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 their 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 opportunity.
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 good.
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 U.S. And while the
temptation exists to value these foreign firms just as we would
their U.S. 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 U.S. 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.
***Here's the deal.
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 U.S. listed shell company,
thereby gaining access to the U.S. 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 U.S. 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 U.S.
The authors continued with a warning regarding auditing
....The Public Company Accounting Oversight Board...recently
warned against lax auditing of U.S.-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 U.S.-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 (Nasdaq: CHNG)
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.
***I've said before that investing in China today is like
investing in the U.S. in the early 1900s - it's the wild west (or
more appropriately, the wild east), and the rules are not well
defined. But the opportunities are still there, and many China
stocks offer huge gains for investors.
We've been aware of these risks, and accept them when pursuing
outsized gains in these types of volatile stocks. But that doesn't
mean that we should ALWAYS stay in them or keep buying shares for
our retirement portfolios - we're investing in these companies to
make money, not as activists.
So what, if anything, does it mean for investors in China and
for investors in small cap China stocks?
It means two simple things:
1) Don't invest in China unless you can handle the risk
2) Remember the China Discount
By now the above should be obvious - but what might not be so
obvious are the specific risks inherent to investing in these types
of companies. Outlining all of the risks would take a 1000 page
manual, so I'm not going to do it. But I'll outline the basics:
***First, China is a communist country. This means it is a totally
different investment climate than the U.S. The 2010 Index of
Economic Freedom ranks the country 140
in the world in terms of economic freedom, with a total score of 51
out of 100. The following graphic, available at
, gives a little more color. Click
to see a lot more of the details on China's Economic Freedom
rankings relative to other countries. Bottom line, expect that
public-private partnerships in China are the norm, but they are
vastly different than those found stateside.
Second, accounting rules and tax law in China is totally
different than here in the U.S. China has a value added tax (VAT)
that applies to certain types of businesses, as well as a business
tax that applies to others - most notably service industries.
Reports vary regarding the efficacy of China's oversight of tax
reporting and collection.
Despite best efforts to come to some agreement on International
GAAP (Generally Accepted Accounting Practices), investors in China
based companies do not get two versions of financials. Differences
exist between Securities and Exchange Commission (SEC) financials
and Chinese State Administration for Industry Commerce (SAIC)
financials - most likely because of different tax regulations but
also because it's almost certain that loopholes exist between the
different systems, governing bodies, regulating authorities, etc.
etc. Accounting is more art than science, and there are people -
not impassioned machines - doing these jobs.
In summary, the potential to avoid oversight and regulation,
engage in fraud, etc., etc., is greater in China than here in the
U.S. So risk is greater - but reward can be great too. The
following chart shows the relative performance of China's Shanghai
Index, the S&P 500,
L&L Energy (Nasdaq: LLEN),
a company I've been bullish on, and two companies discussed in the
Barron's article: , China Green Agriculture, and China Natural Gas
over the last 355 days.
Notice the vast outperformance of the individual stocks over
this period. And the following chart shows the Shanghai Index, the
S&P 500, and the Russell 2000 small cap index over the last ten
Notice how, even after a massive pullback, the performance of
the Shanghai Index still trumps that of the S&P 500 and the
The prior discussion and above charts bear out what should be
clear (even though my stock selection doesn't represent a
statistically significant sample): there is great risk and great
reward potential for investors in China.
I can't tell you exactly where the Shanghai Index will be one
year, or ten years from now. But I bet that it will be higher than
it is now. That doesn't mean that there's not still going to be
huge bumps along the road for investors and highly volatile China
small caps, but having some exposure to the Chinese market seems
well worth the risks to me.
Of course, it's important to choose the right companies. And as
a starting point I'd look for those trading at a deep discount and
those where management is transparent with shareholders.
article, the protagonists with pitchforks, and the plummeting share
prices of many China small caps, are all signals that investors
have had about enough of the opaque investing climate for now. Look
for the strongest companies to counter with shareholder
communication initiatives. Yesterday China Natural Gas announced
that it had retained big four accounting firm Ernst and Young to
help the company sort out its current mess.
I'll continue to look for great opportunities to invest in China
small cap stocks, and to try to limit the risks. Hopefully the
above helps you decide if these types of investments are right for
you, and to explain why there is so much interest at present on