Welcome to the Chinese Investment Minefield

From go-go growth investors to curmudgeonly value cheapskates, investors of all stripes appear to be converging on one destination lately: China.

This is a fairly unusual circumstance because growth and value types usually play at opposite ends of the pool. In the late '90s, tech stocks were the growth gang's game. In 2002, after valuations had imploded, value investors stepped in and picked up stocks previously priced on metrics like enterprise value-to-eyeballs for less than working capital.

Scratch that
The foregoing is actually a major oversimplification. The late '90s really belonged to large-cap tech. Investors like Michael Burry (of The Big Short fame) dug around the small-cap space for ignored and unloved tech stocks during those years, finding all sorts of bargains. I think this investor convergence on China is somewhat similar, in that the big stocks are pulling in momentum players, while languishing small caps attract bargain shoppers.

At one extreme, you have companies like Puda Coal (NYSE: PUDA  ) , which has doubled this year, and Baidu.com (Nasdaq: BIDU  ) , which is up 170%. These are both hot growth stories, with Puda providing a pure play on Chinese coking coal demand, and Baidu cashing in big on Internet search.

At the other extreme are small stocks like SmartHeat (Nasdaq: HEAT  ) and American Oriental Bioengineering (NYSE: AOB  ) , which have basically been left for dead. In the wake of a full-blown accounting scandal at RINO International (which was recently delisted from the Nasdaq after saying it misstated its financials) and fraud allegations leveled at companies like Orient Paper (NYSE: ONP  ) and China Education Alliance (NYSE: CEU  ) , this is an understandable reaction. That doesn't mean each sell-off is rational, however.

Does fraud-free mean you're home free?
Because I'm of a value bent, that class of securities certainly has more appeal than big momentum stocks like Baidu, but I'm still extremely reluctant to invest in these smaller Chinese stocks. I suspect that American investors are being played for patsies in the case of many such companies that have come public via reverse merger. Even if any given company isn't an outright fraud or an earnings manipulator, U.S. shareholders still run the risk of being treated extremely poorly, and may have little recourse through the usual legal channels. My Foolish colleague Sean Sun walks through some of these matters in this fine article.

Dipping a toe in the water
One company that has come under fire recently is China Green Agriculture (NYSE: CGA  ) . Our Motley Fool Global Gains team has done careful work on this company, visited its greenhouses, and tasted the fruits (and/or vegetables) of its labor. When the shares took a drubbing in early November, I couldn't quite bring myself to buy the shares outright, but I did sell a put option with an extremely short expiration, for an extremely fat premium.

That particular trade worked out, but if repeated over time, with companies into which I have less insight, such a strategy would inevitably blow up in my face. The Chinese small-cap space is a minefield, to be navigated with extreme care. For that reason, I believe it would be a mistake to take a concentrated position in a single name here, regardless of how good the reported financials look.

One for the watchlist
If you're dead set on going bargain-shopping in China, I would recommend the basket approach that has been utilized by the folks at Global Gains. Speaking of which, co-advisor Tim Hanson recently wrote about the service's Chinese Consumer Basket and shared his top pick within that basket -- an advertising company trading for less than the cash on its balance sheet. Click on over to read more about the challenges the company is facing and why Tim thinks this one's unreasonably cheap.

Never say never: Here's a peek at what I look for in a growth stock.

Baidu is a Motley Fool Rule Breakers choice. China Green Agriculture is a Global Gains selection. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool owns shares of China Green Agriculture. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (17)

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 December 08, 2010, at 3:46 PM, threefourteen wrote:

    You mention HEAT and AOB, but don't say much about them. I am assuming its because you are focusing on the issues that other Chinese companies are having, but then fail to mention the issues with PUDA happening the same day you posted this, saying only that it doubled in the last year. There are tons of other China plays out there. Of course I am only a casual investor, and don't know all the ins and outs of each and every company, how else is one supposed to do their due diligence? I personally like watching $TPI and $BSPM and feel that they get beaten up for the general Chinese investing stigma that is out there. Maybe its warranted, but I would like to think that there are some companies still that are good value and time will show this to be true.

  • Report this Comment On December 08, 2010, at 4:22 PM, Gonzhouse wrote:

    You didn't mention NEP - China Northeast Petroleum, an oil driller in China who has a guaranteed oil sales contact with PetroChina. They went thru a re-statement this year and got hammered.

    NEP has brought in a Big 4 firm to help with SOX compliance which I'm hoping is a sign of a functioning brain for them.

    Bottom line: even something that appears as a slam-dunk lock in having a Chinese oil driller selling Chinese oil to another Chinese oil company under a guaranteed contract can blow up.

  • Report this Comment On December 08, 2010, at 7:29 PM, XMFSmashy wrote:

    A funny coincidence, that PUDA plunge. I wrote this the day prior, so couldn't have known it would fall 17.5% today. Pretty sure it doesn't hurt my case, though.

    TS

  • Report this Comment On December 09, 2010, at 11:36 AM, TheSecretHistory wrote:

    Wealthy Chinese people have been investing in foreign passports.

    http://www.chinadaily.com.cn/china/2010-12/09/content_116771...

  • Report this Comment On December 09, 2010, at 1:30 PM, zbouck wrote:

    If your time horizon is 10 years+, you really can't go wrong investing in China. The emerging agrarian class is becoming industrialized, and the industrialized middle class is graduating to a consumer driven society.

    Over the next 10 years China will become stronger and wealthier.

    This is a cool info graphic showing the rise of societies over 200 years.

    http://freakonomics.blogs.nytimes.com/2010/12/07/visualizing...

  • Report this Comment On December 09, 2010, at 2:56 PM, TheSecretHistory wrote:

    zbouck, I have some .com stock I want to sell you.

  • Report this Comment On December 11, 2010, at 9:50 AM, alabama4606 wrote:

    In my experience I would have to recommend staying well away from most if not all chinese companies listed on US exchanges. Shareholder value is of no concern to management (who a lot of the time are as crooked as they come).

    The chinese small caps experienced a boom caused by 'irrational exhuberence' much like the dot.com bubble, only this time every company which had 'China' in their company name or description instead of 'e/internet' or '.com' was attracting investment, and I have been badly burned investing in the likes of AOB, CEU, NEP, HEAT and APWR. It is certainly not worth the risk and there are far better investment opportunities out there.

  • Report this Comment On December 14, 2010, at 12:27 PM, decbutt wrote:

    This is getting a little infuriating.

    Fool.com were all too eager to call CGA a buy a few years back. In successive glowing articles and write-ups.

    Now there are all kinds of rumors swirling around and Fool.com's response is this:

    Don't actually shine a light too close to CGA.

    Mention CGA every now and again, and give a nod to the fact that the SP has fallen.

    Apart from that, don't comment on the specifics.

    And by no means express or even give the impression that you feel any kind of responsibility for encouraging 1000's of people to invest their hard-earned money into this company.

    If it was me, the embarrassment would force my hand.

    I'd have to go to China - unannounced - to get some verifiable answers. See the product in distribution chains; shops, etc. Manually count buyers. Look at physical assets. etc.

    Regardless of whether they were answers I liked or not.

    But that's just me.

  • Report this Comment On December 18, 2010, at 7:59 AM, Patrick856 wrote:

    I keep my shares of AOB just to remind me to do my own due diligence. Even though my AOB shares are basically worthless, they are valuable to me for several reasons. Most importantly, never hold a losing stock. It is as important, if not more important, to plan your exit either to preserve your principal or any gain you may have accumulated. Also, attempt to buy a stock when its moving up and has a following in the financial media. Shy away from smoking hot stocks(e.g. MGIC, etc.) after they rise to unrealistic levels. Those types of stocks might be good picks after the crowd moves on to the next big thing. My first paid service was Motley's SA. After a one year subscription, I found myself on the losing end. Not only was I out the cost of the service, but every recommended stock lost value. To be fair, many of those stocks turned out to be winners in the long run, but it was too frustrating for me to hold on when all I could see was my investment dwindling away. The only advice I can give to any investor, especially a newbie, is to keep moving....never camp out on a stock. Don't fall in love with a stock, and get out with moderate losses or take your gain without excessive greed. Good luck to all, and Happy Holidays.

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