Odd Lots - A Forensic Accountant On Why Chinese Internet Companies Are So Tough To Analyze

Episode Date: November 2, 2020

The IPO of Ant Financial will go down as one of the most extraordinary deals of all time. And in general, Chinese internet companies have been huge winners in the post-crisis period. But what does it take to really analyze the quality of their businesses? On this episode, we speak with Stephen Clapham, a forensic accountant, and the founder of Behind The Balance Sheet, who explains why understanding what's really going on with these companies is so tricky.See omnystudio.com/listener for privacy information.

On April 4th, 2023, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, I don't know if you've been following what's going on in Hong Kong markets lately,

but there is a very, very big event coming up. Well, it's only a few weeks away now. Although I have to say, I'm not exactly sure when we're releasing this episode, but in theory, there is a very big event coming up. So much to choose from, I feel like, you know, when you say something like, oh, I'm not sure if you're following what's going out in Hong Kong lately. My mind darts to like 10 different things. Yeah, okay. But in the market, there is just one thing I think that everyone is focused on at the moment. And that is the IPO of Ant Group, which is this sort of offshoot of Jack Ma's Alibaba. The big thing about this particular IPO is that, I think they're aiming for a valuation of something like at least $280 billion, which would easily make it the biggest IPO ever. And the whole transaction, again, it hasn't actually taken place yet,

but the whole transaction is so big that we're actually seeing it affect things like demand for Hong Kong dollars. We've seen liquidity in that market tighten. The demand for ant shares is expected to be so high that they haven't even bothered with Cornerstone investors, which is really unusual for an IPO. We're also seeing brokers in Hong Kong offer retail investors 20 times leverage on the ant shares because they're so certain there's going to be a pop on the first day of trading and everyone wants to get an allocation of the equity when

it first comes out. So it's a really, really big deal. And you can see that there's a lot of excitement around Ant at the moment. Wow. Those are some great stats. And I knew it was a big deal. I knew it was a big company. But actually, you sort of just blew me away with all that stuff. I mean, two quick questions for you. A, what does Aunt do? I mean, I know it's like this big finance thing, but I actually have no concept of what the company actually does. And B, $280 billion. I mean, that's got to make it, you know, it's bigger than any U.S. financial institution by a long shot, right? Yeah, I think that's right. And if you think, think back to Saudi Aramco, I mean, there was so much talk about Saudi Aramco when they listed on public markets for the first time. I think we even did one or two episodes about it. That ended up being something like $28 billion raised, so much smaller than what we're talking about now, Ant Group. I'm sure I'm not going to describe it right. I'm sure some people are going to take issue, but it's basically the sort of, I think it's the

FinTech portion of Alibaba, including AlliPay, which is one of the big, big payments providers in China along with WeChat. So if you've ever visited China, you know that cash is almost non-existent at this point, and anywhere you go, be it a Starbucks or a streetside vendor, you can pay using a digital wallet like AliPay or WeChat. So that's one of the reasons people are really excited about it. And of course, it's a big fintech giant in a very, very large market in one of the few markets that is really growing at the moment given China's purported economic strength. But of course, when it comes to this type of growth, particularly in China, there's always a

question mark over how you're actually measuring that and whether those measurements or those numbers are accurate or not. You know what I mean? Absolutely. So just to step back, just to sort of conceptualize, the company, Alibaba is this sort of, right, e-commerce, powerhouse, extraordinary company doing all kinds of things. And so I guess you could sort of imagine it as like, say, like Facebook or some of the U.S. mega cap internet companies, they have their own like sort of payments apps and payments messaging and stuff like that. And so this would be,

this is Alibaba's. It's gigantic. And they're essentially spinning it out into its own publicly traded company that's worth an insane amount of money. But as you say, you know, with so many of these companies, I mean, they produce financials, but all kinds of difficulty really gaining from the, the outside, like a true, like, size and scope of the business. Yeah. I guess you could think about it as imagine if Amazon also owned Venmo or something like that, and everyone used Venmo to pay for

virtually everything in the U.S. Oh, and also that Amazon had a gigantic money market fund that people using Venmo could also invest in. That's kind of Allie Pay in a nutshell. I'm excited now. Okay. So for today's episode, we're going to do a deep, dive onto Chinese internet companies. We're going to get a better sense of how they're actually accounting for the growth that I just described. And I think we're going to get a better idea of whether or not all that excitement over future growth is necessarily justified. And to do that, we're going to be speaking to Stephen Clapham. He's the founder of behind the balance sheet and also runs an investment and research training consultancy.

He recently published a very, very detailed and expensive report into Chinese Internet stocks looking at them from a forensic accounting perspective. So really the perfect person to discuss all this with, I think. All right. I can't wait. You got me super excited. Okay. All right.

Stephen, welcome to the show. Thanks so much for coming on. Oh, thank you for having me. So I guess to begin with, I'm curious what piqued your interest in Chinese internet stocks in particular, because there's no shortage of companies that you could be looking at with a forensic accounting background. And you chose to look at these ones in particular. I think you looked at five of the biggest ones. What sparked your interest?

Well, Tracy, you said that this report was expensive. and in fact, I want to disagree with you wholeheartedly because I think this report is very cheap. And the reason I looked at these is... $5,000, right? Honestly, Tracy, $5,000 is a bargain for this report. And before you laugh, let me explain why. So the reason that I looked at this, I was commissioned to produce this report by client. And one of my training clients is particularly interested in the Chinese internet companies,

and was concerned that they hadn't been able to get to the bottom of the way they were accounting in various aspects. And we talk about what those aspects were. So they asked me if I could help. And I said, yeah, of course. And foolishly, I completely underestimated how long it would take to do the work. And when I tell you that Alibaba's 2018 accounts were 1,077 pages long, you can probably understand why it's quite easy to underestimate how long it would take.

And so I went back to the client sort of halfway through the work. And I said, look, I'm having a bit of problems here because it's taking me far, far longer than I was anticipating. I knew that it would be complicated, but I didn't quite understand how much work would be involved. And the client said, look, no problem at all. I said, look, the best way around this is I don't want to do a bad job for you. But equally, I don't want to spend a huge amount of time. time that I'm not getting rewarded for. So the best compromises, why don't I just sell the report once you're finished with it and once you've done everything that you want to do in the stocks?

And they said, that's fine. And so we just put the report up on the website a few weeks ago. There's been quite a bit of interest. We haven't actually started to advertise it yet. Obviously, these are very, very big companies and they are incredibly complicated. And if you think about a set of accounts, it's over a thousand pages long. The most recent accounts are about half that. But it's still a huge amount of time to go through. And what we do is we go through word by word, number by number, dissecting every element of it. And if you're the average institutional investor, you just not have time to do this detail work. So that's why $5,000 is actually, it's not nearly as much as it sounds because it saved people a huge amount of effort.

And there's a huge amount of effort involved in our side in producing it. Okay, so setting aside whether $5,000 is a fair value or not, stepping back a little background, tell us your sort of general work. You mentioned that this was originally produced for a training client. What do you do for clients when you say training clients? So what was the sort of request that came in that ultimately led to this research? Oh, sure. So, I mean, our business has got three parts to it.

We've got our retail side. So we've got an online training school for retail investors. So you can go there and you can buy one of our courses, which helps you understand how to invest. And then on the institutional side, we do two things. We do bespoke research for people and we run training courses. So we've got a forensic accounting course, which we started in June. 2018, and we've done, I think, about 300 people have been through that course in the last two and a bit years. Obviously, fewer people this year because it's a physical in-person course,

although we've been doing a little bit of it on Zoom. And on the bespoke research side, people typically will come to us when they've got a problem. They've got a piece of research that is either too difficult for them to do in-house or too time-consuming for them to do in-house, or sometimes too controversial for them to do in-house. Often what happens is you own a stock and it goes down. And the analyst that's involved in looking after that position will do one of two things. You either say, he or she will either say,

you know what, I think I made a mistake we should just get out. Or they'll say, I'm right, we've just got to be patient. And often what happens is the portfolio manager, doesn't feel that the analyst is able to make the decision rationally without emotion. And he doesn't have enough time to do the work himself. So they bring me in as a sort of independent third party without any emotion attached to the holding that can make a rational assessment of where the risk and reward lies at this point after the shares have fallen. And that's, we do a little bit of that.

And the other thing we do is we do forensic accounting research. So people will say, you know, I'm thinking of buying a stock and can you please have a look at it? Or they'll say we own this stock, can you please have look at it? In fact, it won't be a surprise to you, Tracy, sitting in Hong Kong, that Hong Kong listed or Chinese-based companies are quite a popular area for people to ask us to get involved. One we did quite recently was Hutchison. So a client, again, I mean, I do this almost exclusively for Trump. for clients that are clients on the training side. I don't get random people coming in off the street asking me to do forensic accounting reports

for them. I do it for the people that know me and like my work. And this particular client, very big 200 billion asset manager, were interested in Hutchson because it looked very cheap. And he said, can you go and have a deeper dive and tell us if it really is cheap or not? And that's typically what we do. And this is exactly what we did in the case of the five Chinese internet companies, Alibaba, Tencent, JD.com, Baidu, and Maituan Ding, Dianping.

Those five stocks we were asked to look at and to look at on a series of, I think it was a dozen different elements. And there were things like, is the company flattering its earnings? Is the company using investment gains to boost earnings? is it carrying the value of unlisted investments, are they being carried at the correct values? So there's a whole string of things that we were asked to look at. That's a really helpful description of what you do. I'm curious when it comes to Chinese stocks, though, are there particular challenges that investors face

when it comes to things like transparency or realistic accounts? I guess this is a criticism that we hear about Chinese accounting and Chinese companies quite a lot. There's all sorts of issues you face. I mean, clearly the first problem you've got is that the first problem I've got is that I don't speak the language. I can't read the language. So you're at a massive disadvantage relative to looking at a company in the United States or in the UK where you've got that sort of home country advantage. and where you've got local pools of knowledge, local source of intelligence.

And we've got some contacts in China. But for example, one of the things that the client asked us to look into was the role of the audit firm and any connections between the partner involved in the audit and the companies. And we had to say to them, look, we can't really do that because we just don't have sufficient knowledge. We don't have any feet on the ground in China. to be able to assess if there are any hidden links between the company and the auditor.

Whereas in UK, for example, that would be, it wouldn't be easy to do, but we've got various tools and techniques that we deploy in order to make an assessment if there could be that sort of connection. But it would be impossible for us to look at something like that in China. And we don't even try. But there's a number of issues with Chinese companies in general. Obviously, the use of these variable interest entities is a very common way that these companies are set up. And that has a whole set of other issues, which we don't go into detail in this report, because they're generic.

That's a generic thing. What are you buying when you buy one of these businesses? And, you know, there's lots been written about that. And people, I think, have made their own judgments about whether they find that an acceptable risk or an unacceptable risk. Instead, what we did here was we drill down into some of the specifics. And many of the specifics are related to the nature of these businesses, the fact that they are internet businesses and that they're heavily involved in a whole investment ecosystem.

And so a lot of our work was dedicated to that area, that part of them. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court. Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday,

then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day, and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me. June Grasso. Subscribe today wherever you get your podcast. So to do some compare and contrast, obviously we have our internet giants here in the U.S., Facebook, Amazon, et cetera. Talk to us about some of the general differences that are required for someone to do serious accounting analysis of the books or of the statements of U.S.-based internet companies versus Chinese ones.

Well, I mean, some of these companies report under US Gap. So, you know, the accounting rules are the same. Right. Tencent reports under IFRS, which I think is quite unusual because ordinarily, companies that are listed in the US generally have GAP as their main language, main accounting language. But the accounting rules are exactly the same. But what you've got here is if you think of Alibaba and Amazon,

they're kind of similar. in concept. I mean, obviously they do different things and they're different scope. Tencent, JD.com. You would think of those in the same light as thinking of an Amazon. But if I told you that the Alibaba accounts went from over 1,000 pages to just under 500 pages,

do you know how long the accounts are for Amazon? Do you want to make a guess? 100. Good guess. So you're obviously practiced at this game because the Amazon accounts in 2019, including Jeff Bezos's letter at the front, which is an addendum to the actual 10K filing, was only 87 pages. So the accounts are much, much simpler.

And Amazon, I think, although I disagree with some of it's, some of the way it presents its numbers, you know, I wrote a blog a little while ago about the fact that it presents its free cash flow, in three different ways. All of them wrong, in my view, I've got a different definition, but at least it is quite helpful in the way it presents its numbers. Some of these Chinese companies are, I would I put it, they're less helpful than Amazon. Sorry, can you just dive into that point? So how are the numbers less helpful? And I'm aware that, you know, one of the criticisms of tech companies all over the world is flattering their growth, figures, you know, how many users they have on their platform. There's also, I guess,

use of non-gap metrics, the most famous being we work and community-adjusted EBITDA. Is that the kind of thing that you're, that you found in your report? Yeah, absolutely. I mean, the, the use of non-gap, I mean, this isn't a criticism solely of these Chinese companies. I mean, it's a, it's very prevalent throughout S&P 500 as well. But these companies, the non-gap numbers and the gap numbers are often miles apart. Not so much in the case of 10 cents, but in the case of the other four, they're very significant differences. And one of the main differences, which isn't a criticism of the Chinese companies,

more a criticism of the way the Southside community treats the reporting these. days, but they all make huge adjustments for stock-based compensation. So I think in the case of Alibaba, if I remember it correctly, it was something like $5 billion. And that, obviously, stock-based compensation is a real expense, because if you didn't give people's stock, you'd have to pay them real money. And it's a real expense because it comes at the expense of shareholders. Shareholders are diluted to the extent that these shares are issued. So it's that analysts ignore this number when they're calculating earnings. Because if it wasn't stock-based, it'd be cash, and they wouldn't ignore it. So I think this is just, you know, one aspect.

But one of the big elements in the Chinese group, which is different from the US, peers is the use of investment gains to flatter profits. Do you see a lot of gains on either the sale of investments or on the revaluation of investments? And this isn't to say that these companies are doing anything wrong because the counting rules, I think, are slightly daft in this respect. because what happens here is that I've got an investment in Company X. Company X is a young, fast-growing Chinese Internet company. It's hungry for capital. So it needs more capital and it decides to bring in an outside shareholder.

When that outside shareholder makes an investment, it's likely to be at a higher price than the price at which I have invested. and accounting rules require you to revalue the investment and book the gain through the P&L, which is obviously ludicrous. I mean, whoever thought up this accounting standard, I don't know what planet they were on, but I think it's a silly system. And I'm not saying that the companies are doing anything wrong by adopting this is what they're required to do. but it gives a misleading representation of their profitability.

So this should be a balance sheet item as opposed to something that would flow down to the bottom line, basically, if we're trying to get a true understanding of the company. Yeah. Well, I mean, I would argue that it shouldn't even be adopted in the balance sheet. You might want to note what the most recent valuation was because obviously it's helpful for investors. But to give you an example in the case of Alibaba, Alibaba had an investment in a business, and the investment was being reorganised. These are almost invariably very complicated structuring. So this particular investment was an investment that they held jointly with financial. And the business was restructured by being merged with another business.

and who should come in to make an investment in it, but SoftBank. Now, we all know that SoftBank is not the most disciplined purchaser of assets and that they've been prepared to invest on the basis of a longer-term vision than most other more ordinary shareholders would be prepared to take. So they've been prepared to pay very high prices for some assets that, I think are quite questionable. So Alibaba also owns, is also partly owned by SoftBank. So SoftBank owns a big stake in Alibaba.

So what you have is SoftBank coming in, paying a very high price for one of Alibaba's assets, and Alibaba then revaluing the value of that asset in its books and taking the difference to profit loss account. What could go wrong? Wow. Just on that note, could you maybe talk a little bit more about related party transactions? Because this is something that also crops up quite a bit with Chinese companies where you often have this sort of shadowy network of companies that are tangentially related to each other and are sometimes, if not self-dealing, lending each other helping hand when it comes to things like funding. What examples of that did you? you find? There are a lot of related party transactions in these companies. Alibaba is actually not the main culprit here. I think it was jd.com had the largest exposure to related party transactions. And the problem with the related party transactions, and we cover this in our forensic accounting

course for our institutional clients. We also cover it in online courses for retail investors. to say, look, one of the first things that we look at when we open a set of accounts is we look at the related parties note. Because if there are a string of related party transactions, you then have to ask yourself, well, who's verifying this? How do we know that these numbers are accurate? How do we know that we're not being disadvantaged? And it's almost impossible for the outside investor to make a rational judgment of this. And equally, it's probably pretty difficult for the auditor to make a real assessment of have the related party transactions been booked correctly in their accounts. And so many of the frauds that I studied,

when I was originally building the forensic accounting course, I went to, spent time in the British Library and I poured through all sorts of academic studies. I poured through lots of accounts. I looked back at past frauds. And many of them, one of the, one of the, one of the, one of key signals in advance was related party transactions. And where you've got related party transaction, you just don't know what the motivation is and you don't know whether you are being fairly treated. And that's a huge, it's always a huge risk. So what I say to my retail clients is, look, if you open their accounts and there's a page related party transactions, it's probably not worthwhile pursuing that as a potential

investment because it could take you a huge amount of time to verify. And even then, you may not know that you've got the right answer. So what else is in there? I mean, you mentioned that the Alibaba accounts are 500 pages, the Amazon accounts are 87 pages. What else is found in that 413 page gap that fundamentally makes the analysis of an Alibaba more complicated and more work than the analysis of Amazon. I mean, it's just the sheer scale, volume, number of transactions that they're doing, apart from anything else. You know, when we look at companies that are doing a lot of acquisitions and disposals, it's very difficult to determine what's actually going on, because where you've got a lot of acquisitions and even where you've got disposals, the underlying cash flows can be obscured.

Just explain what I mean, using perhaps a simpler example, would be, you know, you often see roll-ups, platform companies where they're making acquisition after acquisition. One of the things that we worry about when we see these is when you look at the operating cash flow in any year, you don't know how much the cash flow has been generated from the business itself and how much the cash flow has been generated from improving, for example, the working capital in the businesses you acquired last year. And you often see this in roll-ups where they'll do a lot of acquisitions of mum-and-pop businesses. They'll buy the mum-and-pop businesses, which maybe didn't have an independent credit controller, and they'll enforce very strict terms on their customers.

And immediately, they get a cash return in that the working capital shrinks. So their operating cash flow looks much better than it really would do, where it not continuing to make acquisitions. And that's fine as long as you carry on making more and more acquisitions and repeating the formula. But as soon as you stop, what often happens with these businesses is the cash flow unwinds. And this exact same thing is true, but on a different scale for these Chinese companies, because they're making loads and laws of acquisitions and disposals each year. And so trying to divorce what's going on in their core business with what's going on as a result of acquisitions is extremely difficult. Now, they would probably argue that

they're investing in young, immature businesses, and to the extent that they're making acquisitions, they're probably having to invest in the working capital so that the actual cash flows are worse than they would otherwise be. But you're seeing also a change in the composition of the businesses. So more of these businesses are going to subscription time. models in which customers are paying in advance. So obviously, the opposite is true and their cash flows would then be enhanced relative to what they would have been if they hadn't been making acquisitions. So the most complicated part of this is the fact that there's lots and lots of moving parts and they're all moving very quickly. And that's what makes the job of understanding the

business much, much more complicated. short daily news podcast focus on just one story. But right now, you probably need more. On Up First from NPR, we bring you three of the world's top headlines every day in under 15 minutes, because no one's story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR. So your description of ad backs just reminded me very much of Valiant's roll-up strategy back in the day. And I remember one of the issues with the roll-ups was that you ended up getting a lot of ad-backs where the company would add back line items for acquisitions. So, for instance, if it expected a transformational

M&A deal to really add to its bottom line, it would add back extra revenue or extra profit into its accounts. Is that something that you see with Chinese companies? And does that also impact their funding? Because again, going back to the Valiant example, I remember that the ad backs basically made Valiant appear a lot less leveraged than it otherwise would have appeared, which allowed it to tap the debt market relatively cheaply for a very long time and keep buying extra companies. Yeah, I mean, Valiant is a very curious example. because there was such a massive difference between the numbers that the analysts were focusing on and the numbers which were being reported that you would have imagined that people would have spent more time focusing on that. I think the case of these Chinese companies is slightly different.

If I told you that if you looked at the last five years for these five companies, and I told you that they had made investments in the Chinese, predominantly Chinese, they made a very small number of acquisitions, very small value of acquisitions overseas. But they basically, they've invested in a huge range of Chinese venture capital. And if I told you that they had spent nearly three trillion. That's trillion, Rumbi, in the last five years. So what's that? That's like five vision funds. These five companies in five years. I like how we measure everything in vision funds nowadays. Yeah, it's a great, it's a great unit of account. I love it. I think it's a useful, it's a useful unit. It's absolutely great. You want to look at, you want to scale something ridiculous. So, you know, on average, there's a vision fund every year or a vision fund every company, do you look at it? But that's basically what we're saying. And you then have to decide, okay, unlike perhaps the vision fund, have they made sensible investment? And the issue here then

becomes, okay, well, what is the carrying value that they're showing in their books for these investments? And to be fair to them, the disclosures do vary from company to company. Some are better, some are worse. But, you know, there are enough disclosures at some of the companies that you can do some quite detailed analysis. And you can come up with an assessment as to whether you think the numbers are sensible. And that's what we've done. A little spoiler for you, they're not all sensible. So there are some, you know, there's some numbers in there that if we were the finance director, we would be rather uncomfortable about the carrying values of those businesses. But the real point here isn't that, you know, I can sit here in London trying to value an investment in an

unquoted, unlisted, no public information, Chinese venture. I mean, obviously that's extremely difficult and would be impossible for me to do the whole thing. But the question I've got is, how can the auditors do that? Because it is not easy, right? And, I mean, just the scale of these investments is phenomenal. So what you would have to ask yourself is, how likely is it that the auditors would have found all the right bands that were required and made the companies take those write downs?

And I can tell you that there are, there have been right downs. Not saying there's never been any write downs, but the write downs are on a somewhat lower scale than the vision funds. So what does that tell you? Well, it tells you either that they're phenomenally successful at making these investments, or that they can justify carrying values because they found somebody else to come in at a higher price, which that doesn't mean to say that the values are accurately disclosed in the balance sheet, but it does mean to say that they've conformed with their counting rule.

Right. Or it could be that they've invested a lot of money, and obviously the valuations of these stocks has gone through the roof in the last few years. And they've carried on investing throughout. So is it possible that these companies will be forced to take some significant write-downs in the next few years if the valuations don't hold firm? And they've invested in a range of, I mean, you know, a very wide range of products. It's not like they're, you know, confined to a single vertical. They're all trying to expand across a whole range of different activities.

Many of them completely divorced from their core business. So we started this conversation talking a little bit about Ant Financial and the upcoming IPO valuation target is something like $280 billion. If someone is buying a share of Ant Financial, what do you think they're buying exactly? And financial wasn't one of the stocks that we were asked to look at because when we were asked to do this work, the filings weren't available. And, you know, perhaps the client will ask us to come back and have another look at that one. The difficulty with these sorts of rotations, and, you know, it's particularly true in emerging markets. And I've seen it a number of times in Asia is that when there's a buzz and particularly when there's a large retail, component to the deal, the institutions will just follow in because they'd be daft not to. So these things,

you can create your own success by producing a big enough buzz about the story. And then, as long as the numbers appear to be going in the right direction, everything is fine. It's only if things stop, then you find that they've been sold for more than their otherwise worth. I always think with IPOs, I used to specialize, one of my specialties when I was at the hedge funds, one of the things I used to do was I used to look for IPOs that were either really unpopular. So a company coming to the market, which was deemed unattractive for whatever reason, needed to come to the market, needed to raise the capital, would often come at a ridiculously cheap price. And on the other side, what we used to do was you used to look for these over high.

stocks coming to the market, and we used to short them. And it was an incredibly profitable strategy, because the issue with an IPO is that you've got a very level playing field. Very, very few people in the stock market have got history with the company. So everybody's equal. And if you spend more time than your competitors and understand the company better, there is one of the few areas in the stock market where you can deploy an information advantage legally you know sometimes there's an information advantage but you've got inside information obviously you can't deploy that but this is one of the few areas where a fund with a bigger research department with more resources can effectively deploy these resources to gain an

information advantage actually i have a sort of curveball question here is something i've wondered about. But you mentioned earlier on that, you know, you give advice to people that if they see a whole page of related party transactions and a filing, that's probably a red flag to steer clear. Are there any, you know, when people think about forensic accounting, they think about uncovering a good short or maybe sort of justifying a long position. Have you done or are people doing any work on sort of quantitative uses of this stuff? So, for example, just, you know, short all the companies with lots of related party transactions, go long, all of the parties, all of the companies that don't have them, to some sort of market neutral strategy.

Are there any sort of approaches to investing in the work that you do that don't try to drill down in one company, but just take a few accounting rules and then do a big balanced, diversified portfolio based on these items. Yeah, I mean, I think it's a very good question, Joe, and I think that actually most of the popular tools have been all go out of existence. So there was a very good paper by research affiliates

looking at gross profitability, which was a subject of an academic paper in 2013, came up with some very, very good results. The fact is that all the algorithms have been using the findings of that paper, and what's happened is those stocks have been re-rated. And they've done well, but they've done well because they've been re-rated. I think most of these issues are, most of the accounting issues have been arbitraged away. And in fact, in my book, which comes out next month, we talk about the fact that all,

have been kind of the enemy of the analyst because algorithms can do all this stuff much better than the analyst. And the one area which I'm quite intrigued about, but slightly helpless about, is natural language processing. So we've done some basic textual analysis in this report, looking at the words and trying to interpret whether there's been an unusual amount of obfuscation by these companies relative to an Amazon, for example. And you can't do this without a computer. And there's all sorts of things, areas in the area of understanding text, understanding words, that computers can do much better. To my knowledge, there isn't anybody that can analyze, dissect a computer that can

analyze and dissect the related parties' notes, because obviously they're very complicated, very specific. And I think that's one of the areas where you do need a human being. Fortunately, there's still some areas where you do need humans. Just on the subject of natural language text looking at Chinese accounts, one of the surprising things, or one of the things that I think is surprising to people who aren't familiar with this particular market is sometimes you read the accounts and you get a lot of. lot of mentions of what the company is doing to benefit China or to benefit the Communist Party and President Xi and things like that. I remember one of the, I guess, the most amusing examples

that I found of that recently was there was, I think it was a bank and someone, probably an old lady in China had microwaved her banknotes in order to get rid of the virus. on them. She thought COVID might be transmitted through banknotes. And she brought these destroyed banknotes into the bank, and they had helped her piece them back together or salvage them in some way. And the bank had written a footnote in its accounts about this particular incident, and it went into a lot of detail,

just to say that it was doing its part to help people during the coronavirus outbreak. So that's a long-winded way of me asking you, how much does politics enter into Chinese accounting, corporate accounting? Well, and for these companies, I think they're looking westward, really. They're looking at the investors in, or maybe it's not so true today, but going back a few months, they're looking at Western investment. And I think, you know, talking too much about how they're engineering, themselves to help the Chinese government doesn't endear them to the average marginal investor

in New York. So I don't think there was as much of that as you might see in a domestic Chinese issuer. But there's some interesting. I mean, some of them have got some quite interesting observations about what they're doing to help the Chinese consumer, what they're doing to help their employees and those sorts of things. I don't think we saw too many too much discussion about microwave banknotes or anything along those lines. I don't recall one of those.

One last question for you, Stephen. What's your I guess your number one tit to any investor who's trying to survey the accounts of a company that they're considering putting money in, whether it's Chinese or from somewhere else in the world. Corticia, I'm glad you asked me that. And if I can just put in a plug for my book, the smart money method,

we talk about three pillars. So there's three things you should do when you look at a stock to make sure you're not buying a fraud. And you might not be looking to avoid a fraud. You might just be looking to avoid a company that's not going to perform well. And all of the studies tell you that the majority of stocks do badly. The majority of stocks underperform. So if you do these three simple checks,

then you will protect yourself and reduce the odds that you're buying a loser. The first check is to look at working capital ratios. Companies that have rising days of receivables, rising days of inventory, tend to be, well, they can be frauds, but they can be frauds, but they tend not to be as good investment. And the reason is very simple. If your customers aren't paying you, that probably isn't a good thing. If your stocks are rising, it usually means your customers don't want what you're trying to sell. The second tip is always do a comparison of the margins today with the past and with the peer group. Every single fraud I studied for my forensic accounting course had margins which were higher than peers, and usually unexplainable.

And the third thing is, don't just look at the earnings, look at the cash flow. Is the company generating as much cash as it's reporting in earnings? And if there is a trend in which earnings have carried on going up and cash hasn't, that's usually a sign to stay away. So those three simple tricks, working capital, margin comparisons, and cash versus earnings. will keep you out of trouble. That was really great. Thank you so much for coming on Odd Lots.

A great conversation. Oh, well, thank you so much for having me. I mean, I'm absolutely delighted to do it. That was fantastic. I'm really excited about reading the book now. Thank you so much. Joe, I really enjoyed that conversation. I think it was a useful bit of critical analysis

to offset some of the optimism and excitement that we've seen lately, not just around the Ant IPO, but around tech stocks really all over the world. I feel like we could just do episode after episode with accountants and particularly forensic accounts. It's just like it's always so interesting. And every time we do it, we're like, we got to do more accounting episodes and then we forget. But I always remember after these conversations like why they're like so interesting. And he was like a great sort of articulator of some of the issues that make corporate analysis so difficult and interesting.

thing. Yeah, I can't even imagine going through a thousand pages of accounts, but I thought the point about, for instance, related party transactions was a really good one. If there are pages and pages of complex footnotes and related party transactions, then that's probably a red flag right there, or at least, I don't know, I kind of, I wonder how many investors are actually going through all of those. I can't imagine it's many. You know, it's interesting. I thought your question was really great at the end about politics and the connection between the corporate leadership, particularly of these big Chinese companies and the government in China. Just in general, it feels like that is such a sort of factor in understanding both like how the economy works and how specific businesses work. I was thinking back to our conversation with Tom Orlik, the Bloomberg economist who has the book about the China bubble. And so much, so many misconceptions of analyzing China, at least in Orlik's view, sort of stemmed from the idea that the Chinese government by control of the banks can sort of get any outcome it wants. And it can forestall a bubble or it could stall bubbles from crashing as long as it wants. And so thinking about like some of these sort of the non-financial companies and the investments they make and how they mark their investments and whether they can, whether they have a, whether they can find an entity to invest in investment that will continue to increase the value, it just seems like it's got to be pretty tough to analyze that from any sort of like outside sort of like typical Western standards.

when you have so much of the large industrial leadership of a country so tied in with the government. Yeah, I think that's absolutely right. And that's probably why Chinese political analysis is probably a growing area of opportunity in finance. I mean, it is one of the benefits of a command economy, right? You can direct capital and control industries to some degree. And there are examples in China of companies that have basically based their entire. business model on figuring out what it is the Chinese leadership wants. So the best example of that is China Evergrand, which I don't even know how to describe it. It's a Chinese property company, but it also makes electric cars because the Chinese government was really into that. And it also runs some hospitals because health care is important. At one point, it got into soccer teams or

football because she was really into sports. That's probably the most extreme example of companies trying to tow the party line, but it's one of the most interesting. Let's do an Evergrand episode. Oh, yeah. You know what I love? Like, A, we should do an Evergrand episode. But also, I love how many times I feel like when it comes to a Chinese, big Chinese company,

like, there's a really big challenge with how to describe it. Right? Like it's always like, okay, it's almost like there's no analog that we can think of, at least among Western companies, but there's sort of the range of business lines that some of these, you know, Chinese giants are in. Yeah, I always find myself reaching for American parallels and then saying like Amazon, but much bigger or like Apple, but much bigger or like Google, but also with a random money market fund and things like that. I love it. Well, one other thing, we got to start using a vision fund as a unit of account more often. Yeah, the U.S. economy grew by two soft bank vision funds this year.

Yeah, I like that. All right. Should we leave it there? Let's leave it there. Okay. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway.

And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. Follow our guest on Twitter. He's Steve Claffam, and his handle is at Steve Claffam. And follow our producer, Laura Carlson, at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts under the handle at podcasts. And check out Stephen's new book, The Smart Money Method.

Thanks for listening. Hi, I'm PJ Vote. My podcast search engine has a new two-part series for you. Of all the new technologies coming out of AI, the most transformative one might be driverless cars. They're already on the road in 10 American cities, and they're quickly coming to more. We tell the story of how we got here.

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