5 Steps to Avoid Certain Doom in Chinahttp://www.fool.com/investing/general/2012/03/30/5-steps-to-avoid-certain-doom-in-china.aspx Michael Lewis
March 30, 2012
Emerging markets are both exciting and terrifying. Who wouldn't want to cash in on the inevitable growth of industrializing nations? The truth is, investing in these uncharted waters is dangerous and riddled with fraud traps. To get through the storm, use this checklist to help determine which stocks are winners and which are portfolio torpedoes.
1. Corporate structure
Look out for variable interest entities. Basically, a VIE is an operating company whose profits flow out of the emerging market nation, through a series of intermediaries, and into a foreign holding company. In China, VIEs are not required to submit audited financials to the government.
Now-dormant China MediaExpress was a VIE before allegations of massive fraud surfaced (through private investor due diligence). The scandal cost investors millions.
While not all VIEs are bad, view this as a red flag and conduct thorough due diligence if you wish to pursue the investment.
What DO you want? Foreign invested enterprises are required to submit audited statements to China's business regulatory arm. It's not a guaranteed protection against fraud, but it helps. The graphics below should help clarify how both of these structures work.
2. Related party transactions
3. Key personnel coming in and out
If the executives are resigning, find out why. When a company changes auditors, make sure you look to see whether the auditor had any disagreements with the company's financials. These things may seem obvious, but no one was paying attention during the China small-cap boom of 2009.
Be a sleuth. Call the investor relations firm representing the company and ask questions.
If you get dodgy answers, you have yourself another red flag.
4. Equity offerings
A high-growth company typically requires large amounts of capital, but you need to follow the money. Make sure to read in the corporate filings whether the company has enough resources to continue operations. This often overlooked statement can be the herald of a future equity offering.
5. Method of market entry
In my opinion, if you see a reverse merger, move on. While there are plenty of examples of legitimate reverse mergers, I maintain that if a company wants to be taken seriously and open to public investment, it needs to go through the painful IPO process.
Do your homework, twice
Below, is a table with a few picks that meet most of my discussed criteria. You'll notice th