10 Hilarious Chinese-Stock Red Flags You Need to Know

Depending on how you look at it -- which probably depends on whether you're a long, a short, or a sideline observer -- the wackiness that's gone on among Chinese stocks of late may be hilarious or downright scary.

At first, it seemed like the problems were confined to smaller companies, like A-Power Energy (Nasdaq: APWR  ) and Puda Coal (Nasdaq: PUDA  ) , that had entered the U.S. market through reverse mergers or blank-check companies. But then Longtop Financial (NYSE: LFT  ) was caught up in serious fraud allegations and Sino-Forest wasn't far behind. Even companies like Renren (Nasdaq: RENN  ) , which hasn't been caught up in fraud drama, have given investors reason to think twice.

The U.S. Public Company Accounting Oversight Board and the SEC are set to send a delegation to China to hopefully figure some way to improve the oversight of China-based auditors. This could be good news both for investors who want to invest in China and for Chinese companies, like Baidu (Nasdaq: BIDU  ) , that appear to be fully on the up-and-up.

But nobody knows how long it will really take to clean up the situation and, in the meantime, we seem to be heading further down the rabbit hole every day. With that in mind, here are some (tongue-in-cheek) red flags for investors to look out for when considering Chinese companies.

10. No auditor. In the wake of accounting irregularities, the auditors of many Chinese companies have cut ties. I have to imagine it's pretty self-evident why you wouldn't want to invest in such a company.

9. Little-known auditor. If you're having trouble trusting the numbers at a Chinese company, perhaps it's exacerbated by the fact that you've never heard of the company's auditor. Second-tier audit firms like BDO, RSM, Crowe Howarth, and Grant Thornton may not inspire the same confidence as the better-known "Big Four" auditors.

8. Well-known auditor. Think you're safe if it's a well-known name auditing the company? Think again. Deloitte Touche Tohmatsu was the auditor of China MediaExpress (OTC: CCME) and Longtop, Ernst & Young Hua Ming was the auditor at China Agritech, and KPMG was at China Integrated Energy (OTC: CBEH). Although a well-known auditor is the most you can hope for, it's still not a guarantee that all is well.

7. "China" is in the company's name. A preponderance of companies that have gone under have been named "China Something-or-Other." Has that been a scammer marketing tactic to attract China-obsessed investors? You tell me -- the dishonor roll includes China MediaExpress, China-Biotics, China Agritech, China Integrated Energy, and China Sky One Medical (Nasdaq: CSKI  ) . Of course, perhaps "China" just rolls off the tongue better and that's why we don't have United States McDonald's or America Google.

6. CFO turnover. Many of the most questionable companies have had rapid turnover in their chief financial officer position. This could play right into the hands of fraudsters, since a CFO who's been at the company for less than a year may not have had the time to dig in and find irregularities.

5. A long-serving CFO. Longtop's CFO has been in place since 2006, while Sino-Forest's has been in that position since 2005. A seasoned CFO could be a great asset for a scammer, since he could help tweak the financials so that detection of the shenanigans is even more difficult.

4. The stock has major, well-known investors. Ready to follow your investing heroes into the China fracas? Not so fast. Billionaire hedge fund manager John Paulson made headlines by being knee-deep in Sino-Forest when Muddy Waters pulled the rug out, and one of my favorite value investors, Davis Selected, still owns a big chunk of that company. Meanwhile, Hank Greenberg's Starr International was a major investor in China MediaExpress. Individual investors should probably just assume that most investing pros know as much about Chinese companies as they do about executing a perfect quadruple salchow.

3. The company keeps its money in a bank. Don't be silly and assume that cash in the bank actually exists. Longtop allegedly got its local bank branch to lie to its auditors about its cash balance. Meanwhile, China-Biotics was accused by its auditor of directing auditors to a fake bank website. I suggest looking for companies that keep their cash in a padlocked, Plexiglas box that can be monitored by investors via a live feed 24/7.

2. The company is profitable. The vast majority of the Chinese companies accused of fraud have been very profitable. Could there be scammers that are so bad at committing fraud that they can't manage to report fake profits? Sure, but most of the ne'er-do-wells have thus far been proficient at a basic enough level to realize that reporting profits will make the company a more successful scam. I would cautiously say it's probably safe to assume that a company reporting huge bottom-line losses may be OK to invest in. It may be a dreadful company, but at least it's less likely that it's lying to you.

1. Based in China. Across the board, every Chinese company that has come under fire for fraud has had its operations based in China. Of all of the possible red flags, keeping an eye out for this one is the only way you could have guaranteed you wouldn't end up invested in a Chinese stock scam. My recommendation would be that if you feel the need to invest in a Chinese company, try to find one that's based, and does most of its business, outside of China.

Obviously, I'm channeling The Motley Fool's jester here -- I don't mean for you to take this list seriously. However, there's truth to every joke, and while we can laugh at this ridiculous list, it also highlights the difficulty investors have had finding Chinese stocks that will let them sleep well.

The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of McDonald's, Baidu, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of McDonald's, but does not have a financial interest in any of the other 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.


Read/Post Comments (21) | Recommend This Article (39)

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 11, 2011, at 3:05 PM, dabynelson wrote:

    Amazing hilarious trash talking!

  • Report this Comment On July 11, 2011, at 3:34 PM, 265exit wrote:

    I'm glad you think apwr's decline is hillarious after you've been pumping it for over a year. I used to think you were a respectable company

  • Report this Comment On July 11, 2011, at 3:51 PM, AaronRogers wrote:

    Your still not eluding or discussing ways for a great company to prove its validity. Here you basically, albeit correctly, show no matter what there is nothing any company can do from auditor to CFO tenure besides being a losing money company (which I am certain is not an investment to stamp).

    As you know I have often posted a comment when you discuss CSKI as I have always believed this one to be the diamond in the rough. I might rec that you read the latest Seeking Alpha article on this company. I would be amused to hear your thoughts after investigation.

    As always I apreciate your work and by the way this article was most amusing.

  • Report this Comment On July 11, 2011, at 4:38 PM, TMFKopp wrote:

    @265exit

    First, be careful about putting words in other peoples' mouths. I never said that the decline of APWR or any of these stocks is hilarious, and I certainly take no pleasure in other investors losing money. The overall situation (and some of the specific allegations) among Chinese small caps, however, is at least bordering on comedy because it's gotten so ludicrous.

    Also, by "you" I assume you mean "The Motley Fool." Note that we're a collection of writers and just because one writer feels one way doesn't mean that you should assume the entire organization feels the same way. Personally, I haven't been "pumping" APWR for the past year.

    Matt

  • Report this Comment On July 11, 2011, at 4:42 PM, TMFKopp wrote:

    @AaronRogers

    "this article was most amusing"

    Thanks, that was the goal...

    "Your still not eluding or discussing ways for a great company to prove its validity."

    As I say at the bottom, there's some truth to most jokes (except maybe knock-knock jokes?). While I was aiming to be funny here, the article was at least partially motivated by the frustration in trying to figure out how to separate the wheat from the chaff here. With each new revelation, it is becoming harder and harder to say that focusing on this or that is a good way to avoid shenanigans.

    Matt

  • Report this Comment On July 11, 2011, at 5:29 PM, acbinvestor wrote:

    Wow, this is the most stupid article I have ever read.

    This guy is saying, big four / unknown auditors, profitable / not profitable, seasoned CFO / bad CFO, whatever it is, as long as it's a Chinese company, it's bad.

    There are good companies and bad companies. As a responsible financial writer, you have to write with your brain, not with your rear end.

  • Report this Comment On July 11, 2011, at 7:19 PM, David369 wrote:

    Some people just don't get it...

  • Report this Comment On July 11, 2011, at 11:45 PM, Axbxcxdx wrote:

    What happen to Motley? Thought they had better writers. This worthless article goes to the trash bin.

  • Report this Comment On July 12, 2011, at 11:53 AM, dbackroyal wrote:

    This article was as useless as teats on a bore hog.

  • Report this Comment On July 12, 2011, at 12:27 PM, pbk100 wrote:

    I guess some people have trouble keeping their sense of humor when they've lost money. While it wasn't a particularly deep article, I thought it did a good job of presenting in an entertaining way the fact that there's really no way for any of us to assess whether a Chinese company is fraudulent or not. And that doesn't mean they all are, just that investing in one is a massive leap of faith.

  • Report this Comment On July 12, 2011, at 12:32 PM, MKArch wrote:

    Great article Matt. The end of #3 was my personal favorite, particularly after reading recent auditor resignation letters. I got a good laugh out of that one.

  • Report this Comment On July 12, 2011, at 12:41 PM, TMFKopp wrote:

    @pbk100 and MKArch

    Thanks!

    And to be sure, the situation is likely a lot less humorous if you've been significantly invested in companies caught in the downdraft.

    And for those that are upset, let me just be clear that I'm just as prone as anyone to mistakes and I'm A-OK admitting that:

    http://www.fool.com/investing/general/2011/01/12/how-could-i...

    http://www.fool.com/investing/general/2009/03/12/theres-no-w...

    Matt

  • Report this Comment On July 12, 2011, at 1:56 PM, kaluk2011 wrote:

    Do you guys still have the list of 50% off Chinese stocks that you used to put out over the time? Probably you should check against your bash list.

  • Report this Comment On July 12, 2011, at 3:27 PM, TMFKopp wrote:

    @kaluk2011

    Not sure I completely follow, but I assume you're trying to say that if we've ever said anything good about a stock that we now should be unable to say anything bad about it.

    Unfortunately, this isn't the way it works. We (you, me, other Fools, Wall Street, Uncle Jim) work with the facts that are in front of us and sometimes have to change direction. And sometimes we just plain get it wrong -- as I noted in my comment above.

    Matt

  • Report this Comment On July 12, 2011, at 4:09 PM, TMFUltraLong wrote:

    I had a hard time not spilling coffee on myself while reading this. Well done Matt....

    TMFUltraLong

  • Report this Comment On July 12, 2011, at 4:32 PM, TMFKopp wrote:

    Ha! Thanks Sean!

    Matt

  • Report this Comment On July 12, 2011, at 4:43 PM, NEMnyWtch wrote:

    Wicked good article!!! (and fun too!) I was just talking about this subject with a friend of mine, when asked about my investment ideas. I threw some thoughts out there and ended with - whatever you do, stay out of China. If you want emerging markets, consider Brazil. I had a dance w/APWR myself once. Fool me once, shame on you, fool me twice...well, you know.

  • Report this Comment On July 12, 2011, at 4:43 PM, bigbigbarry wrote:

    A lot of you are obviously missing the author's point...

    which is that every US-listed China company has significant fraud risk. Despite the efforts of investors to come up with "safety rules" for the space (Big 4 auditor, high cash balance, strong balance sheet, famous hedge fund investor, high profit margins, buy IPOs and not RTOs, etc.), none have really worked.

    So be prepared and accept the fact that you "really don't know" if you decide to invest.

  • Report this Comment On July 16, 2011, at 2:39 PM, gmly wrote:

    What happened to your guys who went to China and were supposed to return with some Chinese stock recommendations. Did they get cold feet or did I miss something. gmly@yahoo.com

  • Report this Comment On September 26, 2011, at 2:38 PM, naughtyguy wrote:

    There are many, many companies in the US that start with "US" or "American"

  • Report this Comment On June 25, 2012, at 11:22 AM, tkell31 wrote:

    Amusing, but at least 8 months late. By the end of 2010 it was glaringly obvious that Chinese RTOs were an organized, systematic attempt to defraud investors. If anyone believes these companies all started around the same time in the same fashion and just happened to all be fraud I have some land in Cuba I would like to sell you. Still it is amazing how many investors think they found the real company in the bunch. Right now there are a bunch of surprised people on the CNEP board (formerly NEP) insisting the company is legit. Just like MF keeps pumping Yong like it is somehow legitimate. Oh well, there is a sucker born every minute.

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