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Chinese stocks can be tempting. The world's largest nation is breathing new life into its lagging economy, and the middle class is exploding. Who wouldn't want a piece of that growth pie?
But picking stocks in the Middle Kingdom is a risky idea. The nation isn't exactly known for its tight leash on financial-reporting practices, and Chinese companies have come under a steady barrage of criticism from the SEC -- often prodded along by specialized research firms such as Citron Research and Muddy Waters.
Cast of characters
"Who will save us from Chinese fraud?" asked fellow Fool Dan Newman last December, with the tentative answer being Muddy Waters. Though Dan questioned the firm's ethics, he liked the accuracy of its fraud reports. The firm accused Orient Paper, Spreadtrum Communications (Nasdaq: SPRD ) , and Focus Media (Nasdaq: FMCN ) of committing 50 shades of fraud, and none of these stocks have recovered from the market damage Muddy Waters caused.
But when Foolish analyst Sean Williams looked into these research firms, he found that bad business ethics met questionable reporting. Citron and Muddy Waters weave a tangled web of self-serving conflicts of interest, and it's hard to say whether you should trust their reports or the management teams they're accusing of fraud.
This week, a consortium of China-based businessmen, investors, and analysts had enough of Citron and friends. The group started a website with the ominous title "Citron Fraud," where you'll find Citron founder Andrew Left accused of fraud himself. "China is not well understood by foreign investors, so we urge investors to seek trustworthy professionals for investment advice regarding Chinese companies, and not rely on institutions and individuals with fraudulent history, falsified expertise, and serious interest conflict," the group says. In particular, they point out that Citron got burned on engine manufacturer Harbin Electric, which was supposedly a shell game of bogus bank loans -- until Harbin's founders took the company private at a generous price premium and left short-sellers like Citron licking their financial wounds. That so-called "sham buyout offer" turned out to be very real.
Why should I care?
None of this would matter if we were talking about a bunch of no-name entrepreneurs or defensive short-seller targets. But this consortium comes with brand-name backing.
Among the people putting their John Hancock on this diatribe, you'll find representatives from well-known Western investment firms like Kleiner Perkins Caufield & Byers, Lightspeed Ventures, and Matrix Partners. Kai-Fu Lee, former president of Google China, adds his voice, as do Chinese executives from IBM (NYSE: IBM ) , Microsoft, and German software giant SAP.
Sure, these heavyweights also mingle with plenty of smaller fish in the global business pond, but their presence lends weight to the argument. And they all have a common axe to grind, even though the short-selling analysts haven't attacked everyone on the list. Right now, Citron's prime target is mobile-security software firm Qihoo 360 (Nasdaq: QIHU ) , which recently rose to challenge Chinese search giant Baidu (Nasdaq: BIDU ) with a search engine of its own -- and is winning serious market share. This looks like another busted fraud theory to me.
If nothing else, this public slapfest underscores the risks of investing in a market you don't understand. You might rather side with Citron and Muddy Waters, or perhaps you believe that the bad eggs must have been shaken out of the Chinese market by now, but either way, it's hard to build a long or short investment thesis around most firms in the area.
If you still insist on handpicking Chinese stocks for your portfolio, you might be better off sticking with the local mega-giants. Read up on Baidu in this premium report on China's largest search provider. We'll even help you stay connected to this tricky market, as the report comes with a full year of totally free research updates.