courtyard just beyond the Tian'anmen, thousands of empty food wrappers and other assorted garbage littered the ground, some within feet of perfectly functional waste bins. Just as my friend noted about decision making in China, I can't say that I understand such fatalistic behavior, and I'm not sure that I ever will.
Is Zhongpin committing fraud? I don't know. I doubt it, but I don't know. I do know this: They would make a heck of a lot more money if they made great efforts to be as transparent as humanly possible, so transparent that it hurts. Because "I don't know" isn't an investment thesis -- it's a gamble.
On the way back to my hotel in Beijing, I passed through Wanfujing market, where they sell all sorts of trinkets, Mao-related gear, and a baffling array of street foods. One stall featured skewers of live scorpions. I am comfortable trying most any food, but this was certainly a bridge too far. The question of how to eat live scorpions is only slightly less interesting than why eat live scorpions. As far as I'm concerned, the answer ought to be that the return in pleasure outweighs the risk. I can't see it, though. I feel the same way about the majority of Chinese companies.
For further reading I suggest:
- Chinese Fireworks, by Robert Hsu
- Treason by the Book, by Jonathan Spence
- Big Dragon, by Daniel Burstein and Arne de Keijzer
Best English-language local news source: Caixin Online
Underrated local experience: Participating in taiji racquetball at the Temple of Heaven
Hidden gem restaurant: Ding Ding Xiang (Mongolian hotpot), Chaoyang, Beijing
Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below. Bill does not own shares of any companies mentioned.