Saturday, August 20, 2011

Stock Pick: FUQI Accounts Receivable Account Scam

This is my proudest stock pick. You can call it my 'Don't Pick'. FUQI is a Chinese jewelry company. I always refer to FUQI as my best stock pick because it is the first stock that I spotted financial fraud in and my choice to stay away from it was the fruit of much learning.

So the story began like this. I've been rigorously learning as much finance as I could. By that, I mean I was learning Accrual Accounting and how to read financial statements, not staring at charts all day. One day, around February 2009, a friend of mine told me about this wonderful company FUQI, and how they've been earning a lot of money, and how the company is undervalued, and how he just bought a sizable position. He said he has been doing a lot of 'research' on the stock. By this, he meant that
he has been reading many news articles and drawing some lines onto charts of different dates.

I decided to see how far my learning as come, and so the first thing that I looked at were the financial statements. (See bottom). You may be able to see Fuqi's financial statements from Google finance as well. The income statement could be a poster child for all great new companies. I saw a beautiful increase in Revenue, Operating Income, Net Income, and Earnings Per Share over the past 4 years.

Next, I went to the Cash Flow statement. To my surprise, I saw a -7.96 for Cash from Operating Activies for 2008 and -21.74 from 2007. My accounting knowledge is very limited, but I don't know how this makes any sense. How do you report positive earnings when you are losing money from your operating activities? Money doesn't lie. Numbers never lie either. If the company is really earning money, then there should be an influx of money into the company from somewhere. Sure enough, there is a whopping 69.54 on the Cash Flow statement for the Issuance of Stock. This is a glaringly large number which can cast a shadow on every number on this page.

Now, for some logical reasoning. How do businesses make money? Especially a jewelry store? Well, you'd start off with some money, buy some raw materials like rings and shiny rocks, put them together, and then sell them to someone else, hopefully at a higher price than what it cost you to make it as well as any expenses you pay to your salesmen. We'd like to think the 69.54 was used to buy raw materials and create products. So why is the Cash from Operating Activities negative? Are they selling their final products for less than what it costs to make? Probably not. There must be something else at play.

Turning to their Balance Sheet, I noticed that their Accounts Receivable have been dramatically increasing. There is a whopping 73.95 outstanding accounts receivable for 2008. We also see a huge jump in inventory levels. Accounts Receivable are monies that you expect to get in the future. It is money that you will receive in the future for products or services that you have deliver or will deliver. For example, if you bought a stuffed animal from the internet for $20, and the website has a 1 month pay policy where they will deliver your toy and give you a month before you have to pay, the company may report $20 in revenue and a $20 accounts receivable right now. You are legally allowed to report revenue, and therefore, income, on something that you have sold but have not yet received money. This is part of an accounting system called Accrual Accounting. This is used by just about every company. So the problem is, what happens if you decide not to pay for your stuffed animal because you have buyer's regret? Maybe you suddenly had a huge medical bill to pay and decided that you just can't pay for your toy right now. Whatever the reason, money in the Accounts Receivable might not ever be paid. Just like how credit companies charge you a high interest in order to make up for the people who don't pay their bills, companies need to take into account that some customers might just run off after a meal. The percentage of people not paying should be reasonable and it should be such that you will still end up making money in the long run.

If we check back on the Income Statement, we see that Fuqi reported 27.88 in net income for 2008. Their Accounts Receivable was 73.95 for 2008. I don't know about you, but I wouldn't claim to have a profit of 27.88 when 73.95 has not been paid to me. The receivables are almost 3 times larger than the net income. It's as if you've been running a business for 3 years and no one has paid you in the 3 years that you've been selling. It's actually much worse since Fuqi sold much less than 27.88 in the years before. Does this make sense to you? It definitely doesn't make any sense to me.

Hence, we see why Fuqi is reporting a nice net income while their Cash Flows are relentlessly bleeding. This analysis, believe it or not, only took me about 30 seconds. I saw a nice net income, saw a negative cash flow, and it suddenly clicked in my head that something was wrong. A few more seconds later, I saw the jump in accounts receivables and realized what was going on. I quickly told my friend about what I found and told him to get out of the stock. In my eyes this was clearly accounting fraud and an intentional misleading of investor. My friend however, was so in love with his stock and 'research' that he refused to listen. Not only that, he refused to talk to me ever again. I guess there was a pride issue here. He couldn't possibly imagine how my 30 seconds of looking at a few numbers were more powerful than his many months of staring at charts and reading the CEO's sales pitches about how Fuqi was going to make it to the top. I was tempted to go short on Fuqi, but I knew that accounting scams may take years to surface. It could go up plenty more before it broke down. I decided to stay out of it and just watch from a distance, not knowing when it would crash. Sure enough, just 3 months later in May, the SEC announced that it would probe Fuqi for accounting fraud. The stock fell from 25 to 14 dollars in just seconds. It's currently August 2011 and the stock now trades at 3 dollars. My friend still hasn't spoke to me. I still don't know if he got out of Fuqi before or after the crash.

I don't have a business or finance or accounting degree and these numbers were obvious to me. If I can do it, then many of you should have an even easier time. The beautiful thing about the internet is that you can find all kinds of news articles that were written years ago. A quick search for old articles will show you many analyst saying the best of the best about Fuqi. Upgrades, buy recommendations, big money managers promoting the stock after buying a position. These guys are the true professionals. But I know what 'professional' really means. Being a professional means that someone pays you to do something. It does not mean that you are good at what you do. I hold that dear to my heart, because it means I'm clearly more qualified to manage money than anyone who has entered Fuqi. Every analyst, technical indicator, money manager, chart, and dog, and your mother who told you to buy Fuqi was wrong. They were wrong because their investing strategy was wrong. It's not like a comet hit Fuqi's headquarters and ruined a completely good operation. There is some technical indicator or combination of indicators which would have repeatedly told you that Fuqi was undervalued and that you should buy it. They would have been wrong every time, just like in the case of General Motors. How can you trust a tool that will fail so miserably? Follow my lead and you'll see just how much of an advantage you can achive over a 'professional'.

1 comment:

  1. Great post, clearly demonstrates the importance of cash flow statement.