I've made some bad calls in my time, but I doubt anything will surpass my bullishness toward China-based stocks in 2010.
Why I bet on China
There really wasn't any reason to believe that China and its newly listed army of initial public offerings weren't set up for success. China's economy was growing north of 10% in 2010 and had average GDP growth of 10% over the previous 30 years. Nearly every company based in China and listed on the U.S. exchanges boasted a healthy cash position, a rapid growth rate, and often a very low price-to-earnings ratio. It was almost too good to be true!
I was so confident that investors were overlooking the investment of the decade that I created a tracking portfolio in Motley Fool CAPS called UltraChina to track the success of 200 Chinese companies I suspected would outperform. I even chose to put real money behind a small-cap Chinese natural pharmaceutical company, Jiangbo Pharmaceuticals, which at the time was very profitable and trading below the cash it had on hand.
What went wrong
To be short and sweet, a Fool and his money were quickly parted. The subsequent derailment of many Chinese equities, nearly all small caps, was rapid and unforgiving. Investment and research firms began popping up out of the woodwork questioning the balance sheets of numerous small-cap China-based stocks, and one by one, they began to fall by the wayside as they were accused of fraud -- including Jiangbo Pharmaceuticals. In total, more than a dozen fraudulent Chinese small caps were exposed in 2011. Less than six months after my initial investment, I was left holding a shell of the company I bought at a loss of 91%.
As if that weren't enough of a pride-humbling trade, my UltraChina tracking portfolio is currently the third worst performing CAPS portfolio out of 180,000-plus community members, with only 10% of the 200 picks heading higher and the average pick down 60%!
What I've learned
If it's too good to be true, it most likely is: Just like the Nigerian prince who's eager to share his $40 million with you if you're willing to hand over your personal information, if it seems too good to be true, it probably is. Many of these Chinese equities were brought to market as reverse mergers and had little to no analyst coverage. In short, they were incredibly hard to research and little if any of the data could be trusted.
This doesn't mean all Chinese companies are like this, as there are quite a few names we've covered at The Motley Fool that can be trusted. China's largest search engine, Baidu (Nasdaq: BIDU ) ; SINA (Nasdaq: SINA ) , which owns the Twitter/Facebook hybrid website in China Weibo.com; and Sohu.com (Nasdaq: SOHU ) , which operates the Sogou.com search engine, are all transparent corporations that can be easily researched.
You have to believe in a company's management team: When I purchased Jiangbo, I wouldn't have been able tell you a darn thing about its management team as I was too busy being blindsided by its cash on hand and low P/E ratio. That was a mistake that burned me in the end. It's also worth noting that one of the primary reasons these Chinese companies failed was a lack of conviction in their securities filings. If you can't trust the corporate governance, you can't trust the stock, period!
Past performance is no guarantee of future results: Perhaps the most important lesson here is that it's never worth chasing yesterday's hot trend. Just because Chinese equities did well in 2010 doesn't mean they will outperform moving forward. If you don't feel comfortable leaving your money in a stock for a few years, then that's a stock, sector, or trend you probably shouldn't be chasing.
Investing is a constant learning game. If you aren't willing to reflect on the mistakes you've made, you'll never grow into a better investor. If you take anything away from my mistake, it's that you should never assume anything, and you should always understand and believe in the management team of the company you're invested in.
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