January was a scary month for China’s machinery makers and their investors. First, Zoomlion was accused by a “concerned investor” of booking phantom sales, then Caterpillar accused its own recently-acquired Chinese subsidiary of accounting misconduct and took a $580m write down on the value of the deal.

Time for a ghostbusting analyst to bring some rational rigour to the sector.

Step forward Vik Chopra, analyst at Sun Hung Kai Financial, the Hong Kong brokers. In the full knowledge that it is nigh-on impossible to either prove or disprove the presence of accounting phantoms, he at least comes up with a set of red flags that can help warn investors about any potential menace.

“Given the recent noise around accounting improprieties and fraud allegations in the market against Chinese companies, we decided that it would be worth while to look at some common red flags,” Chopra says.

He focused on the machinery sector, looking at 10 companies listed in Hong Kong and one listed only an the mainland. Then he went through a list of corporate governance and financial factors, all available from the companies’ regulatory filings and most recent quarterly or interim earnings statements.

Chopra picked 13 key factors.

The four corporate governance practices he highlights were whether or not the chairman chief executive roles were split, the size of related party transactions reported by the group — which have the potential for abuse and damage to non-controlling shareholders, he says — and whether auditors had changed frequently, been dismissed or resigned.

The nine financial factors include whether there had been big swings in working capital or inventory days, whether assets or sales had doubled in two years, how big property, plant and equipment investments had been relative to sales and a handful of measures related to the quality of cash flows and their proximity to sales numbers.

Chopra is not aiming to claim that the companies he picked on are about to be beset by claims of misconduct or worse. His red flags are though a handy check list of corporate health in a sector that has expanded very rapidly, but which for the past year has been suffering from the slowdown in basic industry and infrastructure investment in China and elsewhere.

Perhaps surprisingly, given it is has attracted the most market noise, Zoomlion gets only 4 red flags, as does Hong Kong listed Sany Heavy International, a mining equipment maker, and Haitian, a maker of plastic injection molding machinery. Dongfang Electric, Shanghai Electric and Weichai Power all attract six red flags, while First Tractor gets seven.

Sany Heavy Industries, the mainland listed arch rival to Zoomlion, gets 8 red flags, mainly due to its extremely rapid growth and substantial working capital changes. Sinotruk and Lonking get eight red flags, while Harbin Electric does the worst with nine, due to its negative free cash flow and operating cash flow alongside declining sales and an increasing asset base.

Forewarned is forearmed, as they say. With short-sellers increasingly turning their attention to the Hong Kong market, there is plenty that investors can do to ensure they do not get spooked when the next speculative attack comes.

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