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Some investors are shying away from Chinese stocks based on a belief that businesses located there have a greater likelihood to be involved in fraudulent activity. Their fears have a basis in history as in 2011 many Chinese companies were accused of being frauds or involved in some kind of scandal. But continuing to avoid investing in the country out of fear of fraud is a mistake as those people are missing out on a huge economic opportunity, particularly on eCommerce companies. After the exposure of many frauds in 2011 and the resulting SEC crackdown, it has become increasingly difficult to find bad apples in China.

Muddy Waters Research is a firm which claims its expertise in being able to uncover Chinese scams. When it developed a report on NQ Mobile (NQ), Toro Investment Partners provided a summary of Muddy Waters' target Chinese companies in this article which shows that Muddy Waters has been unable to prove fraud or the company was bought out at a substantial price premium in its last eight calls including NQ dating back to mid-2011.

Assuming that Muddy Waters employs competent analysts who are experts at finding the red flags for fraud, we can conclude that it is much harder to find Chinese frauds trading in the US today simply because they are almost non-existent in this post-2011 world. It makes much less sense to be fearful of Chinese companies now than in 2011.

Investors seem to hold companies like NQ to a much higher standard than ones that operate in North America. When myself and others called out Fairfax's dubious bid on BlackBerry (BBRY) as a sham to try to stop the bleeding on the stock price and stimulate bids which otherwise would not take place, nobody claimed fraud when the deal was pulled. There would be greater outcry if NQ insiders pulled a similar ploy. Even management's stock buyback plans have been met with criticism of trying to pump the stock price.

As accusations of fraud perpetuated by NQ have been shown extremely likely to be false, the focus has switched to the company being overvalued. According to Yahoo Finance, NQ has a trailing P/E ratio of nearly 100 and a forward P/E of over 9 when priced in the $13 range. In contrast, Symantec (SYMC) has a trailing P/E of under 20 and a forward P/E of under 12 with a stock price of around $22.50. The trailing P/E on NQ is so high partially thanks to stock compensation expenses due to the company's recent acquisitions negatively impacting its EPS. In theory these costs should not continue going forward and when adding in analyst expectations of continued strong growth we can understand why a 10x increase to the EPS is achievable next year, leading to a forward P/E that is superior to the much more mature company of SYMC, along with higher revenue growth.

I will shift the focus to the Chinese eCommerce industry as many investors are overlooking the current high growth and future potential that this industry brings. On November 11, Alibaba processed $5.75 billion worth of online sales, tripling the amount that Americans spent on Black Friday and Thanksgiving Day online at $1.9 billion. Since Alibaba's Tmall comprises about half of the online sales in China, total sales likely surpassed $10 billion on this one day. According to the article linked above there are 500 million people in China who use the web and many of them live in cities devoid of malls or large retail centers. Unlike their Western counterparts, shopping online in their only option when purchasing many desirable goods.

Until Alibaba does its IPO, the opportunities for investors to capitalize on Chinese eCommerce is limited to a few companies, and those companies will likely rise as Alibaba's IPO gains recognition for the entire industry.

Consider some of the tremendous growth in revenue seen by Chinese eCommerce companies so far for 2013. Vipshop Holdings Limited (VIPS) achieved 146% revenue growth for Q3 2013 over Q3 2012, E-Commerce China Dangdang (DANG) achieved 19% revenue growth for the quarter, and Fireswirl Technologies (OTC:FRWRF) achieved 128% revenue growth for Q3 and 115% year-to-date. If November 11th sales for Alibaba are any indication, Q4 will continue this great trend for these companies. LightInTheBox (LITB) also saw a revenue increase of 33% for the quarter, but the company mainly sells internationally so it's not going to benefit as much as the others which focus primarily on Chinese domestic eCommerce growth.

VIPS has had great success with its flash sales strategy, having become the number one source for limited time sales strategies as well as discount pricing for clearance of overstock items. Vipshop's dominance in its market niche has allowed them to take a 25% to 30% deduction fee from the companies selling on its site, enabling it to rise to profitability and improve its margins over the past few quarters.

While 19% revenue growth is still quite strong by most standards, DANG has lagged in growth relative to the other Chinese eCommerce companies as it follows an Amazon model of doing business that has stiff competition from 360Buy and Amazon.cn. DANG used its powerful brand recognition in China to launch its own flash sales channel as it tries to expand into an integrated online shopping mall. Out of all the companies, DANG is the furthest away from achieving a breakeven point in operations but is still within reach at around -7%.

Fireswirl is a company that is often overlooked as a Chinese eCommerce investment choice since it trades primarily in Canada and its microcap status of around $10-$15M in valuation. But it deals with many big companies as it has an agreement with eBay (EBAY) to expand their enterprise foothold in China through the GSI Commerce subsidiary. Fireswirl's website shows the online stores it runs for international brands in China, including Sony, Casio, Motorola and Toys 'R' Us, among others. This also shows its niche in Chinese eCommerce of facilitating the sales of foreign brands to local people. The strong growth in revenue for 2013 projects to be an annual figure that should be in the $45M to $50M range.

A criticism of VIPS, DANG and Fireswirl is that these companies have thin gross margins and don't make money (up until VIPS turned profitable late last year) and are therefore not undervalued companies. The Oxen Group produced an excellent article outlining the Chinese eCommerce growth potential and competitive landscape, but I disagree with their conclusion of DANG being merely fairly priced in today's market. Just like North American investors appear to hold Chinese companies to higher standards in terms of accusations of sketchy activity, we also hold these companies to higher valuation standards.

Consider Amazon (AMZN) when it was a start-up company years ago in 1994 and started trading on the NASDAQ in 1997. Referring to page 27 of the company's 2003 annual report, we see key financial data from 1999 to 2003. Amazon did not hit annual profitability until 2003 after six years of public trading and nine years of losses and thin margins.

Before the bubble burst in 2000, the stock traded mostly around the $60 range. After the bubble burst in 2001-02, the stock hovered around $10. With over 350M shares outstanding at the time, even at the low range of its valuation, AMZN still had a $3.5 billion market cap. Since the NASDAQ is in the 4,000 range right now, using AMZN's pre-burst market cap of around $20 billion as a comparison point seems more fair. In 2001 AMZN achieved $3,122M in sales with a gross profit of $799M or gross margin of 26% and an operating loss of $412M or operating margin of -13%.

Even at the low end of its valuation at the time, AMZN had a price to sales ratio of over 1 despite having an operating margin that is inferior to VIPS, DANG or Fireswirl today. At its top-end valuation, that ratio was over 6. By the time AMZN pulled an 8 cent EPS for 2003, the stock price was at least $40 for most of 2004 and with 420M fully diluted shares out on the company by then, it was back up to pre-bubble valuations of close to $20 billion in market cap. At a stock price of over $9, DANG's Price to Sales ratio is in the 0.7x range while at a price of $83, VIPS has a Price to Sales ratio of about 3.5x. Fireswirl's stats will produce a Price to Sales ratio lower than DANG, in the 0.3x to 0.5x range depending on how Q4 2013 turns out for it.

Perhaps the argument could be that Amazon had a "first entrant" type of valuation as it had the opportunity to grab significant worldwide eCommerce market share. But Amazon's revenue was $2,762M in 2000 and $3,933M in 2002 so its revenue growth was 13% in 2001 and 26% in 2002. Investors who are disappointed in DANG's revenue growth of "only" 19% when it is trading at a lower Price to Sales ratio than AMZN did in bust times in 2001 and while it has a superior operating margin shows they are holding DANG to a much higher standard than Amazon ever was while in its growth stage. VIPS, LITB and Fireswirl all have far greater revenue growth and superior operating margins to DANG so they should be valued more highly than DANG and much more highly than AMZN a decade ago.

One final thing we can learn from these eCommerce companies is that a little bit of profit goes a long way to improving the stock price. AMZN more than doubled in 2003 from about $20 to about $50 when it started turning profits. VIPS has been on an incredible run from $17 at the start of 2013 to over $83 now, fueled by its great revenue growth and positive net income. This is what the future holds for the other Chinese eCommerce stocks once they achieve profitability too.

Source: Investors Afraid To Buy Into Chinese Internet Stocks Missing Out On Great Future Gains

Additional disclosure: I am long NQ, DANG and FSW.V