"Intelligent people need a fool to lead them. When the team's all a bunch of scientists, it is best to have a peasant lead the way."
-- Alibaba founder Jack Ma

In September, Chinese e-commerce giant Alibaba (NYSE: BABA) came public on the New York Stock Exchange with an offering worth $22 billion, the largest in history.

This story was big. Really big. So big that it nearly (nearly!) drowned out the launch of the iPhone 6. Surely, it would have been tempting to swoop in and scalp some of those hot IPO shares? Money for the taking, bro!

But if you stayed on the sidelines, you might have made the right call for a few reasons. Let's review them.

Reason No. 1: It's easy to be skittish about China
Perhaps this headline from September helps explain our macro view of China:

"Wal-Mart Recalls Fox-Tainted Donkey Meat in China."

No, wait, that's not the one. Though while we're on the subject, I'm not so sure that the thought of non-fox-tainted donkey meat is any better.

Here's the headline:

"CEO and COO Disappeared, Most of the Company's Cash Missing."

This is from a German holding company called Ultrasonic, with all of its operations in China. On Sept. 12, a Friday, its COO, Wu Minhong, informed the board that he had to go to the hospital for medical treatment and was taking a six-month leave of absence. On the 16th the CFO of the company reported to the board that Wu Minhong and the CEO, Wu Qingyong, had disappeared, and that most of the company's cash was no longer in its "range of influence." The money had been transferred from company accounts in Hong Kong to unknown accounts in China. Which is, you know, bad.

I know this sounds kind of berserk (maybe not fox-meat berserk, but close). Believe it or not, the details make it sound even crazier. The company was listed in Germany on the Deutsche Borse, which had made the decision in 2013 to cease attempting to attract Chinese companies to list there because of difficulties verifying their accounting. The Germans decided that the potential reward of taking on Chinese company listings wasn't worth the risk to shareholders.

But this also isn't the story that best crystallizes the risks of investing in China. Oh, no. For that we have to go here:

"In China, Detecting Fraud Riskier Than Doing It"

The basics of this story: A Chinese-born Canadian, Kun Huang, languished in jail for more than two years for the crime of contributing information for a report that a short-seller issued on Silvercorp, a company based in Canada but with its mining operations in China.

Specifically, Huang's crime was "impairing business credibility and product reputation." Huang got his information in part by comparing reports Silvercorp gave to the Chinese government with ones it filed in Canada, and by counting trucks and taking samples from the site. You know, the kind of stuff that in the U.S. would be considered "hard-nosed primary research."

Put that all together, and the "trust, but verify" premise that underlies a lot of the research equity analysts do doesn't have a leg to stand on in China.

Reason No. 2: It's easy to be skittish about Alibaba
Of course, it would be unfair to both Alibaba and potential investors to simply write the company off because it's a Chinese company in China. Just like Sberbank in Russia, there are certainly companies in China that are well run and would make great potential investments at the right price. At its current price, however, Alibaba Group does not appear to be among those companies.

Foremost among the red flags is Alibaba's robust valuation relative to its apparent lack of regard for outside shareholders. You may know, for example, that Yahoo! continues to own a substantial stake in Alibaba and benefited financially from its IPO. What you may not know, however, is that Yahoo! also left a lot of money on the table. See, back in September 2012, Yahoo! sold back to Alibaba 523 million of its shares for $7.1 billion. That's a tidy sum, to be sure, but it valued the company at only $13.57 per share. Today Alibaba trades for more than $80, a price that would have made those shares worth more than $40 billion.


But perhaps Yahoo! could not have known that Alibaba would ever be so valuable. These were Alibaba's operating margins in the years leading up to the Yahoo! sale:

  • 2010: -1%
  • 2011: 14%
  • 2012: 17%

And here they are in the years after:

  • 2013: 42%
  • 2014: 50%

Yes, this is a business with operating leverage, but a cynic might suggest that Alibaba was holding back profitability and/or withholding information from a major shareholder to buy back shares from them at a deflated price.

You may also remember that Alibaba Group restructured and deconsolidated its Alipay subsidiary without telling its board or major shareholders.

And you may be aware that holders of Alibaba Group stock don't actually own a stake in anything in China. Instead, they hold shares of a Cayman Islands-based holding company that has some contractual agreements with companies in China -- a complicated corporate structure that's known as a variable interest entity. But it's not clear that such a structure is legal in China or that Chinese courts would enforce any of those contracts in the event the counterparty walks.

Given the eyebrow-raising nature of Alibaba's dealings with Yahoo!, that type of risk should concern any potential investors.

Reason No. 3: IPOs are inherently risky
Finally, investors are right to hold a healthy skepticism for newly public companies. That's because investors don't know how a company may react when subjected to a volatile stock price and the quarterly scrutiny of the public markets, investors don't know whether they dressed up their financials in advance of the IPO (as we at Motley Fool Funds opined that Arcos Dorados may have done), and investors don't know whether the management team underpromises and overdelivers. More succinctly, investors haven't had a chance to get to know them yet.

Combine the skittishness involved in investing in China with the skittishness involved in investing in Alibaba and IPOs in general, and despite the hype surrounding Alibaba, sitting out may just have been the right move...

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