Buy That Chinese Stocks Cos Of The PE Is Very, Very Low

Many of us are taught that low PE stocks are a buy. Some even add in yardsticks like ROE and cash per share. And as long as these requirements are met, they believe that they have a safety margin for their investment.

Me say? I feel the investors should look deeper. Understand the business and understand the company's books. Don't just simply invest in a stock because of the yardstick.

I believe more in practicals than theories.

I look for examples and as long as I could find an example that proves the theory wrong, then I feel one should be cautious.

Let me use .... Chinese listed stock (S-Chip) in Singapore as an example.

Take this OLD report from UOB Kay Hian back on April 2008. http://sinotechfibre.listedcompany.com/misc/UOBKH_SINBuyS-chips_030408%282%29.pdf

Let's look at page 14 of that pdf file.

Look at the data.

China Milk was trading then at S$0.675.

It has a ROE (%) 32.4 and net cash per Share (Rmb) 1.07.

UOB Kay Hian gave it a target price of S$1.32.

UOB reasoned...

• Outlook. Demand for dairy products in China remains strong. C Milk has adopted a multi-prong strategy to steer growth and to better leverage on domestic consumption. The strategy includes the following: a) improving herd quality to bolster production of semen and embryos so as to expand margins, b) moving downstream to produce processed milk, and c) developing herd size through internal breeding, the import of highly-productive herds, and even possibly mergers and acquisitions. We expect a smooth implementation of all these plans, backed by the Rmb1.8b cash in hand.
  
  Cheaper way to milk China dairy theme. C Milk is a cheaper way to ride on the rising dairy product consumption trend in China. The stock is trading at an undemanding 5.9x FY08 PE and 4.7x FY09 PE. Our DCFbased target price is S$1.32, representing 11.5x FY08 PE. Maintain BUY.

Trading at undemanding 5.9x Fy08PE and 4.7x Fy09 PE.

Sounds good, no?

Low PE, high ROE, got strong cash per share too....

What could ever go wrong?

Just about everything! Look at how China Milk Products shares have performed since April 2008!

The stock was suspended on Feb 2011!

And the story?

Scandal!

http://nextinsight.net/index.php/story-archive-mainmenu-60/912-2011/3971-shame-on-china-milk-management

From the article:

• This was a company that once commanded a market capitalisation of S$1 billion and, since its listing in 2006, had wow-ed a lot of investors with its supposedly immense profit margin, its profitability and cash hoard.

Great profit margins and cash hoard!

• The hard truth started to emerge when China Milk's convertible bond holders decided to redeem their bonds.
  
  The company at first claimed it had the US$170.56 million to meet its obligations on the convertible bonds. It just needed time and special approval of the authorities to remit the money out of the country.
  
  After all, it had said in its financial results announcement that as at end-September 2009, the group’s cash and cash equivalents stood at 2 billion yuan (S$409.7 million).

S$409.7 million in cash and cash equivalents. The bonds was only US$170.56 million.

• As matters worsened, the Singapore Exchange directed the company to appoint a Special Auditor.
  
  KPMG was the chosen one and it found a company whose cash hoard had been milked in major ways.
  When it repeatedly asked the Group to arrange an interview with its bank manager in China, KPMG was told that the manager had no time and could not assist.
  
  When KPMG asked to interview the main contractor which did US$72.9 million worth of improvement works, they were presented with a Mr Zhang Hong Tao who came across as being unfamiliar with the works done.
  
  In the first place, he didn’t own a construction company.
  
  The Group had commissioned improvement works to the farm and facilities and paid USD72.9 million over a period of 5 – 6 months ending in or around March 2010.
  
  When KPMG visited the sites, it was unconvinced.
  
  “One would expect salubrious farming facilities after spending USD72.9 million. However, the buildings and its facilities cannot be said by any stretch of reason to be no more than basic or at best average.”  .....

And do read for from the shocking full report from KPMG posted on SGX website.

http://info.sgx.com/webcoranncatth.nsf/VwAttachments/Att_B8AB2097A023C947482578AA00383459/$file/2011_06_07_ChinaMilk_FinalReport_Executive_Summary.pdf?openelement

So how?

In China Milk Products we have seen how the sad outcome of an investor who invests in the stock based solely on yardsticks.

Investing solely based on yardsticks is never enough.

I strongly one have to really understand the business and with China stocks listed abroad, you just got to be more careful because you never really know if those numbers (cash included) could be trusted!

I know that last statement is rather ... tricky. Look, I am not insinuating that all Chinese listed stocks are scams but with all the accounting fraud going on .... how can one be sure?

How?

Yeah... yeah... no risk no gain babe! No sugar no honey! ..... but is this the risk you want to take?

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Here's another article : http://www.sharesinv.com/articles/2011/03/25/s-chips-to-buy-or-not-to-buy/

• Interestingly, one distinctive characteristic about these S-chips is that they hold a lot of cash. This is evident from the financial statements of China Hongxing Sports and Hongwei Technologies, which had Rmb1,738m and Rmb145m respectively as at 30 Sep-10. As such, investors are spooked by two basic questions: Is the cash really there at all? And is it true that buying into an S-chip, will generally turn into a bad investment strategy?
• Detecting Red Flags
  As you may sympathize, many of the minority shareholders in all of the companies above as well as China Hongxing Sports & Hongwei Technologies have invested in good beliefs. As such, is there any method for those investors with limited analytical skill in detecting the potential red flag on S-chips?
  
  To put it simply, a company that has a lot of cash but refuses to give out handsome dividend may prompt the question on whether the cash is there in the first place, as in the case of China Milk. David Gerald, the president of Securities Investors Association (Singapore), said that companies with burgeoning cash balances should provide reasons why they are not declaring a cash dividend.
  Moreover, many S-chips are making cash calls even though they are already cash-rich. As such, this could be an indication that the management lacks capital discipline or that the company’s growth is not sustainable. Furthermore, an ‘unreasonably high’ capital expenditure (capex) also signals that the firm may poorly manage their manufacturing capacity and their budget. More often, an unreasonably high capex is often linked to other issues such as inflated profits.
  To top things off, JPMorgan Chase (JPMC) indicated that half of the S-chips are audited by a ‘Big Four’ accounting firm. And by contrast, three-quarters of Hong Kong-listed China firms do so. Astonishingly, the firms which do not hire ‘Big Four’ auditors are 60% more likely to fail than those who do, added JPMC.