5 Steps to Avoid Certain Doom in China

Emerging markets are both exciting and terrifying. Who wouldn't want to cash in on the inevitable growth of industrializing nations? The truth is, investing in these uncharted waters is dangerous and riddled with fraud traps. To get through the storm, use this checklist to help determine which stocks are winners and which are portfolio torpedoes.

1. Corporate structure
Normally, most of us pay little attention to this aspect of a company. But with an emerging market play, identifying corporate structure is a great way to weed out the good from the bad. So let's get right to it.

Look out for variable interest entities. Basically, a VIE is an operating company whose profits flow out of the emerging market nation, through a series of intermediaries, and into a foreign holding company. In China, VIEs are not required to submit audited financials to the government.

Now-dormant China MediaExpress was a VIE before allegations of massive fraud surfaced (through private investor due diligence). The scandal cost investors millions.

While not all VIEs are bad, view this as a red flag and conduct thorough due diligence if you wish to pursue the investment.

What DO you want? Foreign invested enterprises are required to submit audited statements to China's business regulatory arm. It's not a guaranteed protection against fraud, but it helps. The graphics below should help clarify how both of these structures work.

2. Related party transactions
Look at who the company is leasing equipment or land from. If there was an acquisition that involved a decent amount of money, check to make sure they bought from an independent, and not the CEO's nephew. Basically, look for any irregularity that would logically raise an eyebrow. A public company needs to be acting in good faith, and this is a quick way of determining otherwise.

3. Key personnel coming in and out
In 2009 and 2010, there was a revolving door for CFOs and auditors at many U.S.-listed Chinese firms. This should have raised immediate concern.

If the executives are resigning, find out why. When a company changes auditors, make sure you look to see whether the auditor had any disagreements with the company's financials. These things may seem obvious, but no one was paying attention during the China small-cap boom of 2009.

Be a sleuth. Call the investor relations firm representing the company and ask questions.

  • How long was the executive with the company?
  • What was the severance package?
  • Does the individual still own stock, or did he or she cash out?

If you get dodgy answers, you have yourself another red flag.

4. Equity offerings
After a company's initial offering, every additional capital raise can hurt you, the investor. Dilution can kill an investment even if the company is legitimate and growing. Many emerging market firms have had secondary and even tertiary offerings. You need to discover:

  • Where is the money going?
  • Are they investing in their operations, and are those investments yielding a good return?
  • Will they be raising money again in the near future?

A high-growth company typically requires large amounts of capital, but you need to follow the money. Make sure to read in the corporate filings whether the company has enough resources to continue operations. This often overlooked statement can be the herald of a future equity offering.

5. Method of market entry
This is the big one. Anyone tuned in to CNBC during the last couple years most likely heard the term "reverse merger." Basically, a company "moves" its operations into a publicly traded U.S. shell company. It's a quick and easy way for a foreign company to avoid the big fees associated with IPOs and enjoy less scrutiny.

In my opinion, if you see a reverse merger, move on. While there are plenty of examples of legitimate reverse mergers, I maintain that if a company wants to be taken seriously and open to public investment, it needs to go through the painful IPO process.

Do your homework, twice
You now have a basic tool set to help you sidestep the next emerging market sinker. But don't rely on these as absolutes. The takeaway here is to be extremely careful. If you can, talk to people on the ground in the market you are interested in. Asking even the most basic questions to someone who is in the middle of the action is extremely helpful. It certainly would have helped John Paulson to have conducted the necessary due diligence on Sino-Forest before it ended up costing his firm half a billion dollars.

Below, is a table with a few picks that meet most of my discussed criteria. You'll notice they are not trading at the ridiculously low multiples commonly associated with many emerging picks. These are legitimate growth companies raising capital responsibly and employing reputable auditors -- all signs of a mature, respectable public firm.

Company

Market Cap

Gain/Loss Since IPO

P/E

Auditor

Baidu (Nasdaq: BIDU  ) $52.59 billion 1,078.1% 50.1 Ernst & Young
Spreadtrum Communications (Nasdaq: SPRD  ) $782.5 million 3.1% 6.7 PWC
Qihoo 360** (NYSE: QIHU  ) $3.12 billion (26.8%) 192.7 Deloitte
MercadoLibre (Nasdaq: MELI  ) $4.49 billion 242.8% 58.8 Deloitte

Sources: Yahoo! Finance, EDGAR online database. **Qihoo is a variable interest entity. I overlooked this in favor of its method of market entry IPO and as an example of a nonfraudulent VIE.

Be Foolish, but invest wisely. Sound like too much? We have some people who've done the initial legwork for you and found a great emerging market pick. Check out our special free report, "The Motley Fool's Top Stock of 2012."

Fool contributor Michael Lewis used to own way too many reverse mergers. He would currently rather invest in ant farms. Motley Fool newsletter services have recommended buying shares of MercadoLibre and Baidu. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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