Friday, May 27, 2011

Corporate governance issues as a risk factor

In the space of 24 hours two reasonably prominent PRC companies listed in Hong Kong have been subject to allegations involving accounting irregularities:

1. Chaoda Modern Agriculture (HK:682) was subject to an allegation by a tabloid newspaper that it had overstated the size of its land bank (among other issues). The company's general denial carried no weight with investors and the share price dropped by about 25% during the course of yesterday's trading. This is from a company that was already deeply unpopular with investors due to various actual and proposed capital raisings which had diluted and damaged existing shareholders' interests;

2. Real Gold Mining (HK: 246) has been subject to claims reported in the SCMP that it filed different sets of accounts with the Hong Kong Stock Exchange and the regulatory authorities in the PRC. For 2009 (the most recent year for which both sets of reports are available) the revenue reported to the HKEX was in excess of 0ne billion RMB while the company's PRC operating companies collectively reported sales of only RMB3.45 million. The reports filed in the PRC have now gone "missing". These allegations have followed a number of top level management changes in 2009. As at the time of writing, the shares are suspended from trading.

In both cases, the companies have denied the allegations. In both cases, the denials are general rather than specific, there has been no confirmation that a more detailed explanation will be forthcoming and no proposals to verify the companies positions (unlike in the case of China Gas (HK:384) which dealt with its own much less serious issues in a robust and open manner).

While Real Gold was not a company that I ever considered investing in (I am not a believer in gold), I did take a long hard look at Chaoda Modern Agriculture but (fortunately) decided not to invest. If I did hold shares in either company, at this point I would be taking my losses and heading for the exits (where possible) - if the allegations are true then the problems are very serious.

The two cases illustrate some of the risks of investing in equities. These sorts of problems can occur in any market (and even the most heavily regulated markets have had their share), but are not going to deter me from maintaining my bias towards risk assets. Almost all companies are run honestly and there are few other investments which offer the potential returns of equities over the longer term. The "safe" alternatives simply represent a different types of risk. IMHO, being aware of and managing risk is a better strategy than avoiding it altogether.

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