Is China a Complete Joke?

It was almost five years ago now that our Motley Fool Global Gains research team started visiting China, regularly searching for overlooked investment opportunities in the country. We were attracted to the market for the same reasons every business and investor is attracted to China -- it's the world's fastest-growing economy and will someday be the largest as well. Furthermore, because of infrastructure development, rising consumer purchasing power, increasing demand for food and energy, and a growing need for higher quality health care, there's not an industry in the world that can look at China and not see the potential for a growth bonanza.

Investors beware
Yet there are realities about China that make doing business and investing there very difficult -- particularly for foreigners. While we knew it was a relatively dicey business culture, aware of stories of companies keeping two or three sets of books, breaking contracts, bribing officials, and so on, our perspective was that the relative opportunity made it worth the real risks -- and that we could solve for the risk by doubling down on our assessments of management, demand massive margins of safety on any purchase, keeping our exposure to any individual Chinese company small, and getting some of our exposure to China through well-known multinationals.

More importantly, we believed that time was on our side. Our expectation was that business practices in China would get better over time. It turns out that may have been naive.

A tough week for China
While accusations of fraud against small Chinese reverse mergers have been ongoing, two more recent events illustrate just how dicey China really is and how it may not be improving. The first is the incredible story of Longtop Financial (NYSE: LFT  ) , a Chinese financial software company that was at one time capitalized at more than $2 billion and counted some very savvy investors among its shareholder ranks. Following accusations of financial shenanigans, the company's auditor, Deloitte Touche, resigned. There's nothing very remarkable about that, but what is remarkable is the story Deloitte told in its letter of resignation.

Although Deloitte had already received confirmation letters from Longtop's banks concerning the balances in Longtop's accounts, Deloitte felt it necessary to go the extra mile and actually visit the banks. When they did so they discovered that Longtop's stated balances and the relevant confirmation letters did not match what they found at the bank when they accessed the accounts via tellers. In other words, some relatively senior person at Longtop's Chinese bank, which is undoubtedly state-owned, was complicit in helping Longtop deceive Deloitte and its investors. Unfortunately, Deloitte's letter does not name which Chinese bank or banks were involved, but my guess given Longtop's ostensible size is that it was a high-profile one. That means fraudulent practices may be systemic in China's financial system -- undermining any confidence foreign investors like us might have had.

Of course, many never considered Chinese banks to be upstanding corporate citizens. The fact that they were Longtop's principal customers was one reason we were never interested in the stock -- or that of peers such as Yucheng Technologies (Nasdaq: YTEC  ) . It's also why we've never thought the way to invest in China was through the China 25 Index (NYSE: FXI  ) , a popular Chinese investment that has better than 50% exposure to financials. Because Chinese banks are run by the government, they're known for having lax lending standards, loaning to pet projects, and propping up other state-owned enterprises in order for the Chinese government to preserve jobs. These banks are being run for somebody, but it's not shareholders.

Who else is complicit?
The other shot fired across China's bow came from Microsoft (Nasdaq: MSFT  ) CEO Steve Ballmer, who noted in a speech in Beijing that the company only generates 5% of its sales in China despite the fact that there are almost as many computers sold in China as in the U.S., which accounts for 58% of the company's $62 billion of sales. The reason? Piracy. The Chinese government simply does not choose to protect trademarks and intellectual property, and particularly foreign trademarks and intellectual property. After all, piracy creates jobs in China and makes things like software more affordable for Chinese citizens -- both realities that help keep the population in check.

This, however, is starting to change, which helps explain why Ballmer was in Beijing in the first place opening a new $400 million research and development facility. The reason, though, is not that the Chinese government is suddenly respectful of foreign intellectual property, but rather because Chinese companies such as Qihoo 360 Technology (NYSE: QIHU  ) , Li Ning, BYD, and others are starting to develop valuable intellectual property of their own. But the country still has a long way to go.

Are we crazy?
Given this context, why are we going back to China again this year in search of investment ideas? First, we still believe in China's long-term economic opportunity. There will be significant growth in the country over the next few decades even if investors need to work hard to figure out how to benefit from that growth.

Second, China does not want to be considered a corrupt laughingstock by the world forever. Although recent events have been difficult for investors, their coming into the spotlight will force the central government to act. The first evidence that this is happening was the rumor last week that China will finally let the Public Company Accounting Oversight Board auditors in the country. It will also be interesting to see whether any Chinese bank officials are detained in conjunction with the Longtop fraud.

Put those facts together and while China has not come as far in five years as we would have liked, we continue to believe the country is making progress that will ultimately benefit patient, long-term investors. We also think that by getting on the ground in the country, we can identify management teams that are ahead of the curve, helping China and its capital markets get to where they need to be. If we can align ourselves with those types of executives, investors like us can still make good money in China.

If you'd like to follow along with our trip and get our real-time dispatches from the field, simply enter your email address in the box below.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position in Microsoft, as well as recommending BYD. 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 Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (25)

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 June 01, 2011, at 2:46 PM, Gonzhouse wrote:

    I think your trip has two purposes: 1) continue the discovery of companies with huge potential, and 2) spread the word on just how low the Chinese have sunk in the eyes of the investment community and how it will impact China.

    There are many investors like me, who have previously held Chinese companies, who won't touch them now, no matter how attractive them seem. I could completely fabricate a report on virtually any Chinese company and send it out to a critical-mass of investment sites and be guaranteed someone would pick it up for publication. That's how bad the situation is now.

    China has the resources and the will to fix the problem (no joke: they put enough executive's heads on sticks to get attention). Maybe a groundswell from the companies you visit could be a start. Good luck.

  • Report this Comment On June 01, 2011, at 4:53 PM, TMFMmbop wrote:

    We have certainly communicated in the past how weak we thought corporate governance was at some companies, but the lesson didn't sink in when the stocks were rising. I think the last 12 months have gotten their attention, and we should expect to see some changes. There will be some interesting meetings.

    Tim

  • Report this Comment On June 01, 2011, at 5:54 PM, TimothyVR wrote:

    I would rather invest in China through US companies that invest in China.

    I just saw a story about MCD opening another 200 stores in China in the coming years. I would rather put my money in MacDonalds than in a Chinese company that I know very little about.

  • Report this Comment On June 01, 2011, at 6:46 PM, zbouck wrote:

    China has a lot of problems with government and corruption, but to the discerning investor there are some great companies in China.

  • Report this Comment On June 01, 2011, at 9:21 PM, artheen wrote:

    Is China a Complete Joke? Yes. So far.

  • Report this Comment On June 01, 2011, at 9:34 PM, soycapital wrote:

    I'll never invest in individual stocks in China. Live and learn! It's going to take awhile to recover what I've lost over there, glad to be out of it.

  • Report this Comment On June 02, 2011, at 12:33 AM, Schwaggz wrote:

    China has a major corruption problem ingrained into thier culture. It takes a long time (20 years?, 30?, a generation?) of consistant pressure to rid a culture of its undesireable characteristics. Just look at how long it took to create a culture here in America where rascism is unacceptable. Look how long gay groups have been pushing for it to be unacceptable to publicly use gay slurs and are still not there yet. I wouldn't expect any major culture changes in China any time soon.

  • Report this Comment On June 02, 2011, at 9:54 AM, bonznstonz wrote:

    Despite doing the needed d/d on my stocks, I've gotten burned once too often on some of these Chinese stocks. Because of this, I'll continue buying in US companies that may entere the Chinese market.

  • Report this Comment On June 02, 2011, at 10:04 AM, noryakerson wrote:

    I will not touch a Chinese stock. I made some money on CFSG--but lost a whole lot more on AOB. All of the 13 China stocks that I have been tracking have tanked, some due to the fact that they created a facade for investors. I'm finding much better international companies in Canada and Northern Europe. The Chinese have a lot of work to do before I'd trust putting any money into one of their companies; I don't care how strongly touted they are by analysts.

  • Report this Comment On June 02, 2011, at 10:22 AM, catoismymotor wrote:

    I wish the "Fat Tony" factor could be taken out of Chinese small caps. There must be some cultural pressure to cook the books. I also wish Fosun Int'l was available through my broker. I think I could trust their ability to weed out the bad seeds to find and invest in the best real opportunites.

    Until things change I'm staying with Canadian and US companies.

  • Report this Comment On June 02, 2011, at 10:25 AM, Nikita40 wrote:

    I do not see the difference from investing in the U.S. - except a different degree of sophistication in the fraud - with the government ultimately deciding the winners and losers

  • Report this Comment On June 02, 2011, at 12:31 PM, TheDumbMoney wrote:

    China is a country led by a corrupt, morally abhorent leadership that detains dissidents, is intolerant of democracy, and does not only does not respect intellectual property, but actively encourages the stealing of it.

    Foreign companies are essentially forced to give their intellectual property to Chinese companies in order to do business there and sell to Chinese consumers. That is in addition to the piracy you mention. They won't let PM sell Marlboros there because the Chinese government wants a monopoly on the cigarette market. American movies are heavily restricted and most are never shown there. How is this tolerated? How does China even get away with all of this and remain a member of the WTO at all? The greed of the West is how. And our toleration of China is incentivizing other countries, notably Russia, to attempt to follow that model, rather than the Indian or even Brazilian model.

    Meanwhile, too, search engines are forced to restrict "dangerous" search terms, Ai Weiwei has been charged with nonsense tax and fraud violations, Tibet continues to be forcibly resettled with nationalist Chinese speakers, the Falun Gong have been obliterated, China is engaged in a neocolonialist, rapacious, state-organized resource extraction enterprise in Africa, China continues to support the North Koreans, a monster it created, and of course there is the corruption you mention.

    Oh and lest I forget, state media, the very existence of which is abhorrent, actively and successfully encourages and promotes simplistic and virulently dangerous nationalism of the worst sort.

    Other commenters have said the best way to play China is with multinational corporations. Well yes, maybe, but be very wary of any multinational corporation, be it GE, Microsoft, or any other that is playing the game of selling to Chinese consumers, and in exchange "partnering" with Chinese corporations, which really means giving away technology, and creating a new future competitor.

    In my view, the best way to play China is most likely with brands that are competing well there, things like YUM and MCD and COH and KO and french luxury brands. Chinese companies can't ever steal a brand name the way they can steal (and have in fact stolen) wind turbine technology, and many other technologies. Or, the writer says, find a Chinese company that isn't corrupt, or that unlike PTR will not betray (on government orders) foreign investors the instant it suits the government's economic and political interests.

    This is not meant to be a xenophobic rant. I understand that trade needs to be a two-way street, and that it is not correct for any "western" company to think it can sell to Chinese consumers and not give anything back in the way of technology or know-how. But China has gone way beyond that, way beyond. Meanwhile, too, the repression and nationalist indoctrination and neocolonialist enterprise continues, and Putin (and many other leaders) eye China and think, ah....

    Take with a grain of salt the words of the "sophisticated realists" who take the "long term view" and say China itself is following Singapore's model. Is it? And even if so, is this the model we want to encourage and incentivize the rest of the developing world to adopt? Japan arose in a generation under a largely open democracy. South Korea was autocratic at first, but became an open democracy much more quickly and has thrived. India is a corrupt mess, but its economy is growing by leaps and bounds. Even Indonesia, for all of its problems, is doing relatively well. Germany arose out of autocracy and disaster. And of course there is the story of America itself.

    But anyway, enjoy your China trips. In my view, China is no joke. It's a moral and political horror-show. It's a shining example of how we should hope and pray the rest of the developing world does not choose to develop.

  • Report this Comment On June 03, 2011, at 12:58 PM, Popnfresh100 wrote:

    Chinese companies have a lot of fraud issues, but I think the biggest "joke" in this article is Steve Ballment!

    Seeing how he is abusing his patents here (suing for the use of an OS they had no part in creating!) I can't blame the Chinese for not respecting them at all over there.

  • Report this Comment On June 06, 2011, at 2:32 PM, FelixHoenikker wrote:

    Progress would be the Chinese government dismantling their opressive internet censoring operation and putting these people to work sniffing out corruption. But, that would put the current governmnet out of busniess in a few weeks.

  • Report this Comment On June 07, 2011, at 8:13 AM, brooooo wrote:

    As a Chinese mainlander and certified public accountant, I can't say i have a lot of confidence in Chinese system. Everything can be bought at a price, including audit reports. Fake contracts are everywhere - to meet your sales target, no problem. Have your friend sign a contract at month end and reverse it out later with another contract from a friend. It happens every day, only the foreigners beliving China story will buy into the bubble. Literally everything is fake - diploma can be fake, jobs can be fake even food can be fake.

    At the end of the day, wall street likes bubble anyway. Chinese knows how to play the game and suck you in and there are enough fools out there who are willing to jump in.

    My question is - do you really know about China or you are just ignorant as long as the next fool is even a biggar one, until the music stops?

  • Report this Comment On June 07, 2011, at 1:42 PM, dengle76 wrote:

    brooo... I am working in the US for a 12K person Chinese firm listed on the NYSE and have just returned from two weeks of business in China. I have some observations that I that may affirm some of your comments if you are interested as I am trying to put the "real" pieces together. dengle76@comcast.net

  • Report this Comment On June 30, 2011, at 5:55 AM, mrhmotley wrote:

    Anyone reading the above comments would be forgiven for thinking we live in a free society in the West, yet Google just handed over what percentage of private data to the US Gov? was it 80% or 90%? While apparently the UK gov is the largest requester of information from Google!!! You talk about corruption in China, yet Sarkozy just came out in support of nuclear power and said they will spend 1 billion euros on it because he says there is no alternative - this is while Fukishama is still spewing radiation! Are you telling me he has not been promised a re-election campaign donation of x% of that money plus a fat thank you when he leaves politics! Same with the UK minister who today came out in support of nuclear power. These people are SO CORRUPT it is beyond comprehension. They are not just selling their souls but our futures as well. The CEO of softbank intends to create a solar power company that will supply the same amount of electcticity in Japan as Tepco, using existing proven technology, so how does Sarkozy come to the conclusion that there is no alternative but nuclear. You talk about China supporting N. Korea and speak of their HR atrocities, questioning how they can be in the WTO, but I don't see them bombing Libya!, nor Iraq, Don't even get me started on the fact that the US is in effect BUST, the Euro zone is a slow motion train wreck with the Greek bailout nothing but a delaying tactic so the EU politicians can milk the sacred EU cow for another year or two before the music stops and the banks can milk the likes of us.

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