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The China Syndrome

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As fraud allegations sweep Chinese stocks, many people who put their money into these once-thrilling companies with dreams of quick riches have plunged instead into a nightmare of devastated investments. Unless investors stay vigilant, the same problems now haunting China's companies could one day harm U.S. investments as well.

Made in China
The "Go-go China" investment thesis made logical sense at first. In this incredibly populous country, a rising middle class is better able to spend, spend, spend. Get in quick! However, serious problems have recently emerged at numerous Chinese companies, fueled by shoddy or nonexistent oversight and poor corporate governance policies. As a result, many investors who jumped into these companies without doing appropriate analysis have lived to regret it.

Remember how the Internet bubble infused bullishness into just about any company with a "" in its name, until the whole market went belly up? Similarly, stocks associated with the word "China" seemed like great ideas -- until they weren't.

In December, GovernanceMetrics International sounded a sobering alarm about investing in Chinese companies:

In truth, many U.S.-listed Chinese companies have little to no intrinsic value, regardless of investors time horizon. Many of these companies have relied on the China brand in order to go public. The vast majority of these companies are thinly capitalized and are in lines of business that are neither unique nor innovative. Their ability to find a public market was merely opportunistic.

As these companies are scrutinized, investors will uncover the facts behind the Chinese Curtain. Many of these stocks may prove to be valueless. Focusing solely on our Accounting & Governance Risk (AGR) score provides investors with some insight.

In May, GovernanceMetrics International's Jim Kaplan followed up on this warning, pointing out that in a six-month period, the Russell 2000 Index had returned just more than 4%. In the same timeframe, Chinese stocks in GovernanceMetrics' high-risk list had underperformed the index, losing an average of more than 31%.

A creeping calamity
Regular investors lose money all the time, but the situation now unfolding in China represents a much bigger problem. It's linked to what The New York Times dubbed "audacious" frauds by Chinese companies, many of which even had their banks as ready accomplices.

Companies like China Media Express and China Agritech came to the U.S. stock markets through reverse takeovers, allowing these companies to avoid U.S. Securities & Exchange Commission scrutiny. The Nasdaq recently delisted both of the companies named above, citing what it assumed was fraudulent activity.

Investors have also accused some bigger Chinese companies of potentially fraudulent practices. Short sellers have been digging into companies like Sky-mobi (Nasdaq: MOBI  ) and Longtop Financial (NYSE: LFT  ) in search of possibly shady activity. For example, these folks believe Longtop has been increasing margins by hiding its operating costs.

The risks aren't limited to individual investors, either. Yahoo! (Nasdaq: YHOO  ) , which owns a stake in China's Alibaba, was notified after the fact that Alibaba had shifted its online payment service Alipay to its CEO Jack Ma's personal control because of Chinese regulatory demands. Worse yet, Yahoo! wasn't compensated for losing that extremely lucrative asset.

Whew. Investing in China no longer sounds like some get-rich scheme for healthy, exciting stock returns, does it?

Noticing red flags could have helped investors avoid some of these situations. In May, the Corporate Library's post Cooking the Books in China said the likelihood of fraud-related financial problems increased at Chinese companies with high debt levels or under central government control. The Corporate Library also flagged companies preparing for equity issues as another trouble spot.

A global issue
In response to this tumult, American investors might be tempted to simply avoid Chinese companies and leave it at that. However, this issue stretches beyond China, all the way to our own shores.

True, China's shifting economic landscape, government, and certain cultural elements probably contributed to these stocks' risks. But shoddy corporate governance guidelines create major risk for investors no matter where they're investing -- especially if those investors aren't doing much, or any, due diligence of their own.

Proponents of strong corporate governance rules recognize how important honesty and trust are in the marketplace. Our rules about accounting and disclosure may occasionally fall short, as the financial crisis revealed, but for the most part, these regulations protect investors. So do rules that allow shareholders to push back against management-centric corporate cultures willing to take everybody else down while lining their own bank accounts. Still, these protections alone just aren't strong enough.

Lessons in vigilance
We can't simply contain his new "China Syndrome" by avoiding Chinese stocks in favor of the "next hot thing" in investing. As GovernanceMetrics' Jim Kaplan noted, the Chinese companies that performed worst had "no intrinsic value," and business models that were "neither unique nor innovative." Their investors shouldn't have jumped into the supposed next big thing without first conducting proper research.

To cure ills like these, investments of every nationality need honesty, solid corporate governance policies, and managers and boards who answer to stakeholders. China's problems remind us all that we must remain vigilant about shareholder-rights issues right here at home.

Check back at every Wednesday and Friday for Alyce Lomax's columns on environmental, social, and governance issues.

Alyce Lomax does not own shares of any of the companies mentioned. The Motley Fool owns shares of Yahoo!. Motley Fool newsletter services have recommended buying shares of Yahoo!. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (22)

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  • Report this Comment On July 08, 2011, at 5:48 PM, GoNuke wrote:

    "China's problems remind us all that we must remain vigilant about shareholder-rights issues right here at home."

    That means regulation and policing of those regulations.

    The Bush administration did not think regulation was particularly useful. It also shifted most of the FBI agents trained in investigating fraud to homeland security just at the time that when unscrupulous mortgage lenders where passing off high risk or de-facto no/low-doc mortgages, & "liar loans" as low risk mortgages to big banks that repackaged them as investment grade securities.

    "The number of FBI agents currently investigating financial fraud is just a fraction of what it was a decade ago."

    William K. Black -white collar criminologist, Assoc. Professor, Univ. of Missouri, Kansas City & Sr. regulator during S&L debacle said:

    "The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds."

    "Black asserted that the banking crisis in the United States that started in late 2008 is essentially a big Ponzi scheme; that the "liar loans" and other financial tricks were essentially illegal frauds; and that the triple-A ratings given to these loans was part of a criminal cover-up."

  • Report this Comment On July 09, 2011, at 8:34 AM, ETFsRule wrote:

    Good article, and I like the conclusion you reached.

    However, I can say with absolute certainty that MOBI is a real company, and therefore I find it irresponsible that they were mentioned in this article.

    Anyone accusing MOBI of fraud will ultimately be proven wrong, whether it is Citron or anyone else. You can quote me on this :-)

  • Report this Comment On July 09, 2011, at 2:07 PM, ohwonder wrote:

    One might add the curious creative phantastic packaging work investment bankers are again and still developing and selling to someone who does not understand the explosive power (leveraging and non discloser of those products) those products have, incl regulators. Those bank managers do make their fortune again within the same comfortable environment getting not punished at all when it does not work out and a next (ultimate) bailout might be provoked.

    A part from this general issue I am wondering what all about the Global Gains chinese recommendations is, with respect to this article, Tim and Nathan were recommending even ín those days. Most are 80% down from peak. Probably bottoming out following the last 2 weeks trading action after we have seen some institutuional buying into Sino Forest, MS buying into Yonge ?

    Where were Tim's and Nathan's "appropriate analysis" to use Alyce Lomax words ??

  • Report this Comment On July 09, 2011, at 9:05 PM, jekoslosky wrote:

    Nice read, Alyce. I got out of the last of my Chinese investments a few months back due to the risk.

    I did not jump from there into the "next big thing," however, unless the next big thing is Berkshire Hathaway.

    I think reading as much as I did about the Chinese frauds sent me looking in the opposite direction, for a good value play on a reputable name that I can hang onto for years to come.

    More about my decision to leave China here:

  • Report this Comment On July 10, 2011, at 2:28 AM, lotustpsll wrote:

    This article serves as a wake-up call for those investing into China. I am fortunate to switch out , in first QTR this year, all my H shares (listed in hongkong) and purchased instead hongkong corporates, primarily in the luxury, high fashion and media sectors. These companies have at least 20 years of operations. Todate for the year, my portfolio is up about 6%. Since I started investing in Hongkong in 2008, my return is over 250%. My advice is to focus on established hongkong corporate entities which have withstood the test of time. Some of my favourites are Sing Tao, Hongkong Economic Times, Suga Electronics, Oriental Watch, Luk Fook, Moiselle, Joyce. These are solid companies, nil gearing, wth positive growth potential.

  • Report this Comment On July 11, 2011, at 12:06 PM, ETFsRule wrote:

    lotustpsll: A lot of short-selling firms are now investigating fraud in Hong Kong. I would read this article before thinking that Hong Kong is safe:

  • Report this Comment On July 11, 2011, at 7:55 PM, TheDumbMoney wrote:

    More fundamentally, this is the problem with China:

    It is a moral and political horror movie.

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