Investors Should Steer Clear of These Chinese Small Caps

great wall of china
Great Wall of China

By Ben Strubel of Strubel Investment Management, LLC

The Chinese small cap space has been attracting much interest recently due to the low valuations of many companies. Many of the companies are trading at low single digit price to earnings multiples and at or below tangible book value. Beware! There is good reason for most of the low valuations.  Several negative articles have been published in the mainstream media and various blogs about a few of these companies. For example, China-Biotics has had trouble telling investors the exact locations of the stores it claims to have; and Universal Travel, an online and kiosk travel agency, has a nonfunctional website.

When I compared the articles about these companies, one item was the same. The companies both earned very low interest rates (less than 1%) on their cash balances. I dug deeper into the issue. The Chinese small cap bulls claim that the interest earned is so low because interest rates around the world are low. The bears say that the real reason is that the companies do not have the cash balances they report on their financial statements.

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To find out which view is true the first thing we need to do is find out what the base case is for interest income for small cap non-financial Chinese companies. After all, if all or most of these companies are earning interest of around .15% on their cash deposits, then nothing is out of the ordinary. To discover the truth, I looked at interest income earned by 113 small and midcap Chinese companies listed on the major U.S. exchanges: NYSE, NASDAQ, and AMEX. I looked for companies that make a majority of their sales in China. I excluded companies that did not break out interest income as a separate item on their financial statements. I also looked at the average implied interest rate over a two-year period. The goal of this research was to smooth out any large changes in cash balances that could skew the data. Finally, I included any current interest earning assets in the calculation of the interest rates. This would include any cash accounts or securities maturing in one year or less. I will discuss the rationale for including all current interest earning assets and not just cash later in the article. Obviously, companies with only cash earned slightly lower rates. Companies with a mixture of cash, term deposits, and short-term securities earned higher rates. I found that the average Chinese small cap earned 1.53% on their cash or short-term securities.

The 1.53% figure makes sense when looking at the official interest rates for China that are set by the People’s Bank of China (PBoC). A mixture of short-term call deposits and longer term 12 or 6 month deposits will easily lead to a figure near 1.53%.

Chinese Interest Rates

PBoC Interest Rates (before the October 19th rate hike)

Demand: .36%

3 Month: 1.71%

6 Month: 1.98%

12 Month: 2.25%

Agreed: 1.17%

Call Deposit: .81% (1 day), 1.35% (7 day)

Also, because all Chinese small caps I looked at are listed on U.S. exchanges, we can assume that the reason is for access to U.S. capital markets. Therefore, some of their funds may be held in the United States and earning interest at U.S. rates.

U.S. Interest Rates

Bank of America: .35%-.60%

Wells Fargo: .30%-.40%

Chase: .25%-.50%

Note: Rates are for $25,000 and greater deposits w/o and w/ relationships.

Looking at the mix of interest rates offered in both the United States and China, I then compiled a list of all companies earning under what I considered a minimum interest rate of .40%. If a company had just completed a capital raise in the United States, it could have a majority of its cash in U.S. bank accounts earning around .40%; anything lower would begin to be suspicious. Also .40% is well below one standard deviation of the mean interest rate earned.

The following is a list of all Chinese small caps listed on major exchanges earning less than .40% in interest income:

Another red flag about this list is that rumors of fraud swirl around many of the companies. China-Biotics, Universal Travel, China Sky One Medical, and other troubled companies have been the subject of fraud rumors in addition the having low interest earnings. Many of the listed companies also filed numerous amendments to their quarterly and annual reports to correct mistakes and they made many late filings with the SEC as well.

The low interest earned means that one of two things is true for these companies. Either the companies do not actually have the amount of cash that they report on their balance sheet or management is incredibly incompetent and has specifically sought out the worst possible places that pay the lowest possible rates on deposits, including finding financial institutions outside the United States or China that pay lower rates than either country.

Regardless of which is true, why would someone invest in such a company? You are either a partner with a business that cannot file accurate financial statements (for whatever reason) or is run by incompetent management that cannot properly manage a cash balance.

For investors seeking a great undervalued company, there are about 11,000 public companies traded in the United States. Investors would be wise to avoid the 16 companies I listed in the table above. Instead, try the many high quality large cap U.S. companies trading at historically low multiples. Why not invest in low priced companies where you know the product, know that the internal controls over finance and accounting work, and know financial statements can be filed on time? More importantly, why not invest where you know management is honest?

Disclosure: None

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