Caution Needed When Investing in Chinese Firms

Even though I have been, and continue to be, a China bull now for over a decade and a half, investors should employ a healthy dose of caution before investing in Chinese companies. Why? Sample this: According to the May 5, 2011 issue of the Financial Times, 15 of the 19 NASDAQ stocks currently suspended are Chinese.

CHina Stocks
CHina Stocks

Unless you conduct serious due diligence, you should not be investing there. Even multi-billionaire dollar private equity firm Carlyle Group’s portfolio companies, China Forestry and China Agritech, had their shares suspended recently.

China Forestry had its shares suspended in Hong Kong after its CEO Li Han Chun was arrested for alleged embezzlement of $4.6 million and its auditor KPMG warned it could not vouch for the accuracy of financial results.

NASDAQ suspended Agritech’s stock after its auditor Ernst & Young threatened to resign and after it failed to report its accounts on time.

The first rule of investing there is never trust figures senior management report. In a market where it is common to keep three sets of books - one for the tax bureau, one for management and one for investors - executives can often change records to prop up stock prices. Too many analysts base their reports solely on interviews with management or conference calls. What kind of due diligence is that?

Even when chief financial officers are Westerners, be careful. Often the Westerner is a figurehead who does not have a true grasp on the situation. He meets investors, signs some documents and that is about it. One publicly traded company we analyzed had a CFO based in Texas who signed documents airmailed to him from Beijing.

Another rule to follow is to be wary of firms that list in the US first because they did not qualify to go public on the mainland. Internet and social media companies Ren Ren, Youku and Dang Dangrecently listed on the New York Stock Exchange, butwould not have been allowed to list on the mainland because they don’t have enough profits. Companies need three years of profits before they can go public on the mainland China exchanges. In the US, you do not need to show profits in order to go public. Most senior executives have told me they would rather list in China if they could because they expect the yuan to appreciate.

Also be careful of boutique banks, investor relation firms and accounting companies, called middlemen firms, which are responsible for taking companies public and for pumping up stock prices.

One safer way of taking part in the China growth story is by buying shares in Western companies that have a stake in China. For example, Apple or DuPont, which have huge operations in China and whose sales in that market are soaring. Apple is poised to sell $11 billion there this year, up from $3 billion in 2010.

With retail sales growing 16-18 percent a year, DuPont’s chemical ingredients are going into everything from coatings for autos to fibers for clothes Chinese consumers are buying.

Not all Chinese companies are bad. There are some with great potential that will get great returns. But unless you have the stomach to handle volatility and the time to conduct serious due diligence think twice before investing.

Shaun Rein is the founder and managing director of the China Market Research Group ( a strategic market intelligence firm, and is based in Shanghai. Follow him on Twitter at @shaunrein.