Tuesday, March 15, 2011

China MediaExpress debacle, Due Diligence another set required

Short sellers have won the case, congratulations!

In the case of China MediaExpress the human mind can deceive itself, everything was just to good to be true. The longs were unjustifiably optimistic. Maybe we subconsciosly overlooked important information and were so overconfident with the story that we fail to recognize how biases can distort the investment thesis.

The headline China MediaExpress CFO Resigns, Auditor Calls for Investigation


will have a major impact on the US-listed Chinese space. A lot of long investors will get burned, but that belongs to investing. Don't put all your eggs in one basket.

The question remains how can we minimize the risk of another fraud. Due diligence is much needed, so Pinkerton and Kroll will see their business flourish if institutional investors want to be 99.9% sure that their potential investment is not a fraud.

What lessons can be learned?

First I would recommend the book Best Practices for Equity Research Analysts from James. J. Valentine to the analysts who covered China MediaExpress.

In a perfect world, equity analysts would be omnisciently aware of every aspect of a company's inner workings, including the level of conservatism or aggressiveness in its treatment of accounting issues. As much as the general media expects analysts see through walls and use clairvoyance to read management's minds, this is beyond the ability of most equity analysts. Very often when financial fraud occurs, the company has fooled even its own auditors, but this gets lost in the press, which point the blame at Wall Street analysts for missing the problem.

This isn't to say that analysts should just ignore accounting but, rather they should set expectations for what it is: an opportunity to see early warning signs that problems are developing; red flags.

Discovering these problems can require plenty of time and in some cases, specialized resources. Spotting red flags requires that the analyst understand the underlying economic transactions that generate each important financial statement item. Understanding how values are measured using the applicable accounting rules will enable you to identify items where management can take advantage of flexibility in accounting rules to achieve its financial reporting objectives.

A lot of private and professional investor are fooled so I hope someone could come with a red flag score system that would be helpful to the investment public at large.

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