Investing in Chinese Stocks: How to Avoid Fraud and Dilution

| About: iShares China (FXI)

Chinese stocks (especially small-caps) have once again become taboo for individual investors' portfolios. However, almost everyone knows that there is value in that market. The problem is, how do you tell the real thing from the fraud? (Investors in UTA know what I'm talking about.)

The real answer: you can't. However, there are some great ways to mitigate your risks. Depending on your diligence, you can reduce the risk of Chinese stocks to a manageable load.

As I see it, there are two main risks associated with investing in the Chinese small cap market: fraud and/or dilution.

HOW TO DECREASE THE RISK OF INVESTING IN A FRAUD:

1) The Auditor:

Although it's not a sure bet, a reputable auditor is a great start. A Big 4 auditor is great, but it's unrealistic for many of these companies to have a Big 4 Auditor in the early stages. However, there should be an effort to engage a quality,well-respected middle-tier auditor.

2) Who Else Is Invested:

Is there institutional money involved? Although you shouldn't rely on this as your only criteria since they make mistakes too, it's important to realize that they have the staff and funds necessary to research frauds more intensely than most of us.

Also, is the company bringing well-known or well-respected individuals to their board of directors or to high-ranking positions in their organization (AKA people who would have a lot to lose by being involved with a fraudulent company)?

Has the company dealt with reputable US firms such as Google (NASDAQ:GOOG) or GE?

3) Does it Seem Too Good to Be True?

Actually read through the financial statements. Do the numbers make sense? If you are not comfortable or the numbers don't add up, don't invest.

HOW TO DECREASE THE RISK OF DILUTION:

1) Once a Diluter, Always a Diluter:

Avoid companies that have a history of using shares as a source of cash, without adding per-share value as a part of the transaction. Diluting to fund a major acquisition or expansion that increases shareholder value does not necessarily qualify, but it should be looked at. Companies that have seen price appreciation over time without dilution are likely to continue that trend.

2) Do the Cash Flows Support the Earnings:

Cash flow problems are another major cause of dilution. Great cash flow will make funding on-going operations and future expansions or acquisitions much easier. Without cash, massive growth without dilution is difficult.

3) Insider Ownership:

Companies with directors that own a large number of shares are unlikely to have dilution that is not accretive. Why would anyone want to hurt the value of their own stock? Make sure you look at where they received their shares however. Some directors have made small market purchases to appease investors. Those small market share purchases, however, are nothing compared to what investors would lose if the company was fraudulent. It's a cheap convincing way to lure investors.

4) Historical Growth:

Make sure the company has had consistent, historical growth. A huge one-time contract may prompt share dilution that isn't helpful for long-term investors.

If you apply these criteria, you have a good chance of finding some hidden gems. The most important rule however is: if you don't feel comfortable, simply don't invest.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.