What Is The China Discount?


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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 aren't as good as they appear (surprise!). Risk that management is 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, risk, 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. Barron's 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 busts...

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 standards:

....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 ( CGA ) and China Natural Gas (Nasdaq: CHNG) you've no doubt read the comments posted by Seeking Alpha contributors regarding the Barron's 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 th in the world in terms of economic freedom, with a total score of 51 out of 100. The following graphic, available at www.heritage.org , gives a little more color. Click here 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 years.

Notice how, even after a massive pullback, the performance of the Shanghai Index still trumps that of the S&P 500 and the Russell 2000.

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.

The recent Barron's 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 these stocks.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Stocks
More Headlines for: CGA , CHNG , LLEN

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