Tuesday, November 21, 2006

Business Ethic

Business ethic is an important concept that value investing relies on. Value investing relies on the integrity of management of the company to provide accurate financial and company information for evaluation. The basic concept of stock market is to separate the authorities of management and investors such that companies can effectively raise fund for their future development. In such system, management of the company acts as an agent of its stakeholders to take up the responsibility in managing the daily operations of a company. Management will release general company information on a regular basis for the evalution of investors. However, in recent years, this system has been challenged by some facts that the management has performed some cheating behaviors in order to get interests from their responsible company. The most famous one is Enron in the US for which many investors even the institutional ones were cheated. In Hong Kong, such cases also happened such as the Ocean Grand Chemicals Holdings Ltd (2880). The chairman has made use of the gaps between Chinese and Hong Kong monitoring authorities to generate fake transactions and exagerate the profits of his company. In general, it seems very difficult for a general investor to identify such cheating behaviors through their publized information. However, if you find a company with the following phenomenons, you should be very careful :
1. The major shareholder of the company is reducing his stake in the company even though the company is continuing its profit growth. This is because in general, the major shareholder should be the one who understands more of the company than the public. If under a profitable situation of the company, they still wish to reduce their stake. It should be a warning signal for all.
2. A company that always creates miracles in profits even when the economy is in a down turn or flattened. The management will either be very outstanding or cheating. You should find it out.
3. Firing its auditor for which may be because the auditor has found some faults in the company's financial statements and does not agree with it.
4. Raising fund for some projects that are not realistic such as some companies in Hong Kong have claimed to buy some mines in China for which the mines are non-existing or with much lower output than claimed.
Usually the stock prices of those companies with cheating management will continue to increase due to exagerated profits. Some people may not be able to resist such attractions and start to buy those stocks. However, you should be aware that you may lose all your investments when the profit bubble is blown up. In Hong Kong, a company which is a component of the Hang Seng Stock Index has some of the above listed phenomenons. If you are unable to understand their business model and how the profits be generated, it is better for you to avoid investing in it.
Remember :
According to Warren Buffet's investing strategy, value investors should invest in companies with excellent track records which also reflects their business ethics records in the long run. In such case, it will be much safer to invest.