The Next Act in the Chinese Stock Drama

When it comes to U.S.-listed Chinese companies, the shoes are dropping faster than at a barefoot marathon for octopuses. 

Last week, A-Power Energy (Nasdaq: APWR  ) became the latest Chinese small cap to be halted. That came after the company's auditor and two independent directors resigned. The auditor had flagged certain transactions at the company for further investigation and told A-Power to talk to the hand when it didn't take any steps to investigate those deals.

Meanwhile, AutoChina endured a beating Friday after the company revealed it will be restating past financial statements and is being investigated by the Securities and Exchange Commission. The former may not be much to freak out about -- it's the accounting for an earn-out agreement with management -- but it's hard not to be concerned about an SEC investigation.

Where we've been
Investors will have to wait to see what unfolds in the AutoChina situation, but A-Power joins an infamous group of companies including Wonder Auto Technology (Nasdaq: WATG  ) , Duoyuan Global Water (NYSE: DGW  ) , and Puda Coal (Nasdaq: PUDA  ) whose stocks have been halted for months. Many more, such as China-Biotics and China MediaExpress have already found their way to the ignominy of the pink sheets.

To date, the vast majority of companies that have left investors with a pit in their stomach and a hole in their portfolio have come to the U.S. markets through reverse merger transactions. In short, in this process a U.S. shell company acquires a Chinese company, allowing the Chinese company access to U.S. investment capital. Because there is generally less diligence and oversight than in the traditional IPO process, this is a great route for anyone with rotten intentions.

Up ahead?
At this point, though, the small-cap, reverse-merger companies may not be the biggest concern for investors that are sniffing around China. I still think there will be plenty more trouble to come out of that group, but there's no hiding out there -- the entire bloc has been firebombed by short-sellers and fleet-footed former longs.

Meanwhile, it's beginning to look like there may be reason to be concerned about a broader swath of Chinese companies, including larger companies and ones that have hit the markets through traditional IPO processes.

Sino-Forest has been listed for years and was a multibillion-dollar company prior to the Mac truck that short-seller Muddy Waters drove into the stock when it accused the company of overstating its timber holdings. Longtop Financial (NYSE: LFT  ) went through a full IPO process run by Goldman Sachs and Deutsche Bank and is technically still a billion-dollar company. However, Longtop's shares haven't traded since mid-May after its auditor figured out that some of the company's cash balances were about as real as Willy Wonka's Oompa-Loompas.

Really ready for the big leagues?
In the cases of Sino-Forest and Longtop, we're talking about the possibility of true-blue fraud. And there may be more of that to come out of larger, IPO'd Chinese companies.

But investors may not be able to rest easy even if the company they choose isn't involved in full-on fraud. There also seem to be quite a few Chinese companies with poor, or downright questionable, business practices that may not be fraudulent, but still may harm investors down the line.

VisionChina Media (Nasdaq: VISN  ) has plunged over the last couple of years as its supercharged growth strategy of making earn-out based acquisitions -- that is, get the acquisition now and pay later -- fell flat. Of course, one can't help but wonder how management really felt about this strategy since executives signed on to sell millions of their shares in a secondary offering in the midst of the earn-out-acquisition binge.

Renren (Nasdaq: RENN  ) , aka "China's Facebook," makes me shudder even more. Prior to its IPO, Renren got a black eye when it basically said, "Hey, remember we said our user base grew 29%? Well, really, it was more like 19%." The company's IPO filing is also very clear about the fact that its internal financial controls aren't up to snuff.

Perhaps my favorite bit of this indigestion-inducing story is the funny fact that when the company was started as Xiaonei, it so fully and blatantly copied Facebook that it even included "A Mark Zuckerberg Production" at the bottom of every page.

And while NetQin has been doing everything it can to polish the muck off its name, earlier this year, China's state-run Chinese Central Television aired a report accusing the mobile-phone antivirus company of bundling malware with its product to help increase sales.

Watch out!!
I can't blame investors one bit for avoiding individual Chinese companies altogether. But if you, like Austin Powers, like to live dangerously, here are a few basic things you can do to protect yourself.

  1. Watch the cash. Many of the questionable companies have presented killer profitability and bottom-line growth, but have shown a very different story on the cash flow statement. When a company's cash flow from operations consistently lags its net income or it is spending gobs of cash on acquisitions, incredulity may be warranted.
  2. Read the filings. In the examples of VisionChina, Renren, and NetQin above, the troublesome facts I noted are, for the most part, clearly noted in their SEC filings. But you won't find them if you're not doing your homework.
  3. Global diversity. So you think there's value in individual Chinese stocks. Fine. But China is still just a piece of the global economy and there are individual stock values all over the world. Perhaps my (and others') fears about China are overblown, but I'd still advise against betting the house on it.

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Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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