The Idea That Burned Me: Buy Anything Related to China

Worldwide Invest Better Day 9/25/2012

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.

Foolishly yours
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.

If you want to understand Baidu from the inside out, including the opportunities and pitfalls that could affect its share price, then consider grabbing your copy of our latest premium research report on Baidu. This report comes complete with a full year of regular updates and could give you the investing edge you're looking for. Click here to get this report.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of Baidu and Facebook. Motley Fool newsletter services have recommended buying shares of Baidu, SINA, Sohu.com, and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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 (12) | 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 September 13, 2012, at 4:47 PM, GregKS wrote:

    Sean,

    I feel your pain, but probably being a little older than you, I remember 25 years ago the “smart” place to invest was Japan. Their stock market was going up to 35k, they had Toyota, Honda, permanent jobs, no problems, and then what happened? Today's close of the Nikkei was 8,995.15.

    When I think about China, I think about a country that does not create anything. Most of what they have is either purchased, such as space technology from us 20 years ago, or just stolen. Think about patent infringements, copy-write infringements, and dvd pirating.

    Then, you said: “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.”

    This begs the question, “How or why can they be trusted?”. You admittedly purchased stocks that falsified their reports (cooking the books) but now state that the above listed companies can be trusted. My question is “Why should they be trusted?” Does China have an effective SEC? Our SEC sometimes leaves something to be desired, but China? Please.

    The paragraph which really tripped my trigger was when you listed Baidu and Sina as companies to be trusted, and by inference, owned. In the last few years, I have read reports where China is restricting search results based on what the government feels is appropriate, and is chasing down dissidents using the internet. Frankly, I do not want to support those types of activities.

    In conclusion, fool me once, shame on you (Japan), fool me twice, shame on me (China).

    Greg

  • Report this Comment On September 13, 2012, at 5:02 PM, DivingDan wrote:

    Before reading this article, I had just read the article of The Best Investment Advice You Ever Got. Many of them were of the "buy what you know" Warren Buffett/ Peter Lynch variety.

    My knowledge of China come from the products in my home that are made in China... poor materials, poor workmanship... basically junk. This alone made me wary of Chinese stocks and I never went there... thankfully.

    Buy/invest in what you know.

  • Report this Comment On September 13, 2012, at 5:15 PM, TrackUltraLong wrote:

    GregKS,

    My reasoning has to do with Baidu, Sohu, and SINA being more transparent. It's book, business model, and other aspects of the company are tangible and easier to inspect. There's significantly more analyst coverage globally on these companies. I'm not saying they too may or may not have financial "flaws"... one need only look at Enron, Worldcom etc. at home to see that, but they appear to be as viable of an investment (up or down) as any U.S. based company.

    Thanks for the comment,

    Sean

  • Report this Comment On September 13, 2012, at 5:19 PM, TrackUltraLong wrote:

    DivingDan,

    Not sure if you've had time to the check out the devilish brother to the "best investment advice" article, because "Buy What You Know" was the absolutely worst advice I've ever received.

    Some people just aren't programmed to keep track of more than 10-20 different stocks and there is absolutely nothing wrong with that at all. On the other hand, I find myself constantly on the lookout for new companies. I feed off of knowing how businesses relate to one another, who their competitors are, etc. Some of my best gains (and worst losses) came from lesser known companies. That doesn't mean I couldn't tell you what they did, but had I followed "Buy What You Know" to the T, I'd have never discovered these gems.

    http://www.fool.com/investing/general/2012/09/12/roundtable-...

    Again, thanks for the comment,

    Sean

  • Report this Comment On September 13, 2012, at 7:31 PM, leradron wrote:

    Greg, I believe the quote is, "Fool me once, shame on — shame on you. Fool me — you can't get fooled again."

    ;)

  • Report this Comment On September 13, 2012, at 8:23 PM, TruffelPig wrote:

    One can probably now buy some selected stocks from China. My test is dividend - I invest in those with regular dividends. Most reverse mergers do not do that. Also, only companies that went through IPO. Good honest article, thank you.

  • Report this Comment On September 14, 2012, at 9:38 AM, Darwood11 wrote:

    Good article, and I can say it did provide an opportunity to reflect on the ideas or the actions that burn me.

    I've avoided individual Chinese stocks, even though I've subscribed to Fool services that described the companies and made recommendations. Instead, I bought some active mutual funds in the asia-pacific region.

    Part of my motivation was adhering to a "buy what you know" philosophy and part was "if it is too good to be true, it probably is." I did miss some good buys.

    Yes, things can always go wrong, and do. But I'm a cautious investor, having been burned. We can learn from these episodes. I do expect to get burned. I just hope I can limit the damage.

    It's somewhat counter-intuitive, but it takes failure to learn what is required to succeed.

    Yes, we can sometimes do everything right and have it turn out badly. But in my less than stellar career as an investor, I can honestly say I did, in fact, contribute in some manner to most of my failures. Usually a failure to take action and procrastinating. Sometimes jumping in and "taking a chance."

    As the author pointed out, making decisions about companies at a great distance and with insufficient information is difficult.

    Sometimes it gets weird. I reorganized my portfolio in 2008, and began buying as things were dropping. I bought in increments at what I thought was a good price, but as the drop continued I continued buying. I had deployed most of my cash before the market hit bottom. When the carnage had ended, I had a portfolio of the things I wanted, but they were worth less than I had paid for them. I was disappointed. I held because it had been my premise that the "panic" was an opportunity to buy good stocks in good companies at a fair price as a long term purchase.

    But I did not feel wonderful because of the paper loss and decided "I may have blown my retirement." What to do? I decided these were good companies and I would stick to my original plan.

    Today, a few years later, it did turn out, because as we know there has been a market recovery and those stocks did well.

    The current test is one of my "buy and hold" philosophy, because there will be another downturn, by the very definition of market cycles.

  • Report this Comment On September 15, 2012, at 4:21 PM, xetn wrote:

    Not to defend Chinese products, but, China does not force anyone to purchase those goods. What China does produce is goods SPECIFIED by their US customers, companies like Walmart.

    Walmart provides those specifications based on what they perceive their customers want and the price they are willing to pay. So, if you want a cheap product that is what Walmart (through its Chinese producers) stock and sell.

    The real question is, if you are unhappy with those products, don't buy them. Also, don't blame Chinese companies for providing what was ordered.

  • Report this Comment On September 16, 2012, at 10:41 AM, UgolinoII wrote:

    I think it's a little disingenuous to say that walmart is teling china to make poor quality goods. Any manufacturer is going to make its goods as cheaply as it can get away with, because walmart pay X per unit. If a chinese company can make something cheaper, then they increase their profit. This is not an anti-china comment. It's about business in general. Successful businesses try and increase profit (amongst other things). Reducing costs is one way. Charging more is another way. The 'race to the bottom' model is a sad indictment of how people often choose price over value. People make the same mistake in investing choosing to take heed of price (TA) instead of looking at value (fundamentals). We all know how that plays out...

  • Report this Comment On September 16, 2012, at 11:53 AM, convexvalue wrote:

    Awesome article Sean :D I found that usually I learn a lot more from "mistake stories" - what not to do - than from investment success stories (there are plenty of those to be found everywhere).

    Btw i was also burned with some chinese stocks (growing revenue, growing margins, trading below cash at low single digit PE ratios). I'd like to think i've learned my lesson. Phil Fisher put it best when he wrote:

    "It was my first lesson in what in later was to become part of my basic investment philosophy: reading the printed financial records about a company is never enough to justify an investment."

  • Report this Comment On September 21, 2012, at 12:10 PM, kbsTMF wrote:

    I think I learned my biggest lesson in a similar way, but not from China companies, from American ones. When banking was appearing ready to take off, I got along for the ride. WAMU was one high flyer. All looked great. Reports and filings were great. Then one morning I woke up broke. Seems my bank was closed by the government, sold off to another bank for a penny on the dollar, and re-opened worthless. A couple years prior, it was MCI, eek what a loss.

    So, it's not just China.

    BTW - If you were to buy the China stocks now, or a month ago, how would your portfolio be?

    Max

  • Report this Comment On September 21, 2012, at 3:53 PM, josephfumich wrote:

    My motto---when you get burned, you more careful the next time !! After losing over $25000 via purchase of Chinese stocks reccommended by Motley Fool such as China Green,Yongye Intl and China Marine Food. I got careless and without checking further, I have found that Motley Fool's reccommendation isn't a 100 percent winner and that I should be more cautious and knowledable in the future. You would think all the field trips that where made to China would have root out these

    losers !!!

    Joe F.

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