I Will Not Be Buying Chinese Small Caps in 2012

If you want to be a better investor, you must learn from your mistakes. In that vein, I'm sharing with you one of my resolutions for 2012: I will not buy Chinese small-cap stocks in 2012.

Though I'll try to convince you to stay away from the small players, I'll also offer up two alternatives that could give you the exposure you need to the world's most populous country.

You don't even own the company
Because of laws forbidding the ownership of businesses by foreigners, Chinese companies listed on U.S. stock exchanges need to create a complicated web of subsidiaries.

Below, I've shown how one entity, Qihoo 360 (Nasdaq: QIHU  ) , a Chinese Internet safety and search company, has organized itself. As I'll demonstrate, shareholders don't actually own a stake in the company performing the business they're investing in.

Source: SEC filing.

Here's what the picture means: Everything above the dotted horizontal line represents entities outside China; everything below is inside China.

That big box at the top is Qihoo 360, a company that's actually located in the Cayman Islands; that is what you are buying.

Qihoo has three wholly owned subsidiaries in Hong Kong, but we'll focus on Qizhi Software, the subsidiary that's actually located in China and the only one that dips beneath the dotted line. Qizhi itself is just a holding company inside the country. The three dark boxes -- representing actual entities that carry out Qihoo's business inside of China -- aren't owned at all by Qizhi.

If you read the fine print, it says that these three gray boxes are associated through "contractual arrangements." What would happen if those independent organizations go rogue? It may be unlikely, but if they were to do so, investors would be plain out of luck.

Alarming track record
Though the structure of these Chinese entities is suspect, the arrangement alone isn't enough to scare me off. In theory, it's in the best interest of the Chinese companies to remain faithful to their investors (though that's not always the case), or they'll never have access to American capital.

But theory and practice don't always meet up. The last 12 months have served up more than a few claims of corruption and fraudulence -- including accusations targeting the aforementioned Qihoo 360.

Research firm and short-seller Muddy Waters has made a name for itself completing its own due diligence on Chinese companies.  In November, the company's founder and only full-time employee, Carson Block, went on CNBC to explain why Focus Media's (Nasdaq: FMCN  ) management and accounting practices were raising lots of red flags.

In response to Block's assertions, Focus Media -- which provides advertisements on elevators in China -- "admitted that its disclosures on the number of LCD screens was misleading," Block said.

And even though Focus Media said it has hired independent companies to go around and actually verify the number of advertising screens in the country, Block said we simply can't trust those numbers: "The results of those surveys in China are always questionable because of ... private sector corruption." Focus Media, Block argues, is incentivized to hire a company that will give them the results they want, especially because independent verification by Americans is so difficult.

Whom can you trust?
As you can see, this sets up a situation where it's almost impossible to tell the good guys from the bad. Last February, a recent college graduate and amateur investor was able to cause a huge drop in the share price of Chinese fertilizer maker Yongye (Nasdaq: YONG  ) .

Had this investor been to China? No, he hadn't. But our own Tim Hanson had visited with management and been to manufacturing plants in China a number of times; he'd even tested out their products for all to see. He believed in the company. And yet, since then, the stock is down 50%.

Legendary investor Peter Lynch once said: "Investing without research is like playing stud poker and never looking at the cards."  Because it's so hard for individual investors to find research that they can trust about small Chinese companies, I just don't think this is a game of poker we can realistically win.

Better, safer alternatives
But worry not! There are other ways to get a piece of the growth story in China. One of my favorite pure plays is Baidu (Nasdaq: BIDU  ) , aka the "Google of China." With more than 70% of the Internet search market, and hundreds of millions of Chinese residents yet to come online, there's still tons of room for growth.

Yes, the company is located in China, and it has the same confusing structure as Qihoo. But both its size and the fact that it's an Internet company (with a Web page we Americans can visit from our living rooms) help me rest easy. I've already made CAPScalls on my profile for Baidu, and am looking for a price point to buy in.

And if you'd like to stay away from Chinese companies altogether, Apple (Nasdaq: AAPL  ) represents a great option. As my fellow Fools have brilliantly illustrated, growth has been absolutely explosive there: Sales in the first six months of 2011 were six times larger than in all of 2010! As I did with Baidu, I've also made a positive CAPScall on Apple -- in part because of its exposure to China.

If you're interested in international investing and want one more idea, I encourage you to read up on our "Top Stock for 2012." Though the company our top analysts picked is not located in China, it has great exposure to the growing economies of Central and South America, and a very promising future. Get all the details in your copy of the report today, absolutely free!

Fool contributor Brian Stoffel owns shares of Apple and Qihoo 360, though he plans on selling his shares of Qihoo when trading rules allow. You can follow him on Twitter at @TMFStoffel.

The Motley Fool owns shares of Google, Apple, and Yongye International. Motley Fool newsletter services have recommended buying shares of Yongye International, Baidu, Google, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. 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 (15) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 13, 2012, at 3:02 PM, rae13164 wrote:

    I agree; after five years of Foolishness, the only really bad buys I've made as a result of Fool recommendations have been Chinese stocks...and I've left Global Gains as a result...I just bought a little bit of Baidu, and even there I bought less than I would have otherwise, had it not been for the factors brought out in this and similar articles..thank you

  • Report this Comment On January 13, 2012, at 3:07 PM, ETFsRule wrote:

    Yours is a very common approach these days: since some Chinese small-caps are scams, why not just play it safe and avoid the entire sector?

    I'm grateful that so many people have turned to this approach - it has created a lot of bargains.

  • Report this Comment On January 13, 2012, at 4:13 PM, TMFCheesehead wrote:

    @ETFs-

    For the next 12 months, have at it! I just can't put money into something I can't get reliable, factual information about.

    Brian Stoffel

  • Report this Comment On January 13, 2012, at 9:08 PM, AverageIn2003 wrote:

    Interesting article but I have to go with ETF on this one. So, you are having trouble getting good info from Chinese public companies? So we should avoid the sector!? Good grief! I would bet that as a percentage there are more crooks running US public companies than in China. Just a gut feeling from having been burned more than once by the Maddow's, Scrushy's, Lay', et al in the US. And talk about getting factual information! Hopefully you aren't implying the info is better in the U.S.? We've turned being crooks into a science. We've had to put law after law in place to keep Wall Street insiders from ripping off investors. And worse, from supposedly unbiased research firms! And don't get me started on Carson Block. How can I trust anyone who names a one man firm 'Muddy Waters'? Sounds like a marketing gimmic. Get a grip. Like getting on CNBC is suppose to give him credibility? Yea, right. So, where is Carson's 'full disclosure'??

    But enough of that...here's a copy/paste from another web site: Focus Media Holding Limited (ADR) (NASDAQ:FMCN) is the eighth best-performing U.S.-listed Chinese stock on Jan. 13. It was up 1.5% on the day. FMCN's upside potential is 85.9% based on brokerage analysts' average target price of $40.23. It is trading at 57.6% of its 52-week high of $37.58, and 146.2% above its 52-week low of $8.79.

    Like ETF, the bottom line for me is that articles like yours, Carson Block, and the media in general have, as ETF wrote, created a lot of bargains. Of course, I may be wrong, but I hope Carson keeps shorting FMCN.

  • Report this Comment On January 13, 2012, at 10:23 PM, TMFCheesehead wrote:

    @Averagein2003-

    To be clear, I'm talking about small cap Chinese companies, not Chinese companies as a whole. I agree that there are a lot of crooks everywhere, but adding in an extra layer of not being able to check/see the products being offered myself makes it doubly difficult for me to put my money behind these stocks.

    At the end of the day, every investor has different comfort levels. This is where mine ends, for better or worse.

    Brian Stoffel

  • Report this Comment On January 14, 2012, at 7:45 AM, fjfjfjjfjjfj wrote:

    If you want to know who Carson Block really is, read this link about onp.

    http://www.thestreet.com/story/10797742/1/orient-paper-story...

    Putting doubt in people's mind is the whole purpose of his report. He said you cannot trust Chinese private companies because of corruption and you should trust him. LOL. I made a living out of his attack. I bought sprd shares after his attack and cashed out $13.50/sh profit on sprd at $28.50.and now rebuild my sprd holding at much lower price.After his attack on fmcn I made my first investment ever on fmcn and cashed out $3.00/sh profit at $22.5 .I just rebuild my profolio under $20. Today, fmcn closed at $21.65. After earning report the share will be at around $30.00+. Carson Block can succeed on fmcn if the auditor of fmcn refuses to sign off their earning report. Carson Block accused fmcn of inflating the number of lcd by 50%. After it failed, he accused fmcn of providing misleading information. Isn't that a big step down from its orginal statement. It is Carson Block , not fmcn who is spreading rumor and misleading information. He is trying very hard to protect his reputation by continuing to attack fmcn, knowing that he might have to start another venture after failing fmcn. Well, the resume of CB before MW was

    1. A storage business in China with three employees and very little revenue.

    http://www.loveboxstorage.com/location.html

    2. Working for his father as researcher.

    3. A research firm called China Primer.According to their website, they have done research on 1000 Chinese firms with three employee but with no report published yet.

    http://www.chinaprimer.com/equity-research/equity-research.h...

    4. Working as solicitor not a lawyer in Shanghai for a very limited amount of time.

    After all the time he spent in China, he has yet learned how to speak the language. How can he know China/Chinese companies well enough to make any intellgent comment without the knowledge of local language. So far, MW has no full time employee.

    The structure of qihu is exactly the same as bidu and sina. Don't you know that is the only way that internet company in China can be listed oversea? It seems that you have very limited knownledge about what is going on except by reading only negative report. Today, there are still a lot of short sellers on sprd and fmcn and the way they spread rumor on the stocks is very comical. It gives me a lot of chance to buy it back cheap. Truth will come out after ER. Short seller are putting doubt on people's mind before it. Watch and learn.

    Carson Block accused the CEO of onp stealing 10 mln dollar used for buying a phantom machine. Now, the machine have been installed and is running smoothly. I established my porfolio on onp around $3.00+. Insiders are buying up onp's shares by the bundle. It is going to be above $4.00 next week. I won't sell my holding on onp before I have my $10.+/shares in profit. I do not know how Carson Block can get away with making false personal accusation against individual without being sued. FMCN just made an annoucement that they might take CB to court. Stay tune. CB and his cohort might end up in jail somewhere? I might make my first million profit on the back of CB very soon. If you do not buy shares because of doubt, stay away from Wall street. I have doubt about aapl and it does not stop me from investing in it. lol.

  • Report this Comment On January 14, 2012, at 9:37 AM, AverageIn2003 wrote:

    Brian -

    Thanks for your reply.

    I read somewhere (I think it was on the Fool) that if ever there were an environment of "shoot many times in the face first and ask questions later," it exists right now with Chinese small-caps.' This is the feeling I got when I read your article. And you say that you were only referring to 'small-cap Chinese companies', but FMCN is a mid-cap, so I assumed you had expanded your thoughts beyond the title of your article.

    The problem you point out in obtaining reliable information from Chinese companies exists in every market. But it seems fashionable for the self-righteous U.S. media (present company excluded) to promote distrust of China. The simple truth is that we, the U.S., need to examine ourselves more than the Chinese. Wall Street and those surrounding Wall Street have literally made it an art out of cheating investors (and the government for that matter). We have implemented law after law after law to stop the cheating, insider deals, false information, and on and on. Yet it continues to this day. Many of those responsible go unpunished. So it’s really hard for me to swallow anyone in the U.S. throwing stones at China, a country of 1.4B people coming out of the Stone Age.

    Don’t get me wrong, China definitely has its issues. But let’s give them a few more (hundred) years or so, and not use the charismatic Carson Block as an example of righteous, non-biased, objective truth.

    FMCN is a good example, so let’s look specifically at this situation.

    ‘Muddy’ Block tanked Focus Media all by himself AFTER recommending shorting the stock. Then to get the ‘word’ out he goes on CNBC trashing the company on national TV. Focus Media responds by offering an independent audit which was then conducted and which then confirmed their previously announced count. ‘Muddy’ also pointed out some obscure ginseng farm acquired by FMCN, carefully wording this to imply the company was padding the pockets of the insiders. FMCN provides further information about this transaction, which for me was fully understandable and acceptable. But to cover himself, Carson Block plays the ‘we can’t trust the Chinese’ card, nor can we trust the independent French auditing firm! Run like hell, the sky is falling! FMCN responds by announcing an annual dividend equal to ¼ of net income to prove it has the best interest of its shareholders in mind.

    What am I missing here? I’ve owned companies before, and I know that not all transactions are perfect. Sometimes there is some junk in the transaction especially when it involves a Mom & Pop type company. FMCN got a ginseng farm in the deal, so what, it’s a footnote!

    Bottom line for me…instead of writing an article recommending your readers ‘avoid small-caps in China in 2012’, it seems to me a better story is Carson ‘Muddy Waters’ Block on his questionable misguided take on FMCN.

  • Report this Comment On January 14, 2012, at 10:12 AM, webmind wrote:

    Anyone supporting the police state of China deserves to lose every penny they invest.

  • Report this Comment On January 14, 2012, at 12:39 PM, TMFCheesehead wrote:

    @fj-

    I am aware of the structural similarities between QIHU and BIDU. As I stated in the third to last paragraph: "Yes, the company is located in China, and it has the same confusing structure as Qihoo"

    @AverageIn-

    Thanks for your thoughtful response. The point that I think is most important (to me) in your response is this: "instead of writing an article recommending your readers ‘avoid small-caps in China in 2012’"

    I think my intention was more to offer my thoughts about why <<I>> wasn't going to be buying Chinese small caps. I could have worded my second paragraph better by saying: "Though I'll try to show you shy I'm staying away from the small players..."

    Brian Stoffel

  • Report this Comment On January 15, 2012, at 6:24 AM, AverageIn2003 wrote:

    Brian -

    Fair enough. Thanks and I'll keep reading.

    Regards,

    AverageIn

  • Report this Comment On January 15, 2012, at 12:16 PM, fjfjfjjfjjfj wrote:

    Brain:

    It is fair to say you are pessimistic about Chinese stock in general in 2011. However, it was a result of economic outlook of China in 2011, not Carson Block. Look at a company (CYD). Profit of 2010 was over $3.00 and 2011 at $2.65. Share price came down from $32.00 to $15.00. It has never been attacked by any short sellers. It only has one millions shares in short position. Business cycle comes and goes. I think the fear of property bubble is over blown and 2012 is the year when Chinese stocks will make a come back in a big way. Short sellers had their way in 2011 and 2012 is going to turn against them. Watching the performance of CB on FMCN, I think he is near the end of this particular venture. He does not strike me as a very intelligent and insightful person. However, he is a very good writer for tabloids. He said fmcn inflated screen count by 50% implying that the revenue was inflated by the same amount. And now he back peddled to say that the count of lcd was misleading. He even said everybody is corrupted including French, in particular the Chinese and he is the only one who can be trusted. I just wish intelligent people like yourself could see through this and stop giving CB and his kind any credit. Once ER date is announced, I expected price of fmcn is going to go through the roof. I've never invested in Chinese internet stock because of their structure and unpredictablity of their earning and high P/E multiple. However, I trade qihu using baidu as leading indicator. When you invest in stock, you should always have an indicator as where the stock would go. Invest in suppliers of aapl, using aapl as a leading indicator is a safe way to go. As Buffett said : "Buy when everybody is afraid and sell when everybody is greedy and excited." On FMCN's Yahoo message board, one person claimed he put all his profit on hrbn in the millions on fmcn. His cost was $10.00+. He would not sell until after ER. Never venture, never gain. I am not the big on fmcn. I wish I had that kind of profit to spread around. However, making money on CB is very easy and it is very shameful for Americans watching him attacking other people based on race and prejudice.

  • Report this Comment On January 16, 2012, at 10:17 PM, tkell31 wrote:

    Good grief, these guys will pump a stock right up to the day it gets delisted. MF still trying to pump Yong. Where is all the pumping of CGA? That was the one single stock that made global gains have a positive return...of course it has tanked since then like all the other small cap scams.

    Could there be some legitimate companies in the mix? Probably, but when Forbes rates a scam the best small business in the world...well do you really think you can pick out the real ones?

    As for the pseudo geniuses posting about what great "value" there is in this sector. Congrats guys, you can buy up all the stock and make millions. Doesn't take a genius to figure out if the company is legit it will eventually gain the value back or maybe go private. On second thought they are just hear to pump.

  • Report this Comment On January 17, 2012, at 11:20 AM, ETFsRule wrote:

    Sino-Forest Short-Seller Block May Go Long on U.S.-Listed Chinese Stocks:

    http://www.bloomberg.com/news/2012-01-11/sino-forest-short-s...

    This entire sector has been battered so hard over the past couple years, it seems almost inevitable that the "real" ones will post some impressive returns going forward. The only question is, how do you pick the real ones?

    Luckily I have already solved that problem, as I have discussed in my blog. The answer is simple: invest in the same companies that IDG invests in.

    IDG is the most successful venture capital firm in the world, they do their own due diligence on the ground in China, and they have never invested in a fraud. It's really as simple as that.

    Here is the list of Chinese companies that you can buy with 100% confidence because of IDG's due diligence (most, but not all, are small caps):

    CYOU BIDU BSDGF.PK CBPO CEDU CNTF CRTP DANG HMIN HTHT JRJC KGDEF.PK KONG LGCHF.PK LYRSF.PK MEMS MGH RDA SFUN SOHU TUDO VNET WUMSF.PK

    I personally own BSDGF.PK, CNTF, JRJC, and MEMS.

    Go ahead, try to find a fraud among those tickers. I dare you :-)

  • Report this Comment On January 20, 2012, at 7:02 PM, GiveMeABreak917 wrote:

    This article starts off saying, Don't buy Chinese stocks... You don't own any part of the company as outside investors can't own companies in main land china...Then it follows up with BUY BIDU, the google of china...

    Quick Question, isn't BIDU a chinese company?

    Wouldn't you not own any of it either?

    It's obvious this article has an agenda.

    So trying to hide facts in the form of what is represented to supposedly be an impartial article is what this article should really be titled..

    Why not call it, "You are a fool, and believe what I say, because i say so, so I can make some money shorting one company and longing another"

  • Report this Comment On January 20, 2012, at 7:08 PM, GiveMeABreak917 wrote:

    One other tid bit.. Fidelity, T.Row Price, Goldman and a few others own shares in "Chinese companies", Bidu specifically.

    But I am sure "Brian Stoffel" knows much more then they do.......Riiiiight......

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