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 nearly 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 Origin Agritech (Nasdaq: SEED  ) , Solarfun Power Holdings (Nasdaq: SOLF  ) , and JA Solar Holdings (Nasdaq: JASO  ) , which have all more than doubled in just the past nine months 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. And the ones we can see aren't necessarily easy to decipher -- especially financials ranging from Freddie Mac to Toronto-Dominion Bank (NYSE: TD  ) .

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 and Yingli Green Energy -- 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, but investors must be on guard. So while you can check Yahoo! Finance and see that U.S.-based Palm (Nasdaq: PALM  ) , for example, has a better corporate governance rating than two-thirds of companies in the technology hardware sector, such easy tools don't exist for Chinese companies.

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 multinationals like Microsoft (Nasdaq: MSFT  ) and Intel (Nasdaq: INTC  ) 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 are recently back from meeting 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. (You can see all of our notes and stock recommendations with a free trial.)

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 website ShareSleuth.com 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 see what we found this trip (and our current trip to India), as well as our top five stocks for new money right now, 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 information.

This article was first published on July 5, 2009. It has been updated.

Fool analyst Rex Moore received his first scar in a Bourbon Street bar. He owns shares of Microsoft. Intel and Microsoft are Motley Fool Inside Value recommendations. The Fool owns shares of Intel. Motley Fool Options has recommended a diagonal call on Microsoft and calls on Intel. The Fool has a disclosure policy.


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