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A cottage industry has developed for research firms that ferret out fraud in publicly traded Chinese companies, establish a short position, and then release reports detailing the reasons for the action. What these firms such as Glaucus Research and Muddy Waters do is legal, highly profitable in many cases, and provides an invaluable service to investors and the global financial community, as the less fraud in financial markets, the better.

When these reports are released or related events take place like the recent Securities and Exchange Commission accusations that the Chinese affiliates of the "Big Four" US accounting firms were breaking the law by not producing certain documents, the share prices for Chinese firms will fall as investors fear the stocks are overvalued. There is even concern now that all Chinese stocks will be delisted due to the concerns about the reporting requirements.

Too Much Value in Chinese Stocks to Overlook

That is obviously not going to happen. As a matter of fact, the share prices of publicly traded stocks such as China Mobile have increased since the SEC threat. In addition, Canada just approved the takeover of Nexen by CNOOC, the Chinese oil firm. There is no profit to be made in overreacting to fraud concerns in China. There is even less gain to be realized in ignoring the world's largest economy by purchasing power and the world's leading trade partner. But there is much to be gained from investing in Chinese income stocks at attractive prices, such as:

  • China Mobile (CHL), the world's biggest mobile phone company by subscribers;
  • Cnooc (CEO), termed "the most attractive of China's energy company for international investors" by the Financial Times;
  • Xinyuan Real Estate (XIN), a home builder that is up more than 80% for 2012;
  • Nam Tai Electronics (NTE), an electronics manufacturer that has almost doubled this year;
  • Spreadtrum Communications (SPRD), a semiconductor firm that was just upgraded to a buy; and
  • City Telecom (CTEL), a Hong-Kong based provider of telecommunications services to business and residential customers that is up more than 40% for the year.

Tough to Fake a Check in the Mail

There are reasons for the emphasis on the dividend-paying component other than just the income received by shareholders. Dividend paying also provides a form of due diligence. Jesper Madsen, manager of Asian income mutual funds for Matthews International Capital Management, stated in an interview that of the Chinese companies paying a dividend, none has been a fraud.

Low Debt with High Dividend is Bullish in Any Language

Along with the dividend component, low debt should also be appealing to investors. If a company has too much debt, earnings have to go to paying all creditors rather than financing opportunities for expansion and greater profits. A modest debt load allows for a strong cash flow, which should result in a solid dividend payment to all shareholders. As the table below reveals, this is happening for these Chinese stocks. Foolish investors should take note of how much better the dividend frameworks and debt-to-equity ratios are for the Chinese stocks than the industry average in how much higher the dividend is, how much lower the payout ratio, and how much smaller the debt-to-equity ratio. Combined, those indicators point to a dividend income stream that is higher, more sustainable, and much more likely to grow in the future as there is lesser need to service debt obligations.

MetricChina MobileCnoocXinyuan Real EstateNam TaiSpreadtrum CommunicationsCity Telecom
Dividend Yield*3.30% {3.00%}***1.60% {1.40%}4.70% {0.80%}4.00% {2.00%}2.20% {3.50%}14.90% {5.70%}
Dividend Payout Ratio*37.00% {51.00%}23.00% {26.00%}3.00% {n/a}52.00% {17.00%}9.00% {26.00%}60.00% {54.00%}
Debt-to-Equity Ratio0.04 {0.54}0.19 {0.51}0.34 {1.30}0.01 {0.23}0.24 {0.36}0.00 {1.00}

*Average dividend yield for a member of the Standard & Poor's 500 is around 2%; historic dividend payout ratio is around 50% for a member of the Standard & Poor's 500; ***industry average is in brackets.

When all Chinese stocks suffer due to fraud concerns, investors should buy shares of companies with big dividends and small debts. If the company is traded on the New York Stock Exchange that is another layer of comfort as the listing requirements are more demanding. The rational investor with long term investing goals should profit from the short-term overreactions of the market when solid corporate citizen Chinese firms fall in out of favor due to the actions of others.

Source: Is China One Big Value Trap?