How Chinese Investors Invest in China

It's well-known at this point that there have been Chinese public companies trading in Canada, the United States, and in Hong Kong that have either been alleged or proven to be misrepresenting themselves to investors in some capacity. Interestingly, little-to-no fraud has been exposed at Chinese public companies trading in China. This is one of those statistical anomalies that must have some Freakonomics-esque explanation.

Is it because China is only exporting its bad companies and keeping the good ones for itself? That seems unlikely when you remember that China very much wants to put on a good face for the world -- and that the business practices being called into question by foreign investors are widespread across China. Is it because Chinese investors aren't doing due diligence on Chinese companies? Probably not, as a variety of pensions and mutual funds, as well as 150 million individual investors, are all buying shares of Chinese companies. Is it because Chinese exchanges have higher listing standards? Although Chinese regulators require things like a track record of profitability before allowing a company to go public, something like that is easily forgeable given China's other structural problems. Further, with the launch of the Growth Enterprise Market for smaller companies, more small companies are being listed in China and with that, critics believe, more fraud.

It's bad everywhere
In fact, fraud is likely also a problem on Chinese exchanges. Chinese money managers we talked with during our recent research trip to the country estimated that somewhere between 20% to 40% of Chinese listed companies are misrepresenting themselves to investors in some fashion. To corroborate this point, a local audit professional revealed that it can take days for a bank in China to confirm corporate cash balances for Chinese companies, with the auditor suspicious that the bank is calling the company to ask what the balance should be.

So why isn't the domestic Chinese market collapsing?

The likely suspects
Since shorting individual stocks is not allowed in China, there is no monetary incentive for professional investors to expose fraud in China as they have done elsewhere. Put that lack of incentive together with the risk of retribution (there are reports that short sellers based in the U.S., Australia, and Hong Kong have received threats), and there's actually a powerful disincentive not to publicly expose securities fraud in China. Until regulators legalize shorting, many frauds in China will go unchallenged.

That said, Chinese regulators are also reportedly seeking to find out frauds, hoping that their markets will have earned a solid reputation by the time China opens up to international capital. Further, they're finding it, which one would expect given the magnitude of deficiencies described above.

Here's, however, where it gets a little weird. Rather than expose and delist the guilty companies, a former Chinese regulator and several Chinese money managers told us independently that Chinese regulators instead handle it quietly, generally giving the company in question time to gets its business to match its books or forcing management changes and/or mergers that manage to protect shareholders from ever knowing they once backed a fraudulent enterprise.

The reasons this could be so
That's admittedly strange behavior. Depending on how cynical you are, there are two reasons why it could be happening.

First, and more cynically, one investor alleged that getting rid of fraudulent companies would cut off a lucrative and important source of bribes for local government officials. Although the government wants reputable markets, individual government officials also like getting paid. By giving violators time to put things right, those officials ultimately serve both masters.

The second, more structural reason is that the Chinese government will do whatever it takes to maintain stability. China's investors would be very unhappy if they started losing money the way shareholders in Sino-Forest (Pink Sheets: SNOFF.PK) or China Media Express (Pink Sheets: CCME.PK) have: overnight and in a very embarrassing fashion. Since the last thing the government wants is an unhappy and potentially riotous middle class, they go out of their way to make sure the truth about fraud in the Chinese market never sees the light of day.

And yet investors are still investing
Despite these issues, the same Chinese investors, bankers, and accountants who are skeptical of Chinese listed companies are still actively investing and making money in China. How are they doing it and how do they weigh the risks of fraud and weak corporate governance against the rewards of China's long-term growth potential?

Some methods, frankly, are out of reach for Foolish individual investors. One portfolio manager we talked to employs some 40 analysts in China simply to cross-check company accounts. This involves reaching out to suppliers, customers, and creditors, making friends with local government officials to gain access to administrative records, and knocking on a lot of doors. Unless you have billions of dollars under management, that is not an economic undertaking.

Another local investor, however, has a simpler solution. He simply screens out any Chinese companies reporting above-average growth rates for their industry, believing it more likely that not that any above-average company is making up their numbers.

But perhaps it was a third fund manager who offered the most elegant and most actionable solution. He simply considers every Chinese company to be a normal, fraud-free enterprise and mechanically invests in 50 of them with the most fundamentally sound financials -- with a focus on qualitative metrics such as return on capital, core operating earnings (i.e., stripping out non-recurring items and acquisitions), and earnings quality relative to free cash flow. Then, and this is important, he hedges his approach by shorting the index, which is now legal in China. He believes that if widespread fraud is exposed in China, the index will drop, protecting his portfolio. Further, he believes that fraud is more likely to be discovered at companies that, for example, make frequent acquisitions or rarely turn earnings in to cash. In other words, rather than avoid China and avoid bad companies, he is hedged against it. The approach, he claimed, delivered 18% returns last year to his investors versus a Shanghai composite index that was down 13%.

The global view
If this sounds intriguing to you, first bet against the iShares China 25 Index (NYSE: FXI). This is relatively liquid and since that index is already dangerously overexposed to Chinese financial stocks, it's an idea that stands on its own merits.

Next go out hunting for Chinese stocks with strong fundamentals. Based on the simple criteria mentioned above, here are a handful that look interesting.

Source: Capital IQ, a division of Standard & Poor's.

This is not to say that none of these companies has any corporate governance or accounting issues, but rather that, within the context of a hedged, broadly diversified China portfolio, these are the types of companies worth considering. Personally, I'm willing to be slightly more aggressive in my approach to China, but if you're a more conservative type, this is a better approach than ignoring China -- the world's fastest-growing and second-largest economy -- entirely.