There's been a lot of muttering in 2010 regarding the
under-performance of small cap China stocks. If you invest in
this space, you know what I'm talking about. But hopefully you've
made more than you've lost over time investing in China since,
after all, the country has hosted some of the best performing
small cap stocks ever to hit the exchanges.
So what's all the fuss about?
As we know, once the froth starts to settle down in any
market, the protagonists take to the streets with hatchet and
pitchfork. Blood is on their mind - whether it be because they're
sitting on truckloads of useless tulip bulbs or single family
homes worth less than the cost to build them. After the recent
slide in shares of highly volatile China small caps it's not hard
to find support for the "Sell China!" rally cry.
But the big time investment banks have been saying China's
market correction is way overdone. At the end of July, Fidelity
fund manager Anthony Bolton argued that the time was ripe to buy
into the Chinese stock market. Morgan Stanley (
) agreed, stating that China stocks represented a buying
Yet the slide continued. Investors endured months of diluted
offering after diluted offering. And despite robust revenue and
earnings reports - China small caps couldn't catch a bid. People
started wondering; are these companies for real? How can a small
cap company that's growing earnings by 100 percent year-over-year
trade with a current PE below 10?
I'm calling it the "China Discount," and it's not all
I've been a big proponent of investing in China stocks, so
I've seen more than a few companies trade at a deep discount to
companies in similar industries in the US. And while the
temptation exists to value these foreign firms just as we would
their US based competitors, doing so overlooks a critical element
of investing in them.
What's this critical element? It's called risk.
It's the risk that these companies actually
as good as they appear (surprise!). Risk that management
cooking the books. Risk that production capacity and inventory
levels are grossly misstated. It's the risk that these companies
actually are beyond the reach of US market regulators. Risk,
About a week and a half ago, many of these risks - that had
been conveniently swept under the rug during the 2009 stock
market rally - reared their ugly head and reminded investors that
the China Discount should not be forgotten.
magazine recently published a story, "
Beware This Chinese Export
," that called into question the level of trust we should have
for a certain segment of China-based small-cap stocks - more
specifically, those that came to be through a reverse-merger.
In a nutshell, a reverse-merger occurs (in this case) when a
China based company merges into a US listed shell company,
thereby gaining access to the US capital markets. In short, the
reverse-merger process is a short-cut for Chinese companies to
get listed on American exchanges.
The Barron's article summed up some of the risks investors
face with the following excerpts:
Financial filings the companies make with the Securities and
Exchange Commission often diverge from those filed with the
Chinese government-by drastic amounts. Investor and analyst
visits to corporate facilities in China reveal operations
smaller and less impressive than shown in US presentations. The
companies too often select auditors who have previously signed
off on the financials of companies that turned out to be
These companies fall between the cracks of market
regulation. The SEC's enforcement staff can't subpoena evidence
of any fraudulent activities in China, and Chinese regulators
have little incentive to monitor shares sold only in the
The authors continued with a warning regarding auditing
....The Public Company Accounting Oversight Board...recently
warned against lax auditing of US-listed Chinese businesses.
The PCAOB plans to ask Congress to lift restrictions on the
disclosure of its disciplinary proceedings against accountants.
China is one of several nations that won't let the PCAOB
inspect the local auditors used by US-listed companies.
In short, the above article outlines many of the vaguely
recognized, but frequently overlooked risks inherent to investing
in a communist-capitalist country such as China including, among
others: questionable corporate governance, money hungry stock
promoters and discrepancies between financials filed with the
Securities and Exchange Commission ((SEC)) and those with the
Chinese State Administration for Industry Commerce ((SAIC)).
If you follow certain companies like
China Green Agriculture (
China Natural Gas (
you've no doubt read the comments posted by Seeking Alpha
contributors regarding the
article. Both were highlighted in the article, although China
Green Agriculture was in the main line of fire.
>> Continue to Part 2
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