As fraud allegations sweep Chinese stocks, many people who put their money into these once-thrilling companies with dreams of quick riches have plunged instead into a nightmare of devastated investments. Unless investors stay vigilant, the same problems now haunting China's companies could one day harm U.S. investments as well.
Made in China
The "Go-go China" investment thesis made logical sense at first. In this incredibly populous country, a rising middle class is better able to spend, spend, spend. Get in quick! However, serious problems have recently emerged at numerous Chinese companies, fueled by shoddy or nonexistent oversight and poor corporate governance policies. As a result, many investors who jumped into these companies without doing appropriate analysis have lived to regret it.
Remember how the Internet bubble infused bullishness into just about any company with a "dot.com" in its name, until the whole market went belly up? Similarly, stocks associated with the word "China" seemed like great ideas -- until they weren't.
In December, GovernanceMetrics International sounded a sobering alarm about investing in Chinese companies:
In truth, many U.S.-listed Chinese companies have little to no intrinsic value, regardless of investors time horizon. Many of these companies have relied on the China brand in order to go public. The vast majority of these companies are thinly capitalized and are in lines of business that are neither unique nor innovative. Their ability to find a public market was merely opportunistic.
As these companies are scrutinized, investors will uncover the facts behind the Chinese Curtain. Many of these stocks may prove to be valueless. Focusing solely on our Accounting & Governance Risk (AGR) score provides investors with some insight.
In May, GovernanceMetrics International's Jim Kaplan followed up on this warning, pointing out that in a six-month period, the Russell 2000 Index had returned just more than 4%. In the same timeframe, Chinese stocks in GovernanceMetrics' high-risk list had underperformed the index, losing an average of more than 31%.
A creeping calamity
Regular investors lose money all the time, but the situation now unfolding in China represents a much bigger problem. It's linked to what The New York Times dubbed "audacious" frauds by Chinese companies, many of which even had their banks as ready accomplices.
Companies like China Media Express and China Agritech came to the U.S. stock markets through reverse takeovers, allowing these companies to avoid U.S. Securities & Exchange Commission scrutiny. The Nasdaq recently delisted both of the companies named above, citing what it assumed was fraudulent activity.
Investors have also accused some bigger Chinese companies of potentially fraudulent practices. Short sellers have been digging into companies like Sky-mobi (Nasdaq: MOBI) and Longtop Financial (NYSE: LFT) in search of possibly shady activity. For example, these folks believe Longtop has been increasing margins by hiding its operating costs.
The risks aren't limited to individual investors, either. Yahoo! (Nasdaq: YHOO), which owns a stake in China's Alibaba, was notified after the fact that Alibaba had shifted its online payment service Alipay to its CEO Jack Ma's personal control because of Chinese regulatory demands. Worse yet, Yahoo! wasn't compensated for losing that extremely lucrative asset.
Whew. Investing in China no longer sounds like some get-rich scheme for healthy, exciting stock returns, does it?
Noticing red flags could have helped investors avoid some of these situations. In May, the Corporate Library's post Cooking the Books in China said the likelihood of fraud-related financial problems increased at Chinese companies with high debt levels or under central government control. The Corporate Library also flagged companies preparing for equity issues as another trouble spot.
A global issue
In response to this tumult, American investors might be tempted to simply avoid Chinese companies and leave it at that. However, this issue stretches beyond China, all the way to our own shores.
True, China's shifting economic landscape, government, and certain cultural elements probably contributed to these stocks' risks. But shoddy corporate governance guidelines create major risk for investors no matter where they're investing -- especially if those investors aren't doing much, or any, due diligence of their own.
Proponents of strong corporate governance rules recognize how important honesty and trust are in the marketplace. Our rules about accounting and disclosure may occasionally fall short, as the financial crisis revealed, but for the most part, these regulations protect investors. So do rules that allow shareholders to push back against management-centric corporate cultures willing to take everybody else down while lining their own bank accounts. Still, these protections alone just aren't strong enough.
Lessons in vigilance
We can't simply contain his new "China Syndrome" by avoiding Chinese stocks in favor of the "next hot thing" in investing. As GovernanceMetrics' Jim Kaplan noted, the Chinese companies that performed worst had "no intrinsic value," and business models that were "neither unique nor innovative." Their investors shouldn't have jumped into the supposed next big thing without first conducting proper research.
To cure ills like these, investments of every nationality need honesty, solid corporate governance policies, and managers and boards who answer to stakeholders. China's problems remind us all that we must remain vigilant about shareholder-rights issues right here at home.
Check back at Fool.com every Wednesday and Friday for Alyce Lomax's columns on environmental, social, and governance issues.
