3 Reasons to Be Scared of These Stocks

Veteran Global Gains members know what we love about China. There's tremendous potential upside there, with many cheap stocks ready to explode in value -- especially among smaller companies.

We can never emphasize enough, however, the dangers that lurk in the world's most populous country -- the nasty traits of some Chinese businesses that make us fear and loathe them.

An emerging giant
There are more than 2,000 public companies in China. About 450 are listed in the U.S., with that number growing all the time. And many of them are future multibaggers that will make their shareholders rich. Look around and you'll find businesses such as Universal Travel Group up nearly 300% just this year alone.

But we can't pretend these types of winners are easy to find. If you don't know the lay of the land -- the ins and outs of Chinese political structure -- you could quite literally lose a fortune.

Here are just three of the problems to be on the lookout for:

1. Hard-to-decipher financials. The Economist magazine sums it up better than I can:

The financial results of companies that global investors wish to buy into can be as unintelligible as the dialect spoken in the company town. It is said (with apparent sincerity) that some Chinese firms keep several sets of books -- one for the government, one for company records, one for foreigners and one to report what is actually going on.

In fairness, this was written a couple of years ago and Chinese financials are a bit easier to understand now. And there's no doubt that American companies also do not make available the books we'd really like to see. Even the ones we can see aren't necessarily easy to decipher -- look no further than Citigroup (NYSE: C  ) for a perfect example. I'll never forget one of my colleagues expressing admiration for JPMorgan Chase (NYSE: JPM  ) , while at the same time admitting he didn't know exactly what was on its balance sheet -- and this is one of the few financial giants that held up well in the credit crisis.

But there's little question that we simply can't get the same lucidity and transparency from Chinese companies that we do from domestic firms.

2. Questionable quality of earnings. Quality of earnings refers to the extent to which financial reporting can be trusted. The more conservative management is with its assumptions, the better we feel about the numbers it reports. A 2008 Barron's article relayed a pretty sobering study from RateFinancials, an independent firm that rates financial reports. Looking at the five largest recent Chinese IPOs -- including LDK Solar (NYSE: LDK  ) and Yingli Green Energy (NYSE: YGE  ) -- RateFinancials found problems with "big increases in receivables, negative operating and free-cash flows, significant amounts of deferred revenues, major prepayments, and sizable long-term commitments to suppliers."

3. Poor corporate governance. China is "perceived to routinely engage in bribery when doing business abroad," according to Transparency International. And in TI's 2008 corruption report, the country falls well below any comfortable level, ranking 72nd. That doesn't mean every Chinese company is dicey, of course. India ranks 85th on the list, but for every fraudulent Satyam (NYSE: SAY  ) , there's a shareholder-friendly outfit like HDFC Bank. But it's yet another risk to watch out for.

To sum it up, our Global Gains team warns that "Shareholders of Chinese companies should know that there is no real apparatus by which their interests are protected and that they are essentially betting on being on the same side as management and the majority shareholders -- who as often as not are branches of the government, the military, and/or the Communist Party."

And yet ...
Still, China's vast potential cannot be ignored, and investing indirectly through huge multinationals like General Electric (NYSE: GE  ) and ExxonMobil (NYSE: XOM  ) won't cut it. China is a small part of these companies' businesses; to realize the greatest potential from China's growth, you'll need to look to the domestic companies.

We recommend some China exposure as a part of any balanced portfolio. That's why we travel to the country yearly and headed off again earlier this week to meet with several companies and some prominent investors. 

These meetings -- the ability to sit at the same table as management and see the business operations with our own eyes -- allow us to separate the good from the bad, and the quality from the corrupt.

Uncovering a double
In 2008, China Fire & Security Group seemed to have it all. Revenue had doubled in two years, the country's market for fire safety products was huge, and several high-profile industrial accidents had pressured the government to crack down on safety violators. To top it off, the government enlisted China Fire itself to help write safety legislation. Talk about the fox guarding the henhouse!

But there was a hitch: The excellent website had blasted China Fire for some less-than-stellar corporate structure and ownership issues, and the share price had cratered 60%.

We were fortunate, however, that our Global Gains analysts had actually visited the China Fire headquarters, touring the factory and chatting in detail with management. They were convinced the company was working earnestly to address the issues, and that the beaten-down stock price was a real bargain rather than a harbinger of further deterioration. They recommended the stock in May 2008, and it more than doubled before it was sold for valuation reasons.

Travel with us
There is a lot to fear about investing in Chinese companies. But our ability to visit the country yearly and talk with promising companies enables us to separate the good stories from the hype. If you'd like to read about what we found on our trip, we're offering a 30-day free trial to the service. This includes full access to all of our market-beating recommendations. Here's more info.

Fool analyst Rex Moore owns no companies mentioned here, but does have some Chinese exposure. HDFC Bank is a Motley Fool Global Gains selection. The Fool has a disclosure policy.

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Comments from our Foolish Readers

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  • Report this Comment On July 06, 2009, at 5:02 PM, wldgrdnr wrote:

    JPMorgan held up well due to the US government gifting them Bear Stearns and Washington Mutual, and they STILL might not make it. Look at their derivatives...the only reason they did so well is due to their probable hedge fund shorting WAMU into the ground, and they are big players in the Fed and used their influence.

    Additionally they have been accused of Fraud in Delaware, Texas and Italy. They have a long history of underhanded things dating back to 1907. Do a web search and you will see. Click this link for info on their past history

    Until JPMorgan learns to do business above board, I would not have anything to do with them.

    They also need to clean up their derivatives...

  • Report this Comment On July 06, 2009, at 5:31 PM, eaglesjazz wrote:

    I will not subscribe to FOOL again. It seems that every time I get an email you try to sell me another service and often don't identify the specific stocks you seem to be recommending. Every time I request

    a "free" report and give my address things stop there unless I subscribe to another service.

  • Report this Comment On July 06, 2009, at 10:08 PM, reostx wrote:

    I'm with you eaglesjazz. FOOL is king of the one liners always ending in a sales pitch with little info.

  • Report this Comment On July 06, 2009, at 10:58 PM, chris7h wrote:

    I agree that there is far to much " we are great " in your attempt to get people to buy your waresn I will not renew my subscription

  • Report this Comment On July 07, 2009, at 1:21 AM, Laureanb3 wrote:

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  • Report this Comment On July 07, 2009, at 7:58 AM, Dnttrustanalysts wrote:

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  • Report this Comment On July 07, 2009, at 11:44 AM, windsora wrote:

    Fool is an honest service that makes some mistakes which they should recognize and publsize along with the winners. WT anderson

  • Report this Comment On July 07, 2009, at 4:21 PM, shmoola2 wrote:

    I find the Fools' advice to be trustworthy and straight-forward. I don't feel strong-armed in the least. Thus far, my luck with their selections has made my subscription fee well worth the investment. And I intend to follow their advice as regards their advice in the article which I indeed found to be quite free of cost or pressure.

    Simeon in Atlanta

  • Report this Comment On July 07, 2009, at 5:28 PM, ctnative wrote:

    And I thought I was the only one who has a problem with Motley trying to sell more and more information rather than providing it with the subscription. Enough already...We'll take our chances with Bottom Line or the Journal first.


  • Report this Comment On July 10, 2009, at 1:36 PM, evolutionXXVII wrote:

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  • Report this Comment On July 10, 2009, at 2:24 PM, CJuliet wrote:

    The FOOLS do provide some good information. However, the way it presents itself is less desirable - it made me feel like a FOOL as I have to follow a trail before I see the punch line, along the way I may have to subscript to other service... I did not subscript to the service after the free trial. I will subscript to it if it changes the format and make it a more straight forward reading.

  • Report this Comment On July 10, 2009, at 2:30 PM, EvanReed wrote:

    I hope that management takes these comments seriously. I have been happy with the two newsletters that I subscribe to, but do feel increasingly suspecious of all the sales pitches. I "foolishly" thought that the Gardners were really giving out solid information, without the TV- type hype and "teasers". I think you will lose respect and customers if you continue the info-mercials. Do you need more money that badly????? I suscribe to another service that continues to seem more solid to me.

  • Report this Comment On July 10, 2009, at 3:08 PM, mcculldm wrote:

    I agree, I get way to many e-mails from motley fool. every single one trying to sell me something. I will not sign up again.

  • Report this Comment On July 10, 2009, at 3:11 PM, jmtwilson wrote:

    I'll give the site credit for allowing and displaying the negative comments of subscribers and former subscribers. On balance I think their rationale behind stock selections is pretty sound but they don't follow their own logic consistently.

    This piece on Chinese stocks was typically self-serving leaving you to feel helpless to find safe chinese stocks without a MF analyst going over and seeing the company.

    Why not suggest a company or two that CURRENTLY appears to be following GARP-type accounting standards and would be worth an investors look?

    It's also shocking the amount of daily spam the mf sends to all of my email accounts for my foolish idea of trying a couple of their services once. It's hard to turn off.

  • Report this Comment On July 10, 2009, at 3:37 PM, wendee91 wrote:

    I agree with previous negative comments! It seems to be all flash and no cash. Where is the substance for picking your double, triple and quad baggers? I've not seen it!

  • Report this Comment On July 10, 2009, at 4:23 PM, gloryofarioch wrote:

    I'm not sure why all of you get so worked up about the sales pitches. This is, after all, a free article. It wasn't part of your premium subscription. I am not subscribed to any of the Fool's paid services, and yet this article showed up in my ZooLoo RSS feed.

  • Report this Comment On July 10, 2009, at 7:41 PM, weappa wrote:

    Fool is for fools - I subscribed to the dividend feed a couple years back. Boy, did they miss everything when the economy was turning. I have taken to shorting stocks they recommend.

  • Report this Comment On July 10, 2009, at 9:26 PM, jasonjim wrote:

    I cancelled my subscription to one MF service over 6 months ago. I found the whole thing orientated to the US stock market, and ignored the Canadian stock market which I was particularly interested in being a Canadian. I received zilch in worthwhile advice from my 1 year subscription, and the only stock I bought on their recommendation lost me $3,000 (HNP, a Chinese utility). Save your money folks, an MF subscription isn't worth the service they provide.

  • Report this Comment On July 10, 2009, at 10:26 PM, Xitopie wrote:

    Agree, agree, agree, MF is a big internet marketing machine looking to make a buck on any fool that falls for their so called advice.

    Most of these articles are so recycled, is not even funny. There is always a newbie, a greater fool if you will, that falls for their useless advice.

  • Report this Comment On July 10, 2009, at 10:40 PM, inthebiz wrote:

    I really can't find any further use for the info, originally thinking they were going to provide some solid info instead of simply converting the "bobble heads" on TV to a news letter that is basically switch and bait in the form of an email headline to the reality of "oh this needs to go down the primrose path of investing with no real info related to what the subject line states but will get people to look!" I work in this business and abhor this, those who feed off on the emotions of others, who expect sound info in these trying times: might as well tell people the sky is falling and invest in crash helmets from some of the investment hypothesis for decision making I have seen

  • Report this Comment On July 11, 2009, at 2:58 AM, foolishlew wrote:

    My first invitation to MotleyFool Pro was suspect as it touted the "investment of our own $1,000,000". Their membership fee would have supplied manytimes over that investment. Whose million were they really using? Not risking their own for sure. And to hurry because their membership was limited. How many times since then have I been reinvited to join up? Evidently they overestimated the number of suckers that would pay up -- or it was so successful that they just couldnt resist the greed in signing up all they could? Now I see they are starting their own mutual fund. Their base fees way overshadow the fees I pay to Vanguard. If they are so confident of their success, why not lower the base fee and charge more for their success and nothing if they fail? Speaking of their successes, they always cite the same 3 or 4 stocks they called right. The only way to see all their picks is to pay up.

  • Report this Comment On July 11, 2009, at 3:11 AM, FLL1943 wrote:

    Excellent article, notwithstanding the intimation that only by travelling with MF to the companies can you sort the wheat from the chaff.

    I spent 17 years doing EU anti-dumping proceedings for every imaginable type of Chinese enterprise. After investigation by European Commission officials, the vast majority were refused MES ("market economy status") because the accounting didn't hold up to scrutiny. Cost accounting was especially weak.

    In short, what MF says is true, particularly as regards earnings. Caveat emptor--let the buyer beware! And I do not believe that MF folks going to the companies does much to solve this problem. You can trade these stocks on a momentum basis, but investing based on financial analysis will not work.

  • Report this Comment On July 11, 2009, at 10:00 AM, lydiablp wrote:

    I agree with the comments about endless additional subsciption requested !

    I cancelled and will stay with Morningstar and other truly free information sites

  • Report this Comment On July 12, 2009, at 7:09 AM, milanooo wrote:

    what i understand from this:

    1. MF love money a lot.

    2. MF can not make it investing so they try to make

    it out of the readers, the fools.

    3. MF is a Chinese company and/ or its agent try to

    direct as many investors as they can to improve

    the economy of china instead of the US.

    4. amazingly all the registered readers hate MF

    5. the only site in the field were people think they are not sincere toward them.

    6. all the MF articles are written by a single person even they have different authors.

    7. MF are good at one thing and one thing only…they are good at writing head lines, only

    head lines.

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    9. if you are a crooked SOB you can apply to be a writer for MF

    10. every person reads the MF articles promises thy self not to read or fall for their sh!t again.

  • Report this Comment On July 12, 2009, at 7:26 AM, wuff3t wrote:

    Why are you all posting here if you hate TMF so much? Try spending your time more constructively and you might actually make some money.

  • Report this Comment On July 12, 2009, at 11:16 PM, JimL67 wrote:

    The teaser headlines have more and more reminded me 'Supermarket Tabloids Headlines".

    Please, less hipe and more meat. Show respect for yourself and your customers.

  • Report this Comment On July 13, 2009, at 9:00 AM, gumshoeuser wrote: for those of you that are tired of the marketing hype and teasers.

  • Report this Comment On July 13, 2009, at 10:24 AM, sept2749 wrote:

    I take hit after hit following your picks. I do much better myself and I'm a novice. I also have to agree that every peice of email I get from you suggests several stocks but not by name. You guys really should give a couple of freebees with the constant sales pitches to members. However, I have now begun to see you guys as salesmen not advisors. That's not good. It means your in the same boat as brokers, lawyers and doctors- - YOU WANT MONEY. I figure if you were so on point you'd be retired - not hustling subscriptions. I'm through with subscriptions to Motley Fools.

  • Report this Comment On July 13, 2009, at 11:52 AM, eddybugsy wrote:

    I agree, "Fool" sends way to many emails selling another subscription. I guess the two subscriptions I had just weren't good enough. At one time I had 3 subscriptions. Enough is enough I use to like you "Fool" guys, but I guess it is all about the money. I no longer have any subscriptions..bye..bye

  • Report this Comment On July 13, 2009, at 11:58 AM, 1classact wrote:

    Another problem with MF newsletters, is that there are multiple newsletters, requiring separate subscriptions, and each subscription gives advice only about a limited class of investments (such as value investments). By subscribing to any one MF newletter, you do not get MF's best overall advice. Similarly, select subscribers who pay for MF's premium (most expensive) services get faster and/or unique advice not made available (or as timely) to other subscribers. In my view, MF, as well as all other advisors who maintain multiple newsletters for differenet groups of subscribers, conflict themselves, and breach their duty of loyalty in not giving their best advice to everyone who pays for their advice.

  • Report this Comment On July 13, 2009, at 12:19 PM, SPYDERMAN23 wrote:

    I constantly read in these comment sections people complain that these free articles are sales pitches for MF's paid services.

    People, you need to realize that TMF is a business - they are in business to make money. They make money by selling subscription services.

    If you only want to read the free articles, then go ahead, you don't need to subscribe to any of their paid services.

    You watch free TV and they have commercials - I don't see a big difference.

    I would caution anyone who invests in any stocks mentioned in MF articles that if you do so without doing your own research - you get what you deserve. Same for any investment ideas mentioned in their (or anyone else's) paid services.

    If you really can't stand the advertisements for their paid services, don't read the free articles. Simple as that.

  • Report this Comment On July 13, 2009, at 4:28 PM, redkat103 wrote:

    I tried like heck to get the name of the Oil vacuum stock without paying any money out Couldn't do it.

    Sorry just needed to say this lol

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