Depending on how you look at it -- which probably depends on whether you're a long, a short, or a sideline observer -- the wackiness that's gone on among Chinese stocks of late may be hilarious or downright scary.
At first, it seemed like the problems were confined to smaller companies, like A-Power Energy
The U.S. Public Company Accounting Oversight Board and the SEC are set to send a delegation to China to hopefully figure some way to improve the oversight of China-based auditors. This could be good news both for investors who want to invest in China and for Chinese companies, like Baidu
But nobody knows how long it will really take to clean up the situation and, in the meantime, we seem to be heading further down the rabbit hole every day. With that in mind, here are some (tongue-in-cheek) red flags for investors to look out for when considering Chinese companies.
10. No auditor. In the wake of accounting irregularities, the auditors of many Chinese companies have cut ties. I have to imagine it's pretty self-evident why you wouldn't want to invest in such a company.
9. Little-known auditor. If you're having trouble trusting the numbers at a Chinese company, perhaps it's exacerbated by the fact that you've never heard of the company's auditor. Second-tier audit firms like BDO, RSM, Crowe Howarth, and Grant Thornton may not inspire the same confidence as the better-known "Big Four" auditors.
8. Well-known auditor. Think you're safe if it's a well-known name auditing the company? Think again. Deloitte Touche Tohmatsu was the auditor of China MediaExpress (OTC: CCME) and Longtop, Ernst & Young Hua Ming was the auditor at China Agritech, and KPMG was at China Integrated Energy (OTC: CBEH). Although a well-known auditor is the most you can hope for, it's still not a guarantee that all is well.
7. "China" is in the company's name. A preponderance of companies that have gone under have been named "China Something-or-Other." Has that been a scammer marketing tactic to attract China-obsessed investors? You tell me -- the dishonor roll includes China MediaExpress, China-Biotics, China Agritech, China Integrated Energy, and China Sky One Medical
6. CFO turnover. Many of the most questionable companies have had rapid turnover in their chief financial officer position. This could play right into the hands of fraudsters, since a CFO who's been at the company for less than a year may not have had the time to dig in and find irregularities.
5. A long-serving CFO. Longtop's CFO has been in place since 2006, while Sino-Forest's has been in that position since 2005. A seasoned CFO could be a great asset for a scammer, since he could help tweak the financials so that detection of the shenanigans is even more difficult.
4. The stock has major, well-known investors. Ready to follow your investing heroes into the China fracas? Not so fast. Billionaire hedge fund manager John Paulson made headlines by being knee-deep in Sino-Forest when Muddy Waters pulled the rug out, and one of my favorite value investors, Davis Selected, still owns a big chunk of that company. Meanwhile, Hank Greenberg's Starr International was a major investor in China MediaExpress. Individual investors should probably just assume that most investing pros know as much about Chinese companies as they do about executing a perfect quadruple salchow.
3. The company keeps its money in a bank. Don't be silly and assume that cash in the bank actually exists. Longtop allegedly got its local bank branch to lie to its auditors about its cash balance. Meanwhile, China-Biotics was accused by its auditor of directing auditors to a fake bank website. I suggest looking for companies that keep their cash in a padlocked, Plexiglas box that can be monitored by investors via a live feed 24/7.
2. The company is profitable. The vast majority of the Chinese companies accused of fraud have been very profitable. Could there be scammers that are so bad at committing fraud that they can't manage to report fake profits? Sure, but most of the ne'er-do-wells have thus far been proficient at a basic enough level to realize that reporting profits will make the company a more successful scam. I would cautiously say it's probably safe to assume that a company reporting huge bottom-line losses may be OK to invest in. It may be a dreadful company, but at least it's less likely that it's lying to you.
1. Based in China. Across the board, every Chinese company that has come under fire for fraud has had its operations based in China. Of all of the possible red flags, keeping an eye out for this one is the only way you could have guaranteed you wouldn't end up invested in a Chinese stock scam. My recommendation would be that if you feel the need to invest in a Chinese company, try to find one that's based, and does most of its business, outside of China.
Obviously, I'm channeling The Motley Fool's jester here -- I don't mean for you to take this list seriously. However, there's truth to every joke, and while we can laugh at this ridiculous list, it also highlights the difficulty investors have had finding Chinese stocks that will let them sleep well.
The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of McDonald's, Baidu, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of McDonald's, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.