Saturday, December 10, 2011

Sumo Wrestling China Agritech's Quality of Earnings and the Glickenhaus Defense

Sumo wrestlers cheat.

I have never seen a sumo wrestling match and I don't know any sumo wrestlers -- hell, I have never been to Japan. Yet, I know they cheat. Why is that?

Well it turns out that sumo wrestlers, just like any other professional athlete, can make a lot more money if they are on top of their game. A small increase in wins can translate into thousands of dollars a month.

You might be thinking, "Well Josh, that doesn't make a lot of sense." Sumo matches are viewed in a large stadium, there are referees, and if you actually knew anything about sumo wrestling, you would know it's part and parcel of the Shinto religion. Not only is it absurd to say there is cheating but it's also sacrilege.

Yet, they still cheat and here is why.

In sumo wrestling, they have 15 matches; if a wrestler wins 8 matches he moves up the respect ladder and the income ladder quite dramatically. The difference between 8 wins and 7 wins could mean five thousand extra dollars a month.  So if a wrestler has a 7:7 record, he has a lot more to gain than a wrestler with an 8:6 record has to lose. Match records show that 7:7 players go on to win 75% of their next matches, but the probability would imply a 50% chance of winning.  This means there is a statistical blip when it matters the most for the sumo wrestler. Some defend the statistical blip by saying the 7:7 player really wants to win and that's why the statistics shoot up.


However when they meet again, the 7:7 player typically loses to the 8:6 player. This implies that the 8:6 player deliberately lost the first encounter because there is a quid pro quo relationship going on in the world of sumo wrestling. They even have a word in Japanese for these match-fixings; they call it yaocho.

What's interesting about this is you don't have to be Japanese or spend time in a sumo stable to know there is cheating. It's in the numbers, and if you able to interpret the numbers and incentives it stares you straight in the face.


Quality of Earnings by Thornton O'glove helps educate the analyst into looking into the quality of the earnings, not so much the quantity of earnings in and of itself. After all, Enron showed GAAP earnings, but how much quality do you think they had?

Looking first at the quality of the earnings, as opposed to the quantity of the earnings, is a simple concept, but for whatever reasons, it seems to escape most people.

There are several things to look for when analyzing a company's financials for malfeasance:

  • Cash flow from operations is consistently lower than net income. 
  • Profit margins are significantly greater than the industry average.
  • The company is consistently paying large sums for acquisitions that end up growing goodwill.
  • Acquisitions come from related parties. 
  • Accounts receivables and inventory are rising at a higher rate than revenue.
  • There are off the balance sheet liabilities.
  • The company depreciates their assets much slower than industry averages for similar assets.
  • The company funds acquisitions via debt offerings even though they show large cash balances. 
  • The valuation of the assets doesn't hold up to reality since similar assets would deserve an impairment charge. 
  • The shareholders don't own the equity of the operating company -- they own the contract rights to the underlying business. 
  • The company has a much lower property, plant and equipment asset size versus the size of their business and/or employee base.  
  • The cash and assets of the company are held in countries where using your property rights as a shareholder could be very difficult to execute.
  • The management constantly uses common stock to pay for acquisitions or as a bonus to employees rather than cash.
  • The company sells their assets to related parties.

Not one of these in particular means the company is obfuscating the quality of their financials. Things need to be put into context and possibly clarified with management. Yet it's important to be skeptical of the management's explanation and remember that things have to take common sense into account. No matter how mouth watering the financials may be to would-be-investors, if there is no quality, the quantity becomes useless.


In late 2010, reports started to get published about fraud in Chinese companies listed in the US. Lucas McGee published his own report about China Agritech. John Hempton then published a blog post questioning China Agritech as well. It turns out that a money management company called Glickenhaus & Co. had owned China Agritech before the report came out and started to do their own investigations about the fraud allegations of China Agritech; Bloomberg even had a story about this and did a fairly long video interview with them. The youngest of the three Glickenhauses, Jesse, went off to China to personally ferret out the validity of the allegations. He went on to publish a youtube video of his findings and a research report  which concluded that China Agritech was very much a real company and Lucas McGee was nowhere to be found.

I had no dog in this fight and was just a spectator. Time rolled on and the uproar of China Agritech and China fraud caps was silenced by problems in Europe and the general short term attention span of the market.

Then, last Tuesday, I received a comment on my blog for an old post on China Agritech.

James Glickenhaus

The first link was to a press release sent from BDO China that said they found the Lucas McGee research factually wrong and China Agritech was very much a real company, which would appear to confirm Jesse Glickenhaus's investigations in China. The second link was to a Bloomberg interview with James and Jesse Glickenhaus discussing the story of China Agritech and what had happened so far.

If you watch the video you get a sense of how he did his analysis. When asked how he got into China Agritech, he said it was part of the big picture that the world is getting bigger and the world will eat more; therefore, buying fertilizer companies was a natural extension of that thesis.

To me this thinking is overly simplistic. It's obvious the world is getting bigger, but it's important to do the next step in the analysis: what price do you pay? Just like everyone knew cars and radios would be a big thing in the early 20th century, or the internet would be in the late 20th century, now we all know the world is getting bigger. Fertilizer companies are a natural extension of that, but you have to ask yourself, "What price should I pay?"

To James's credit, he did say he looked at the financials and they were on track to earn $1 a share and the company was growing. Now, this sounds like he did the next step of the analysis, but this also seems to be too shallow. When I look at the financials, I see red flags pop up all over the place. I keep on thinking, "What did he look at?"

Notice the operating cash flow being far lower than net income on a yearly basis.

When you have a company that consistently shows negative operating cash flow, versus net income, this is a huge red flag.

Notice accounts receivable growing faster than revenue.

Revenue and receivables should grow aligned with each other. Although the difference isn't large here, it could start to look a bit funny.

Notice where the company gets its cash.

Doesn't it seem a little odd that the company is garnering cash more from issuing stock than operations?

Notice the high level of revenue growth versus PP&E.

The company is generating $76.13M in revenue over just $8.62M in PP&E. That's pushing eight dollars and 81 cents in revenue for every one dollar in PP&E. To show why this looks a bit odd, if you look at CVR Partners, which Clickenhaus mentions as UAN, in 2010 they had annual revenue of $180.47M and PP&E of $433.36M. That's 42 cents of revenue per PP&E compared to eight dollars and 81 cents with China Agritech!

You might say it's unfair to compare China Agritech with any business -- I mean, it's in China and don't you know everything in China is highly profitable, and people are industrious and efficient? (I don't.) Let's look at this metric with Coca-Cola, a company that manufactures high profit non-alcoholic beverages with some equipment that's been around for a while (depreciated). Their 2010 revenue was $35.1B and their PP&E was $21.7B; that's one dollar and 61 cents of revenue per PP&E. Still, China Agritech is a marvel of efficiency at eight dollars and 81 cents.

Maybe it's because the PP&E isn't accounted correctly and it's more than what's stated on the balance sheet. But why hide it? Why continue on with such a high discrepancy? There are possible good reasons for this -- but still, the point is, it's a red flag and it stares you right in the face.


From the outside, it looks like there could never be any cheating in sumo wrestling: there are referees and there are fans watching. Yet, if you take a look at their numbers you can get a good sense that not everything is right. The same thing can be said for China Agritech: if you look at their financials there are definite red flags. Jesse Glickenhaus even went all the way to their factory and reported back that there was no cheating going on. Yet, wouldn't a reporter say the same thing if he went to a sumo stable?

I wish Glickenhaus & Co. all the best of luck with China Agritech. They might even get lucky and someone will buy out the company -- there have been a handful of Chinese stocks that have had similar characteristics, i.e. the financials didn't look good, but they still got bought out. Of course, even if someone does buy China Agritech and does extensive due diligence, even to the level BDO China and Jesse Glickenhaus did, they still might get Richard Heckman-ed.

There are a lot of things I'm jealous about when it comes to James Glickenhaus. He gets to be interviewed on Bloomberg; I have blogspot. He manages almost two billion dollars; I manage 26 Taiwanese students. He drives a 4 million dollar Ferrari he bought from Italian designer Pininfarina; I drive a 15 year old scooter I bought from a Malaysian international student.

The one thing I am not jealous of is his analysis.

P.S. I didn't focus on any red flags I saw in the SEC filings since I wanted to show what I see when I look at the financials. Yet, I have to mention this one because it's one of my favorites when it comes to Chinese RTOs. Right before they go public, you get to see them issuing a dividend to themselves. If it weren't so cliched it would actually be funny. On page F-4 of the 2006 10K in the year 2004, they paid themselves $3.1M. I love it how all these companies decide to pay themselves dividends before going on the American exchanges then decide to never pay dividends again.


  1. Thanks Graham. I spent a great deal of time putting this post together. I hope people find it enjoyable.

  2. This is a well reasoned, highly compelling piece. Your effort shows.

  3. i think the first item you mean CFO is consistently lower than net income not higher.