Can You Trust Chinese Companies?

The Motley Fool Global Gains team is headed to China in July for research. Ahead of that trip, they're taking time to discuss some of the issues facing China, and investors in China, today.

There's no shortage of Chinese companies that have been accused at some point in their history as public companies as misrepresenting themselves, their business, or their financials. And even in the large-cap space, you recently had China Mobile announce a puzzling $6 billion acquisition of Shanghai Pudong Development Bank. So, can you trust Chinese companies to be good stewards of your investment dollars, and if not, why should one bother investing in the sector?

Tim Hanson: My perspective is simple: China's reward profile makes it worth investing there, but it's risk profile makes it necessary to be careful. This is particularly true in the small-cap space, where frequent capital raises, serial and dubious acquisitions, and a cast of shady characters make trying to pick the winners seem even more difficult than navigating a minefield.

I continue to steer clear of Skystar Biopharmaceutical (Nasdaq: SKBI  ) , for example, because I legitimately cannot estimate what its share count might be in a year, even though I like the business.

Further, it's worth recognizing that there are cultural differences. Take American Oriental Bioengineering (NYSE: AOB  ) , for example. That company came under fire for a purchase of a new corporate headquarters in Beijing that by almost any isolated analysis looks like they overpaid for. The wink-wink-nod-nod story that floated, though, was that a heightened presence in Beijing would help them secure tax breaks and benefit from China's new government health-care plan. Given AOB's recent financial results, it's clear neither of these benefits materialized, but given how important guanxi, or relationships, are in China, it's not outlandish to think that they could.

Then there are the instances of restatements, material weaknesses, and allegations of financial shenanigans that have hit FUQI International (Nasdaq: FUQI  ) , China Sky One Medical (Nasdaq: CSKI  ) , and most recently, China Marine Food (AMEX: CMFO  ) , among others.

With all of them, one has to consider the sometimes compelling evidence of impropriety with the reality that these are immature public companies that likely kept several sets of books in China in order to avoid taxes.

Given these "issues," many American investors just avoid China altogether. That's short-sighted. China's economy will be the largest in the world in 20 years. That said, the risks in China are real, so look for companies with reputable auditors, and buy your small-cap China exposure in a broadly diversified basket, with no company representing more than 1% or 2% of your overall portfolio.

Nate Parmelee: Potential aside, China is still considered a market where foreigners won't get a fair shake, and there are plenty of companies out there that back up skepticism of the market. As Tim mentioned, accounting concerns and questionable transactions can absolutely kill shareholder returns.

All hope is not lost though. Every time we visit China, we meet a management team that shows they understand the concepts of cost of capital and return on invested capital. While that's often because that same management team has made capital raising mistake or two in the past, the growing awareness of what is means to be a shareholder-friendly company is reassuring.

As long as I continue to see examples of companies grasping this crucial concept, I think there is a chance for trust to improve.

Sean Sun: Like everything else with China, investing there is all about the subtleties. Viewpoints on both extremes ("China is the promised land!" and "China is entirely fraudulent!") miss the truth that lies in the middle. That said, while it's always safe to be asking, "How am I being screwed here?" the fact is that even when it looks bad with some Chinese companies, there may not actually be malevolence on the other side. Better bets are incompetence, ignorance, and negligence. (Are you reassured yet?)

From an analyst's perspective, the biggest wrench is valuing Chinese equities with any degree of accuracy. That's why I think it's important to look at China with an expected value framework, where you're not looking simply at the outcomes but also the probability of those outcomes actually occurring.

Since our estimates of probability are almost certainly going to be wrong, it's important to have a decent risk-reward profile to make any individual investment make sense. When I look at New Oriental Education (NYSE: EDU  ) , for instance, I think there's essentially a 50-50 chance that my thesis is right. If I'm wrong, EDU drops 50% in value. If I'm right, New Oriental Education remains the dominant player in a huge (and relatively untapped) Chinese education market, and the stock goes to the moon.

Think about it this way: If someone offers you a coin flip where heads means you lose $0.50, and tails means you win $5.00, you take that bet any day, every day (so long as you don't risk so much that you can't stay to play again). China is one of the few places in the world today where that bet exists.

Agree or disagree? Leave a comment below and remember to sign up get all of the team's thoughts from China by entering your email address in the box below.

Tim Hanson owns shares of American Oriental Bioengineering and China Marine Food Group. Nate Parmalee owns shares of China Marine Food Group. Sean Sun owns none of the companies mentioned here. New Oriental Education & Technology Group is a Motley Fool Rule Breakers choice. China Marine Food is a former Motley Fool Global Gains selection. The Fool owns shares of China Mobile. The Motley Fool has a disclosure policy.

Read/Post Comments (16) | Recommend This Article (30)

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 July 01, 2010, at 4:05 PM, FUDweiser wrote:

    What will happen when China rules the world? It is title of the book, but I don't want to live in that world.

    Everything about China is shoddy and fraudulent.

    China has no shame in cutting corners --melamine in milk, stinking dry walls, lead content in toys and cadmium in jewelery. It is not only cheap labor but cheap mentality.

    Chinese stock market is not as open and transparent. It is hard to judge companies based on fundamental analysis. Doubtful merger-acquisition, accounting practices and lack of honest awareness of what is happening have made me less and less confident about investing in China. Now I think of Chinese companies as charlatans exploiting greed and ignorance of global investors.

    I own 2 China stocks AOB and SmartHeat -- 5 star rated in CAPS. But look at the performance --absolutely abysmal and for reasons unknown, vague and fuzzy.

  • Report this Comment On July 01, 2010, at 5:31 PM, drkazmd65 wrote:

    I have owned shares of two Chinese stocks over the last two years. One I no longer hold but sold for about a 3x Profit (YGE) in April 2010.

    I still hold a position in SNBP - they make a profit each quarter (small), but recently did a share dilution that scared off some investors. I may increase my position in SNBP after their next quarterly report comes out - or not.

  • Report this Comment On July 01, 2010, at 10:53 PM, TMFDarwood11 wrote:

    I don't trust the Chinese government and I consider them to be master manipulators. That said, I also think that at present, the Chinese are possibly the best friend the average American citizen has. Why do I think this? It is because the Chinese government will keep pressure on our government to prevent severe debasement of the U.S. currency. Not for any love of America, but to simply preserve the value of the nearly $1 trillion the Chinese hold. Our politicians have less restraint and less true concern for the well being of the average American citizen.

    Anyone who doubts me should check the manner in which the Congress has manipulated the housing market via Fannie and Freddie, the manner in which the government has pandered to all manner of special interests from "immigrants" to Wall Street to "seniors".

    In summary, the Chinese are doing more to protect the American dollar than our own government is. Need I say more???

  • Report this Comment On July 01, 2010, at 10:55 PM, TMFDarwood11 wrote:

    PS: I own no stock in Chinese companies at present. However I do own "emerging market" funds and these do, of course, include such stocks.

  • Report this Comment On July 02, 2010, at 10:02 AM, pondee619 wrote:

    "It is not only cheap labor but cheap mentality. "

    Does anyone else remember when "Made in Japan" had the same reputation?

  • Report this Comment On July 02, 2010, at 11:16 AM, Deepfryer wrote:

    Great point, pondee.

    People are mistrustful of what they don't understand.

  • Report this Comment On July 03, 2010, at 2:59 PM, exileonmainst wrote:

    I put the owners and managers of Chinese companies in the same category as entertainment, cable and French companies. All seek to retain complete control through minority shareholdings, provide distorted or misleading results and perpetuate poor governance. And they do this while shamelessly taking people's money. I don't understand why MF continues to tout these sorts of firms. Makes MF no better than the shills of Wall Street!

  • Report this Comment On July 03, 2010, at 7:30 PM, muddywatersre wrote:

    We (Muddy Waters, LLC) published a Strong Sell report on a China stock this past week, ONP.

    To my mind, the Global Gains member who has it most on the money above is Sean Sun. China will not live up to the hype (i.e., world's largest economy in 20 years). China won't go away either.

    Since we published the report, we've been contacted by a number of players in the China microcap space. It seems from their comments that there is also a problem on the US side (in addition to inability to analyze Chinese companies). Some of these investors believe that there are US-based parties who are knowing and willful participants in importing partly to wholly fraudulent listings to the US market.

    I agree with some of the comments above that in portions of the China business world, there is a destructive mentality. I'm sorry to say (but not that surprised) that parts of the microcap investment world in the States seem to have the same way of doing business - particularly regarding China shares. Caveat emptor.

  • Report this Comment On July 03, 2010, at 8:28 PM, jfrankh57 wrote:

    You people think that we are mistrustful of what we don't understand? What happened to the PRC that practiced subterfuge against the countries of the west including the USA. I still haven't seen the central committee rescind its stated goal to destroy the Imperialist Capitalist societies. Me, I think it is a measns to an end.. They still have strongarm tactics to control their own people and those sociities they have pushed under them thumb...just look at Tibet, the various religious sects and Tianimum Square.

  • Report this Comment On July 03, 2010, at 11:39 PM, muddywatersre wrote:

    Absolutely you should be mistrustful of what you don't understand. Step number one for a lot of investors is admitting that they don't understand Chinese companies / China / etc. Then be skeptical.

    My comments above focused on the US side because some China side issues were pretty well documented in the preceding comments. My point is that the opacity of China along with the greed of certain players in the US is a potent combination for deceiving investors.

  • Report this Comment On July 04, 2010, at 3:21 AM, LawrenceLB wrote:

    Does anyone have any intelligence or recommendations on CMED? Thanks.

  • Report this Comment On July 05, 2010, at 7:43 AM, jamespeer wrote:

    "...the risks in China are real, so look for companies with reputable auditors..." Absolutely Tim, that to me is one of the most important things to consider when looking at Chinese companies to invest in. I learned my lesson the hard way with AOB and APWR and am now very cautious and sceptical when looking at Chinese companies.

    I have learned that if the stock represents a buying opportunity which seems too good to be true, more often than not it is. But there reputable companies out there that are worth your investment so I certainly would not overlook the region altogether as there are some true gems out there. Reliable financials is key though, so extra caution and research is certainly required.

  • Report this Comment On July 06, 2010, at 6:19 PM, sgmojo wrote:

    Reputable auditors, indeed! I've seen reporting problems over and over again.

    In my due diligence on China small caps, my first step is to determine who the CPA firm is. If it's an unfamiliar name, I don't even move to step two.

    There could be many reasons for China companies to employ less than top CPA firms....and most of those reasons are unfavorable to shareholders.

  • Report this Comment On July 07, 2010, at 8:12 AM, titmousejr2 wrote:

    I've been investing in Chinese firms for a few years. Before each investment I researched the company and its industry. I've seen ups and downs, but have found China's securities more stable than the U.S., less prone to panic selling. An investor should be cautious, but there seems to be more opportunity in China, which is only starting to develop a strong consumer market.

  • Report this Comment On July 08, 2010, at 10:02 AM, blueskyAZ wrote:

    China has risks but there is massive US macro risk ahead. I bought China New Energy Group (CNER) which has tripled since I bought it last fall, despite the pullback this year. This stock does not depend on any markets outside China. There is a US trained CEO whose management experience is with the best US energy multinationals. CNER is a nat gas distributor to commercial, industrial and residential. The IEA estimates China sits on 23 Trillion cubic meters of shale gas. Nat gas consumption is growing faster in China than any other country in the world. The nat gas investments by Shell, BP, Exxon and all the China majors in that region are massive. I put this stock in my "buy and forget about it" folder. China has abundant nat gas and they are using it (unlike we who also have abundant nat gas but are not using it). The population is growing. Guangdong is the richest and most populous province and they recently said they will phase out coal powered plants and replace them with nat gas power plants due to severe environmental degradation from coal. Expect all the other provinces to follow. Yes China has risks but the risks ahead in the US scare the daylights out of me and I'm still waiting for Washington to redirect inefficient spending to "good spending" ie bolstering start ups, R&D, innovation etc. as that's the only way to create jobs. So far, none of that in sight.

  • Report this Comment On July 08, 2010, at 5:47 PM, fadler1 wrote:

    I have sold goods to China for more than 11 years and dealt with a lot of things that could be misconstrued based on "western" culture. In the area of biotech, what I have observed is a tremendous pressure from their side to reduce costs since their purchase prices within China are so very low.............artificially low based on understated overhead. Consequently, when they see a "substitution" they can make to lower a cost, they often take it not really understanding the imposed regulations we have in the U.S. requiring "validations" of any changes to process or materials. Those "validations" serve to protect our population. China is not there yet. They can't afford it. They make the decision of affordable versus safe more in the frame of reference of make it available versus not available and what is the net result.

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