01 Dec Forward-Looking Fact-Based Fraud Detection System (1/3)
While a high-conviction investment strategy has worked well for investment businesses such as Investor AB, we believe that value investing needs to be adapted in Asia to mitigate the risks of accounting irregularities and mis-governance. Our investment out-performance with low volatility has been a result of thoughtful systematic improvements to incorporate the fact-based forward-looking detection system as part of the investment process as implemented since September 2015. For instance, screening for high net-cash or high net-current asset as a percentage of market value might be the first step for many “Graham-style net-net” value investors.
To determine the attractiveness in valuation of certain stocks, they assume the “asset liquidation value” acts as a “margin of safety” to protect downside risk against further price declines while call-option-like returns works as mean-reversion to realise returns over time for the patient value investor. However, their financial numbers could be “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunneled out” or expropriated in money-go-round tunneling opportunities via unusual related-party transactions.
A number of these supposed value stocks are thematic stocks that are part of the “Ride the Asian Growth Story!” These stocks turned out to be the subject of some exciting “theme”, but are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Furthermore, western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps. Thus, accounting information can be used to inform – or to deceive.
I am fortunate to have taught accounting at the SMU, including launching the inaugural 15-weeks course Accounting Fraud in Asia and am grateful to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team.
We believe that we are one of the pioneers in incorporating the fact-based forward-looking fraud detection system that combines accounting data, especially footnotes, with a wide array of contextual information including:
– Unusual related-party transactions;
– Money-go-round off balance-sheet activities;
– Governance, group structure, consolidation accounting and ownership analysis;
– Textual and linguistic analysis;
– Analysis of event-based “catalysts” (information-based manipulation)
– Sensitive market announcements (action-based manipulation in prices and volume)
These provide fresh insights in equity valuation to inform our decision making in investments.
Case-Study Using Our Forward-looking Fraud Detection System
One noteworthy accounting irregularities is in the Singapore mainboard-listed companies China Environment Ltd (5OU: SES) first highlighted in February 2015 in the SMU course Accounting Fraud in Asia. The company had all the attractive traits of a “value stock” with single-digit price-earnings ratio and a very low price-to-book ratio.
In the month before, China Environment received the Singapore Exchange’s (SGX’s) approval to its placement of new ordinary shares and warrants to raise capital from the public, the the share price to spike up 20%. In the course, we flagged out its unusual unsecured interest-free loan advances to a mysterious “sub-contractor”, which sudden increased in other receivables. Circular money-go-round transactions where money was pledged as loan guarantees and loans to related-parties along with a multitude of accounting irregularities in the footnotes pointing towards a potential accounting tunneling of assets via short-term rollover loans to undisclosed related-party entities.
In June 2016, China Environment was investigated by Accounting and Corporate Regulatory Authority (ACRA) who had also asked the firm to refile and restate its financial statements for financial years 2013 and 2014 in mid-June under the Financial Reporting Surveillance Programme. This came after China Environment’s auditor Baker Tilly resigned on 15 April 2016.
In late September 2016, its unit Fujian Dongyuan Environmental Protection received a letter of demand from China Construction Bank for overdue interest on a working capital loan of RM23m. A High Court writ of summons had earlier been issued against the founder Mr Huang and his family on 28 September 2016 about alleged non-existent receivables from firms Anhui Shengyun Mechanical and Nanning Youji Technology. The share price of China Environment had plunged 80% since February 2015.
In a presentation to the Monetary Authority of Singapore (MAS) in September 2015, I pointed out the potential of implementing the world’s first fact-based fraud detection system for Singapore using a variety of corporate examples. Huge value destruction and losses harming the minority shareholders in China Environment and many other corporate examples can be avoided. The objective and benefit of this fact-based fraud detection system is not only to detect and prevent, but to also spur corporate reforms.
Categories Of Commonly-Used Tunneling Methods
I suggested a public disclosure of the list of companies by the four categories of commonly-used tunneling methods used by actual insiders, manipulators and syndicates to expropriate corporate assets to be listed on the SGX website to inform and educate public in a Financial Literacy 2.0 campaign:
(1) Money-go-round inter-corporate loans, guarantees, other receivables and investments,
(2) Capex irregularities,
(3) Deals potion,
(4) Consolidation craftiness
These are the improper pushing of operating expenses and debt liabilities into unconsolidated entities in which the listco has effective economic control and power to artificially inflate its own profit and balance sheet asset value.
This would prevent harm before fraud happens and spur the potentially fraudulent firms to act to improve their corporate governance including returning back part of the expropriated “missing cash” to get themselves off the List.
This system is not a company-specific “short-selling campaign” and being fact-based, the companies in the List have no grounds to object. By hanging this sword of Damocles over their heads, this will bring about greater efficiency in the overall regulatory system.
Given the limited resources in going after so many fraudulent cases on a case-by-case basis, these cases may occur and implode systematically during poor market and economic conditions, such as the reverse merger fraud wave in US that was concentrated in 2011.
By flushing out the lemons in the Singapore capital markets, it will no longer be the playground for manipulators and syndicates. Trust and credibility with local and global investors can be restored.
A personal belief is that the capital markets should serve the grand purpose of “藏富于民”, as a vault for common folks to protect, to preserve, and to compound their wealth in outstanding wide-moat innovators.
Until the lemons problem has been resolved, getting retail investors to “invest” their hard-earned savings or/and CPF in the Singapore capital markets is a misguided initiative.
Thus, the pitfalls of investing in the Asian capital jungles due to accounting and governance risks remain very real and the serious investor must never ever dismiss these risks.
“How About Singapore Stocks?”
We are often asked: “How about Singapore stocks?”. When the MIT Investment Management Company (MITMCo), the endowment fund of the Massachusetts Institute of Technology, visited my previous fund house in 2011 and 2012, I used the example of local supermarket operator Sheng Siong Group Ltd to highlight our investment strategy and process. That it is one of the few Singapore companies which we can have huge convictions in for the long-term.
I set up a meeting with the owner-operator Mr Lim Hock Chee and CFO Mr SK Wong in May 2011 before they were listed in July 2011. They had share price of S$0.33 at a market value of around S$443 million at that time. Mr Lim had commented that we were the first institutional fund manager to visit them and he showed us around his new Mandai Link warehouse and distribution centre.
I asked Mr Lim about his Hidden Champion neighbour PIN Corporation, the leading cold storage logistics player, next to his Mandai Link HQ and professed my admiration for both him and Mr & Mrs Liew Yew Fah, and asked whether they might come together one day.
Like Wal-Mart, both Sheng Siong and PIN are innovators in embedding technology into their business model to scale up. This enabled Sheng Siong to command efficient speed in its inventory turnover at S$17,000 per sqm, which is 40% faster than state-run giant NTUC Fairprice and doubled that of Dairy Farm Intl/Cold Storage.
Above is a summary excerpt of the 2011 presentation cover slide to MITMCo to shed insights on the projected valuations in the mid-term of doubling and tripling to S$900 million to S$1.2 billion in the next three to five years. Fast forward five years later to the present, Sheng Siong now trades at a market value of over S$1.5 billion.
Other than Sheng Siong Group Ltd which we publicly profess our love for, in terms of the business and the aligned owner-operators; Raffles Medical Group’s Dr. Loo Choon Yong; a few other listed companies which we have been closely monitoring; as well as a proprietary database built up over the decade-plus of 150 unlisted Hidden Champions, we do not find many other listed Singapore companies which we can be comfortable sizing up to an investment amount of S$10 to S$50 million in a single stock.
“How about Singapore companies with brand visibility all around us”?
In our unrelenting effort to serve value investors and the public, “to explain, exhort, encourage, inform, educate, advise” in the timeless wise words of the late Dr. Goh Keng Swee who was one of the founders and chief economic architect of modern Singapore, we like to share briefly about a listed corporate example.