KYLE BASS: Steve, thanks for taking the time to join us today. We're talking about a subject that's near and dear to my heart. And, unfortunately, it's not near and dear to many, both institutional and individual investors' hearts. And we'll get it that. We're here to talk about the numbers. We're here to talk about something that's both recent and topical, as far as Steve's concerned.
But also, it transcends his most recent reporting into a much longer conversation, which I hope we're going to have today. So Steve, welcome. And let's talk about your most recent experience. If you don't mind, let's give the Real Vision audience just a little primer on what got you to look into some of the big Chinese account firms' accounting policies and practices. And what did you find?
STEVE CLAPHAM: Well, first of all, thanks for having me on. It's really exciting to be here and to be talking to you. The reason that I did this report is very simple. The bulk of my business is training. I do a forensic accounting course for institutional investors. But many of those investors find material in the course that they find interesting or sometimes worrying.
Some of the clients-- they see I've brought up an example in the course, and it's something they own. So I started to do Bespoke research for people. And I was asked by one of my good clients to do a forensic accounting report on Alibaba, and I speak for Peters. So Baidu, JD.com, Tencent, [INAUDIBLE].
And the client came up with a long list of things. So there are like, a dozen different points that they wanted covered. And I thought, well, this is actually straightforward, easy, not easy thing to do, but straightforward thing to do.
I figured out what it would take-- how much time it would take and agree to price of the client and sell off, what the client didn't tell me was that they'd ask one of my competitors also to quote. And the competitor quoted $120,000, which was a lot more than I'd quoted. I could have quite a lot of money.
Anyway, I'm halfway through this. And I have to call the client and say, look, I'm really sorry. But I've really, really underestimated how long this is going to take. And it's perhaps a bit stupid of me. But look, we can do a couple of things. I'm not going to just do a bad job because that wouldn't be the right thing. But if I do a proper job, I'm going to really be way, way over budget.
How would you feel if I had sent you the report and then you let me sell it afterwards? And I said, sure, that's fine. And so that's how I've come, because I don't normally sell research. And the findings of the report, well, no surprise that these five companies are not the cleanest companies when it comes to accounting.
KYLE BASS: I mean, come on, not the cleanest. What percentage of Alibaba's revenue and profits do you think are true and real? And what percentage do you think are completely fabricated?
STEVE CLAPHAM: Well, I mean, I wouldn't like to say that they're completely making the numbers up. That would be slightly unfair and probably uncharitable of me. There's a couple of things here coming. Part of the problem is that accounting rules themselves don't lend themselves to a proper evaluation of the earnings performance, because you've got this daft step-up provision where if a company owns an investment in a third party so they-- and Alibaba's got lots and lots of investments.
If somebody else comes along and pays a higher price for that investment, they are required by their accounting rules to revalue that asset in their balance sheet and book the difference to profit.
KYLE BASS: Is the converse true if a piece of that company is sold at a much lower valuation? Do they have to take the step down in valuation and subsequent earnings set?
STEVE CLAPHAM: Well, theoretically, that should be the case and if the valuation-- and their protection against doing that is they can say if it's not a permanent diminution in value, they can fudge the issue. And the funny thing with these five companies is that you see a lot of upward valuations-- pre-valuations. You don't see many write downs. And that was one of the criticisms I came up with in the report, because if you think about it, if you're a venture capitalist, even the most successful venture capitalists in Silicon Valley-- a lot of the things they invest in go bust.
That's why they do it, right? They're doing these moon shots that they hope will be super successful. And the obvious corollary of that is that they'll have a very low hit rate. Not many of them will be super successful, and they'll have a lot of failures. But in China, they don't have a huge number of write-downs. And that, you've got to ask yourself, well, why would that be?
KYLE BASS: Let me rephrase my question, Steve. In Alibaba's numbers, I've taken a look pretty deeply at Alibaba's numbers. So let me get this straight. If they have an investment in a private company or even a public company where they have either control or not a controlling position, if the value of that private company moves up, do they record that as revenue to Alibaba? Do they run that straight through the income statement?
STEVE CLAPHAM: It goes straight through the income statement.
KYLE BASS: Oh, that's genius.
STEVE CLAPHAM: I should know the number off the top of my head. I can't remember the number off the top of my head. But it's a significant number for Alibaba that. I don't know that you can criticize them for that, because after all, they're required to do that by the accounting rules. So I think you should really level that criticism at accountants rather than the company.
KYLE BASS: Well, which accountants?
STEVE CLAPHAM: I've got a great problem with the people that designed the accounting standards today, because they seem to be intent on producing a perfect theoretical result without having due regard to people like you and me who have to use the accounts at the end of the day. And a great example of that is a new accounting for leases.
So it's IFRS 16 over here. I've forgotten what the number is in the US, but you're seeing exactly the same problem where they're bringing leases onto the balance sheet. But companies-- two companies, which are otherwise pretty identical, are having massively different asset that they're creating.
So two aircraft-- two airlines with the same aircraft end up with a different number on their balance sheet. Well, that doesn't make any sense. And I think part of the problem in evaluating the Chinese companies' accounts is a problem that's not of their own making. There's a problem with the standards.
KYLE BASS: So there is an amorphous line between the government, per se, and the, quote, "private" companies in China. We all know that back in 2013, the Obama administration got the SEC and the PCAOB to get together with the CSRC in China. And it gave them the most famous MOU that our Accounting Oversight Board has ever given anyone.
If you think it's a matter of national security, you don't have to submit you or your companies to PCAOB covered audits. And, therefore, China decided that every single bit of its data and every single bit of its companies, whether public or whether SOE or, quote, "privately held" that are public companies don't have to submit themselves to audit. So PCAOB covered audit.
So when we look at these structures of whether you're looking at Tencent or Baidu or Alibaba or any of the sort, those standards are, quote, "number one, they're Chinese standards." They don't adhere to US standards. And so how do you think about, Steve, this difference between a US or, let's say, Western-- US-UK standard of accounting versus and a China's version of its own accounting?
STEVE CLAPHAM: Well, I feel more comfortable with American version if I put it like that.
KYLE BASS: Really? No kidding.
STEVE CLAPHAM: The problem with this, Kyle, I mean, is that not only is the oversight not what we would expect and desire-- and, clearly, there's no fundamental reason why a Chinese auditor or, indeed, some of these companies have auditors that are based in Hong Kong-- why they shouldn't be subject to some form of oversight.
I mean, there's a real problem here, because even in the UK where we've got the FRC oversees the supervision of audits, I mean, they've got a standard that says, 90% of audits should be classified A1 category. And the last time they reported, only 73% of audits achieve that standard.
So even when you've got somebody overseeing you, the auditors haven't been effective at implementing the relevant and required quality control techniques, which is why we're seeing, particularly, in UK, so many companies going bust. But if you take away the oversight, then you've got to ask yourself, well, how good is audit going to be?
And the problem with these five Chinese companies is the audit fees are really, really cheap. Alibaba is a bit bigger than Morgan Stanley. So you would think that Morgan Stanley is a pretty complicated company. But Alibaba's quite complicated as well. I mean, it's certainly going to be more complicated than most companies. What would you think was the ratio of the Alibaba fee to the Morgan Stanley audit fee?
KYLE BASS: Yeah, I would imagine Alibaba would be a lot less because there's a lot less auditing going on.
STEVE CLAPHAM: Yeah, well, that's right. And that's exactly what you would see, because the Morgan Stanley fee is probably something like, four times the fee for Alibaba.
KYLE BASS: Let's get to, I think, something even larger. Again, back out of the current reporting-- get back to-- look at the financial crises in the US. We have a series of ebbs and flows of crises. And the biggest accounting frauds in America really date back to the WorldCom and Enron fiasco and the blow up post-2000. So get Enron in a one, yet, WorldCom in '02.
You had the famous contemporary of yours, Howard Schilit, write a book, Financial Shenanigans back in 2002 about how do you discern? How do you look through these financial statements to come up with whether or not what you're investing in is financially or structurally sound? And that became very important. It became a rallying cry. It's actually what precipitated in my view-- finally precipitated the Dodd-Frank rules in the United States.
So back then, people cared. Steve, do people actually read 8-K's, 10-K's, 10-Q's? Are people actually paying attention to the numbers these days, whether you're an institutional or individual investor? Or do you even care?
STEVE CLAPHAM: Well, I care. You care. But most people don't. I mean, it's absolutely extraordinary to me how few people read this [INAUDIBLE]. And PWC, the accounting firm did a survey of 400 or 500 analysts both buy side, sell side, some rating agency analysts, some credit analysts, equity analyst. And only 2/3 of them said that they read the accounts.
This is in a survey, right? So 1 in 3 admitted that they didn't bother looking. There was an academic study that I use in my forensic accounting course where they said that on the day of publication, the day after-- the average S&P 500 firm has its accounts downloaded from Edgar only 28 times.
Now, yeah, OK, so there is 300,000 Bloomberg terminals in the world. So maybe people are downloading them from the Bloomberg Terminal.
KYLE BASS: No, they say you know how on Bloomberg, when you pull an AK or a 10-Q from Bloomberg, it takes you to a site where there's a link. And the link pulls it from the SEC site. So I actually think the number you're reading captures Lindbergh.
STEVE CLAPHAM: There was an interview done by The Wall Street Journal. I think it was in 2015. They interviewed the GE CFO. And he said that their accounts had been downloaded something like, 3,000 times. That was all.
KYLE BASS: Huh, and those people paid the price, didn't they? GE was a hell of an accounting fraud.
STEVE CLAPHAM: Have you ever looked at the GE accounts? They're, I mean, almost incomprehensible. I mean, I can understand why people didn't bother downloading them, because when you download them, you couldn't even understand them because they were really, really obscure. I mean, it's a simple fact that we're in a bull market. And people like to listen to stories. They don't like to look at the numbers. And we know how this ends, right?
KYLE BASS: Yep.
STEVE CLAPHAM: And it's funny because you mentioned Enron. There is over the space of four years, there's Enron. There is, then, WorldCom, Global South, and Global Crossing QS. Then the following year, it was Tyco. And I think it was 2003. It was HealthSouth.
KYLE BASS: That's right.
STEVE CLAPHAM: So in four years, you had over $400 billion of market cap evaporated. I don't think that is going to happen again, because you've got all these additional controls and oversize in the United States. But that could happen here. And what you could see also in the United States is you could see a whole raft of companies having their earnings base reset because they're all cheating.
KYLE BASS: Back to something you just said. People aren't downloading K's and Q's. People that I know that have large investments in many of these companies have never read a full quarterly report. And they do listen to the earnings calls. They listen to the questions the street analysts ask. And I don't know if individual investors do that or not.
There was an intense focus back in that time frame that you and I are talking about-- call it '01, '02, '03, '04. There was an intense focus on getting back to the basics and trying to understand accounting, because so many people had just lost so much money. And Steve, I would submit to you that until people lose a lot of money, no one's going to care. And we just had luck in coffee, right?
We have see no forest. We've had many things happen. Can you imagine how much fraud is actually deeply embedded in Chinese companies? There's no way of knowing, and we may never know. But as long as the central banks keep printing as much money as they're printing, it's going to be difficult for people to, I think, lose money until these frauds are brought to the forefront in a shock and awe system. And I think that that's the only time people are going to pay attention is when they actually lose.
STEVE CLAPHAM: Well, you need a catalyst, don't you? With every fraud, you need a catalyst. And the reason that you had that raft of frauds in that 2001 to '04 period was that you'd had that very, very long bull market throughout the 1990s. And in bull market, people get carried away. They don't look at the downside. They don't worry about the numbers. They don't bother.
And it's only when you get an economic shock that it all implodes. And what we've had this time around obviously is we've had a very unusual shock in the shape of COVID. But it's been masked by a massive injection of liquidity. So the companies haven't had the problems. What you see often is the fraud gets exposed because the company can't make its numbers anymore because of an economic backdrop.
KYLE BASS: That's right in some cases. If it's a tech company, they can keep doing it. There are certain industries where you're right where the facts actually catch up with the story. You and I spoke offline. And one of our friends David Einhorn wrote the book after his experience with Allied Capital fooling some of the people all of the time.
And I think it's important to note that something that David said to you is something that resonates with me and something that we talk about with our friends here today. I actually think we're in a post-numbers world. Steve, I'm not trying to minimize your profession. I think your profession is incredibly important.
I think it's incredibly important, but the world doesn't think so at the moment just because of the manner in which they operate. But we're in a post-truth world. We're in a world of great narratives. And who tells the best narrative wins. And so we almost need a forensic narrative accountant and not necessarily a forensic numbers accountant. How do you feel about that?
STEVE CLAPHAM: Well, I think that this is a place for that. I absolutely agree with you. I mean, fortunately, there are enough smart people around who've got a long enough time horizon and are aware of this. And they want to make sure that when the music stops, they're not caught holding the parcel that nobody wants.
So I'm not worried. From my own perspective, there's a lot of people that have a real interest in this. But I'm worried from a wider societal basis, because this is a massive problem. And, as I said before, I mean, I think part of the issue is that the accountants haven't helped the cause by making everything so complicated.
When Alibaba produces its 2017 accounts, the 20th I think was 1,070 pages long. Well, who's got time to read that? It's good in a sense that the companies have to disclose things. But, obviously, the more complicated you make it, the more difficult it is for the layperson to access it. And what I think is wrong is that the accounts should be fairly simple to understand and fairly accessible for anyone.
In a way, that's good news for me because I train people to read the accounts more effectively. So it's an opportunity brilliant business. But from the wider perspective looking at the stock market, it's not good that my clients have to enlist my help in order to look at a few companies. But it's staffed.
KYLE BASS: Well, it actually gets back to the incentives of all the participants. When you look back to let's just say the incentives of those-- back to David Einhorn's example on Allied's Capital. Allied Capital was a prolific equity and debt issuer and deal company, right? They were constantly doing deals. They were a BDC.
And so Wall Street would have loved to continue that business because they were a fee machine. So no one was really incentivized to tell you that the numbers were bad. No one was really incentivized to tell you that their accounting was a problem. And that goes back to even the late 1990s when Bear Stearns was doing a whole bunch of specialty finance securitizing of second liens where they were saying, oh, based on our experience, second liens only have a 4% or 5% default rates.
In the end, they had 30% default rates, and these companies went broke. And Bear Stearns was banking all of them. It goes to the financial crisis where they wanted to keep the securitization machine running. And so no one cared about the numbers until the financial reality-- the economic reality caught up with the accounting. So do you think in this wave of let's just say people turning a blind eye