At the beginning of every month, I brief members on how MoneyGeek's regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also provide an example to show why I’m avoiding investing in Chinese stocks.
Performance of Regular Portfolios
The performance of MoneyGeek's regular portfolios for the month of September 2015 were as follows:
| Sep 2015 | Last 12 Months | Since Apr 2013 | |
|---|---|---|---|
| Slightly Aggressive | -3.0% | +9.7% | +40.8% |
| Balanced | -2.6% | +8.3% | +33.7% |
| Slightly Conservative | -2.2% | +7.0% | +26.8% |
| Moderately Conservative | -1.7% | +5.7% | +20.3% |
| Very Conservative | -1.3% | +4.3% | +13.9% |
I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.
| Sep 2015 | Last 12 Months | Since Apr 2013 | |
|---|---|---|---|
| RBC Select Aggressive Growth | -1.7% | -6.4% | +18.2% |
| TD Comfort Aggressive Growth* | -2.0% | -2.6% | +18.7% |
| CIBC Managed Aggressive Growth* | -1.3% | -2.1% | +19.5% |
| Canadian Couch Potato Aggressive | -4.3% | N/A | N/A |
MoneyGeek's regular portfolios underperformed their mutual fund competitors in September. In comparison to our competitors, our regular portfolios allocate a higher proportion of the portfolios toward U.S. stocks, as well as towards Canadian oil and gas stocks (i.e. XEG). The U.S. dollar rose relative to the Canadian dollar, which helped MoneyGeek’s portfolios, but the currency effect was more than offset by the poor performance of XEG.
Financial news headlines have suggested that stocks fell in September because investors continued to feel nervous about the Chinese economy. Chinese stocks continued to go down in September, and new economic data has continued to point to slowing economic growth in China.
Because of the continued crash in Chinese stock prices, some people have asked me if this is a good time to buy into Chinese stocks. In spite of the lure of low prices, my answer to this question has always been ‘no’. None of MoneyGeek’s portfolios contain any stocks that are based in China, though they do contain North American stocks that conduct business in China.
There are several reasons why I avoid Chinese stocks.
Chinese Government’s Influence
Chinese stocks are still not that cheap according to some popular yardsticks. For example, stocks listed in Shanghai currently trade, on average, at roughly 15 times their earnings. By comparison, Canadian stocks currently trade, on average, at roughly 17 times their earnings.
While Canadian stocks appear more “expensive” than Chinese stocks at first glance, you have to account for the fact that Chinese stocks are considered riskier. Investors tend to pay less for riskier stocks, and this has historically led Chinese stocks to trade at much cheaper valuations compared to Canadian stocks. Indeed, even with the recent crash, the prices of Chinese stocks are still 50% above what they were in the first half of 2014.
Furthermore, I’m leery of the Chinese government’s heavy influence over the stock market. The government’s influence manifests itself in many ways. Many of the companies listed in China’s stock exchanges are state owned enterprises, which are at least partly owned by the Chinese government. If I owned stocks of such companies, I would always feel nervous that these companies would prioritize political goals ahead of business goals.
I also believe that even companies that are or claim to be completely privately run can’t escape the influence of the government. The Chinese government encourages different industries and sectors of the economy from time to time, and such support can significantly alter a company’s fortunes.
Solar panel manufacturing is an example of such an industry. At one time, Chinese companies like Suntech used to dominate the global solar industry because of generous government subsidies and loans. Today, many of them are bankrupt or are teetering on the verge of bankruptcy as the industry ended up creating too many factories relative to customers’ needs and took on too much debt to do it.
That said, it’s possible that some industries could be relatively free of government influence, or enjoy relatively stable government support. However, I just don’t know enough about China to feel comfortable about it.
Last but not least, my past analyses of Chinese companies have always raised some red flags for me . Sometimes, these red flags have indicated that the company may be misusing money. Other times, I have become suspicious that the company’s management was engaged in fraudulent activities. To clarify, let me offer the following example.
Sino Agro’s Accounting Games
The company I’m going to highlight is called Sino Agro Food (Ticker: SIAF). The company mainly produces and distributes seafood and meat to Chinese consumers.
At first glance, the company looks very attractively priced. The company trades at under 3 times last year’s earnings. To put this number in perspective, if the company’s account of its earnings were accurate, it could theoretically pay out a dividend yield of 33%.
Furthermore, the company seems to be growing like crazy. In 2013, the company generated sales of $261 million, and in 2014, sales increased to $404 million. Its margins appeared very healthy too. Its net margin, which by definition indicates the ratio of its final profits divided by its sales, was north of 30%. A net margin higher than 10% is generally considered to be very healthy.
However, a closer look under the hood of Sino Agro Food’s financials reveals some troubling signs.
We can spot the first sign of trouble when we examine the company’s cash flow statement. While the company recorded a “profit” of $94 million in 2013, the cash flow statement showed that the company took in only $84 million in “Cash Flow from Operations” (‘CFO’ for short).
As its name suggests, CFO indicates the difference between cash revenues and cash expenses. CFO is different from profit (technically called ‘Net Income’) because some revenues and expenses are non-cash. For example, a company can bill a customer now, but receive cash from them later. After the company bills a customer but before it receives cash, the revenue that the company books is a non-cash revenue.
In general, CFO tends to be higher than profits because non-cash expenses tend to exceed non-cash revenues. It’s troubling, therefore, to see a CFO that is lower than profits as it might be an indication that the company is playing accounting games to inflate their profits. Still, perfectly legitimate companies do report a lower CFO than profits from time to time, and Sino Agro Food’s CFO came in only 10% lower than profits in 2013, so this by itself doesn’t raise a big red flag.
Unfortunately, the discrepancy became much more glaring in 2014. During that year, the company booked a profit of $114 million, but the CFO came in at only $22 million. In other words, while the company said they “earned” $114 million, they took in only $22 million in cash from its operations - a huge discrepancy.
Investigating the source of this discrepancy only made me more suspicious.
If you look at the accounting notes for the financial statements, you’ll see that one of the big reasons for the discrepancy lies with an item called “Other Receivables”. In general, receivables indicate monies that other parties owe to the company and that the company expects to receive in the near future. For example, if a company bills a customer and if the customer hasn’t paid the company yet, the amount billed falls under receivables.
However, the items that constitute Sino Agro’s ‘Other Receivables’ are unusual. Of the $48 million worth of ’Other Receivables’ that the company recorded, $6 million were “advanced to suppliers”, $14 million were “advanced to customers”, and $28 million were “advanced to developers”. This combined $48 million represents some 40% of the company’s profit for the year.
The problem isn’t just the size of the receivables. It’s the way the receivables are structured.
When legitimate companies have receivables outstanding, they usually charge interest to the other party. For example, if the other party takes a month to pay back the company, the company may charge 1% on the amounts owed. If the other party takes two months, the company may charge 2% on the amounts owed, etc. Charging interest discourages the other party from delaying payments indefinitely.
However, Sino Agro Corp doesn’t charge interest on any of its receivables, nor does it enforce any timeline for the other parties to pay back the receivables. Furthermore, the receivables are “unsecured”, which means that Sino Agro doesn’t have collateral it can seize in the event that the other party doesn’t pay the receivables back. It’s almost as if the company doesn’t care whether it can recover the receivables.
To me, this looks like a blatant accounting game. Let me explain what I think the company is trying to do.
In 2014, the company recorded total expenditures of $290 million. However, I believe the true expenditures were some $34 million higher (i.e. $324 million). Instead of recording that $34 million as expenditures, I believe the company spuriously made the claim that the money they paid to these entities were not expenditures, but rather loans in the form of receivables. In other words, the company made the assumption that the suppliers and developers would pay the $34 million back to the company. This assumption allowed them to reduce expenditures by $34 million.
Also, I believe the company reported at least $14 million more in revenue than they actually generated. They might have reported the higher revenue by giving their customers a $14 million discount. But rather than report $14 million less in revenue, the company said the $14 million was also a loan that would, eventually, be paid back. Treating it as a loan allowed the company to leave their revenue at $404 million instead of $390 million, which served to inflate their profits.
This is just one example of the way that Sino Agro has probably played the accounting game. When I look at Sino Agro’s financial statements, I see many more ways they could have inflated their stated profit. In fact, I believe it’s distinctly possible that they actually incurred a loss in 2014.
Unfortunately, Sino Agro Corp is not the only Chinese company that seems to play such accounting games. I’ve analyzed quite a few Chinese companies in the past that utilized the same tactics. It’s not just the smaller companies either. Even Alibaba, the $150 billion giant listed in the New York Stock Exchange, is facing some disturbing accusations. This leads me to think that accounting problems with Chinese companies are systemic.
In the future, China may evolve to the point that the government exerts less control over the economy. Also, Chinese companies may start to improve the quality of their financial reporting to the point that investors can become confident in their standards. We’re not there yet however, and that’s why I will avoid investing in Chinese stocks or ETFs for now.