Taming the dragon: Understanding Chinese stocks from a forensic analyst’s perspective

The global novel coronavirus pandemic is having devastating consequences, plunging economies into a temporary recession. However, China, where the outbreak began, has made a remarkable economic recovery through the successful application of radical containment measures. This, together with several other factors, has increased foreign investor interest in Chinese securities. However, foreign investors find it challenging to understand Chinese company financials for a number of reasons.

More pronounced issues relating to Chinese stocks include the following:
• Recognition of tangible and intangible assets such as goodwill at highly inflated
  values amid increasing cross-border M&A activity, especially in the Chinese ICT
 sector, often at extremely high valuation multiples. However, these transactions
  often fail to yield the intended growth results, leading to significant write-offs.
• Companies reporting high volumes of other gains and investment income in
  their profit and loss accounts to boost profits.
• Other issues: mitigating impairment of assets using evasive impairment approaches
  and assumptions, and making favourable adjustments to operating profits in arriving
  at non-GAAP results.

Key Takeaways

It would, therefore, be useful for investors to evaluate Chinese company financials, especially of companies in the ICT sector, from a forensic analyst’s perspective, which includes exercising caution in evaluating M&A, and being mindful of methods of “creative” accounting and accounting shenanigans.

In this context, forensic analysis and an extra layer of scrutiny of financial statements provide added assurance to asset managers keen on increasing the share of Chinese stocks in their portfolios but are hesitant to do so due to unfamiliarity. We at Acuity Knowledge Partners have a team of forensic analysts with more than 10 years of experience in catering to this niche market with hands-on experience in Chinese securities in diverse sectors.

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