At first glance, Chinese stocks that trade on U.S. exchanges are dirt cheap. But the truth is you need to take a long hard look before you leap.
Behind the curtain you could find that they've cooked the books.
In fact, last week, the U.S. Securities and Exchange Commission accused the Chinese affiliates of "the Big Four" auditing companies of breaking securities laws after they refused to produce the "work papers" related to accounting fraud investigations at nine Chinese companies.
Naturally, they all cried foul.
According to auditors from Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers producing this paperwork is illegal under Chinese law-hence the stalemate.
It's a dispute that highlights the cultural clash between the Chinese need for secrecy and U.S. anti-fraud efforts that demand more transparency.
The bottom line in this case, though, is quite a bit more simple: If there's no way to ensure the accounting practices at Chinese companies are candid, investors should completely avoid them.
Whether it's here or abroad, you should never invest in anything where you can't trust the numbers.
Chinese small caps are just the latest example now that this brewing accounting scandal seems to be coming to a head. The SEC has filed fraud allegations against 40 individuals or companies.
How the Tables Have Turned On Chinese Stocks
The boom in Chinese companies listing on the U.S. markets began in 2006, and at first appeared attractive to both sides.
China was the world's greatest growth economy. With lots of fast-growing small companies, U.S. investors saw Chinese companies as a way to tap into that growth. Valuations were attractive, and by 2010 over 600 Chinese companies had done a U.S. financing, either through an IPO or through a "reverse merger" into a U.S. shell company.
What's more, even with the accounting scandals, the total market capitalization of Chinese ADRs remains close to $1 trillion.
But once the first small-cap Chinese company, Sino Forest, was shown to have falsified its accounts, market doubt spread like wildfire and the share prices of many small Chinese companies collapsed.
Since then, 50 China-based companies have been delisted from U.S. exchanges, whereas others can be bought for a small fraction of net asset value and at a 1-2 times multiple of earnings — if the net asset values and earnings are correct.
When trouble first appeared, investors relied on the companies' auditors – after all if KPMG, Deloitte or one of the other "Big 4" accounting firms had audited the figures, they could be assumed to be correct, right?
That meant the doubts were concentrated on Chinese companies with second-tier auditors, and you had the amazing spectacle of Chinese companies chasing round after new auditors every year, with each auditor resigning as soon as he faced the daunting task of preparing accounts that would satisfy the SEC.
Who Can You Trust?
However, it has become increasingly clear that "Big 4" accountants are little protection to the Western investor.
While their Chinese affiliates are nominally in partnership with the rest of the global practice, in reality they are subject to political pressures in China that are impenetrable to outsiders.
As the recent hoo-hah has shown, when they are given the choice between offending some bigwig in China's Communist Party hierarchy and offending the SEC– which can do little to force compliance provided the auditors do not personally set foot in the United States– even the best Chinese auditor will always choose his local business.
The problem is that China itself remains a pretty corrupt society, ranked 80th of 176 countries on Transparency International's 2012 Corruption Perceptions Index.
While this still ranks it well ahead of India (94th) – let alone Russia (a startling 133rd) – it indicates the country is a difficult place to do business, and that distant U.S. investors may rank bottom on the list of forces which have to be placated.
China is not likely to allow the SEC proper access to the work of Chinese auditors – for one thing, a matter of sovereignty is involved.
Hence, in the long run we may well find Chinese companies de-listing from the U.S. or perhaps engaged in leveraged buyouts to eliminate the international investors. After all, if an honest and profitable company finds its shares consistently trade at half net asset value or less, there's not much to gain from a U.S. listing.
The Smart Way to Invest In China
For us as investors, that makes Chinese stocks too risky-particularly the small-caps.
Even deals sponsored by major houses, such as China New Boron Corporation (Nasdaq: BORN) introduced in 2010 by Goldman Sachs, can find themselves trading at a quarter of their issue price, even though based on the published figures the business has prospered mightily.
With the ubiquitous short-sellers active, even a completely honest Chinese company with good operations is unable to give its investors a solid holding.
The solution is to buy what my colleague Keith Fitz-Gerald calls "glocals" – global companies which have established themselves in China and built a business that offers exciting growth in the country's huge potential market.
Companies such as Yum! Brands (NYSE:YUM) give us a route to prosper from Chinese growth without worrying about Chinese accounting. You can be quite sure a company like Yum is on top of any problems in its Chinese business.
Globally, the Chinese accounting problem illustrates an important point.
Even when corrupt emerging markets appear to offer exciting opportunities, their corruption may prevent foreign individual investors from obtaining the returns they deserve.
Within the emerging market universe, you're best off concentrating on countries in the richer parts of East Asia, like Singapore, where growth is good and local standards of integrity are high.
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