Monday, May 03, 2010

A case study in emerging market risk

Emerging markets are littered with companies that go bust (or otherwise manage to destroy all or most of their shareholders' investment), often in circumstances which would not be expected in markets which are classified as developed and which, in theory, are better regulated and offer greater transparency.

The SCMP article on the demise of First Natural Foods Holdings Limited is a case in point. The company was listed in Hong Kong and ran a business of selling a range of food products such as the highly popular and valuable abalone from its headquarters in Fujian Province. In June 2008, it reported shareholders funds of RMB1.2 billion and cash of RMB630 million. In other words, the audited accounts showed a very solid and highly liquid balance sheet.

Within a matter of months, the company managed to more or less implode. In January 2009 the Hong Kong courts declared the company to be insolvent.

The insolvency begged the obvious question - what happened to the cash? At this stage it appears that the answer may never be known. Ernst & Young were appointed as liquidators. After 16 months on the job:

1. they have been unable to take control of the company's business and assets (which are located in the PRC)

2. they have been unable to find the company's former top executives

3. most of the company's books and records have been "lost"

4. the (former) top executives are still holding the company's chops (without which apparently PRC law will not allow the liquidators to take over the business)

5. (for the most part) the PRC courts have refused to support applications by Ernst & Young

6. HK$84 million was removed from a company bank account in Xiamen two months before the company was placed in liquidation - a transaction which was not recorded in the company's books

The reality is that shareholders have no remedy for situations like this.

The First Natural Foods case is not an isolated incident. There are plenty of similar stories of inexplicable insolvencies of Hong Kong listed companies. (That said, there is no shortage of corporate bankruptcies in developed markets as well.)

The clear message for me as an investor is not limit my exposure (unlike the unfortunate individual quoted in the SCMP who put 15% of his stock portfolio invested in First Natural Foods).

Most of the companies I buy are substantive businesses, have sound balance sheets, are state backed (for the PRC businesses), have big four auditors, have a visible management presence and have been listed for a number of years. The exceptions tend to make up a very small percentage of the portfolio. The largest position in any individual share (based on current market values) represents less than 1.6% of our household's net worth and my entry level for new investments is currently just below 0.5% of household net worth for most companies (I will invest more in very substantive companies). If a single company in the portfolio disappears over night, it would hurt but would not destroy my retirement plans.

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