He has power to move markets

John Hempton of Bronte Capital writes very entertaining articles. Most of his extensive postings are about companies that have “issues”, such as his strong suspicions of financial wrongdoing at the Chinese company Universal Travel Group (NYSE: UTA).

His latest spread is regarding Northern Oil and Gas (NYSE: NOG), which I found thoroughly fascinating, for a few reasons.

The first reason is that my earlier article on Petrobakken (TSX: PBN) and its steep decay rate of oil flowing from newly drilled Bakken-shale wells assisted his thinking with respect to NOG’s depletion rates. He is very gracious to link to my article.

The second reason is that apparently the rest of the market has “picked up” on Northern Oil and Gas’ low rate of expending of depletion and has decided to price this in (note the article hit the wires on Tuesday, although it seemingly was digested on Wednesday):

Interestingly enough, before this all hit the wires, NOG had about 20,000 shares available for borrowing at Interactive Brokers. Today there are none.

Thirdly, he writes good analysis. There is good reason to be skeptical of NOG’s management and their intentions. Even disregarding that, it does appear the valuation of the company is well above fair value. That said, the company’s balance sheet does show a net cash position (assuming those balances are truly there!), so the shares are most certainly worth something, unlike most of the other likely frauds that Hempton has been writing about.

Disclosure: No positions in any stocks mentioned in this article, nor do I intend on opening any. I’m watching this purely for entertainment value, although others likely have money on the line.

Sleeping through 1999 and not learning the lessons of the past

It appears that China-related IPOs that list on the US exchanges are the latest fad, with Youku.com being the latest example. Shares (Nasdaq: YOKU) went up 161% upon their offering, and reached as high as $50/share from an initial price of $12.80.

Doesn’t anybody remember what happened in 1998 and 1999? Amazing how history is repeating itself. The only difference is that these companies are foreign, and even less accountable to shareholders than if they were domestically held!

Already you have a chorus of people that say the company is overvalued and ripe for shorting, but most prudent investors know that timing when “the top” will be is exceedingly difficult – a phrase to always remember is that the market’s ability to remain irrational can be longer than your ability to remain solvent. It will just be a matter of time, but predicting when this Chinese asset bubble will finally deflate will be a matter of debate – until after it occurs.

Although I am sure there will be some Chinese equities out there that will be stable and provide a decent return on investment, it should be noted that management is even more entrenched in these companies than in the US/Canada, where at least you can pick out some corporations that have shareholders’ interests at heart. It is impossible to pick out the very suspicious cases (e.g. earlier coverage of Universal Travel Group, NYSE: UTA) versus the legitimate companies. Investing in Chinese equities feels more like pure gambling, hoping for the herd to ram the share prices higher, rather than investing or even “speculation”.

Anybody from North America playing these types of equities has to realize that they are playing against players that are loaded with insider information, and Chinese language/culture knowledge. As a result, people would have to be insane to invest in these types of companies. It’s like going to war with a pellet gun when your opponents are armed with sniper rifles – and you don’t even know what your opponents were armed with when you entered into battle.

I am sure there will be a few people here and there that will be bragging about the small fortunes they made by investing in Chinese equity, but this is the financial equivalent of reading the list winners from the last lottery.

Why I will never invest in China

John Hempton has a classic story of his research on an “online” travel agency.

My rule of “Never invest in a jurisdiction that does not have English as its primary language” holds very, very true. I am sure there are a lot of wildly profitable companies in China, just that you can be absolutely sure that minority shareholders’ interests (i.e. the suckers that buy a few hundred shares to have a “China play”) will never be in alignment with the board of directors or management. In this particular case, UTA looks great on paper, but is likely their accounting and reporting is completely crooked.

In their last 10-K filing, you even had the auditors (a firm I’ve never heard of in New Jersey) saying in their audit letter the following:

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses were identified:

The Company’s policy documentation of all controls identified during their assessment and remediation process was incomplete.

Lack of technical accounting expertise among financial staff regarding US GAAP and the requirements of the PCAOB, and regarding preparation of financial statements.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 consolidated financial statements of the Company as of and for the year ended December 31, 2009.

Translation: “We have no idea whether these guys were lying to us when they provided us with alledged ‘proof’ of the revenues, expenses and balance sheet items you see here. Good luck!”

Suffice to say, I wonder if Hempton (who has probably made a small fortune shorting this thing earlier when the stock was trading higher before writing this huge article on the company) will be able to single-handedly get the stock delisted when his 2,200 readers (at least according to Google Reader) eventually hammer the stock down to the zero it probably deserves.

Just for full disclosure, I am not long or short the stock, nor do I plan on trading the stock. Trading from other people’s research is a great way to lose money – capturing real value in the market is done by performing independent research when nobody else is watching.