This column originally appeared on CNBC
"As the Chinese get richer," the private equity investor glowed, "this company is going to be the next Google."
I was sitting in my office in Shanghai while the investor rattled off about why he loved the company. It had 50 retail outlets and planned to open another 100. Moreover, its website had 10 million monthly hits.
The executive was ready to invest $50 million but at the last minute one of his partners wanted some due diligence first. This was why he was Skyping me from the U.S.. He had only been to China once, when the CEO of the target firm had wined and dined him, introduced him to some supposedly high-ranking government officials, and showed him a packed outlet.
Four weeks later, after traveling around the country, my team had only found a grand total of two of the target firm's outlets. At one, there were a couple of security guards sleeping at the front desk and not much else. At the other, an elderly lady sat idly, drinking tea out of a jar. The other 48 outlets? We couldn't find them. Calls to phone numbers went unanswered.
And those web hits? Not a single consumer we surveyed had ever heard of the store. Not one. Most surprisingly, while we were in the process of due diligence, the site switched from a social media site to a dating site to a portal for soccer fans.
It was obvious that the CEO of the target company was trying to mislead the private equity firm. He had gamed the system to make it look to Amazon.com's (NASDAQ:AMZN) web traffic subsidiary, Alexa, that his portal got a lot of web traffic and spruced up an outlet to make it look packed.
Luckily for my client, he did his homework before committing the $50 million. But not everyone is this lucky. Despite the many horror stories investors run into in China, it still amazes me how little due diligence is actually done by people investing there.
If it can almost happen to professional private equity firms, it can happen to you. Even though I have been, and continue to be, one of the biggest China bulls for over a decade and a half, I recommend a healthy dose of caution for most everyday investors before buying Chinese stocks. In fact, they might be better off investing in companies like Apple (AAPl) or Yum! Brands (NYSE:YUM) that make money in China but whose numbers you can trust.
Unfortunately, fraud is commonplace there and the investment banks, law firms, and accounting firms that should be protecting you and doing due diligence aren't doing their jobs. Why not? Often they just want to get deals done to get their commissions and, frankly, often they are simply not up to the job. I've seen many non-Chinese speaking executives fly into China for for a few days to conduct due diligence and get hoodwinked.
What are some things to keep in mind before investing there?
First, be very careful of investing in any small-cap Chinese firms that go public in America by doing reverse mergers through which they buy shell companies in the U.S. and inject assets there. I would almost categorically stay away from those firms if you are an individual investor.
Why? Most good Chinese firms do not need to do reverse mergers to raise money. There is plenty of domestic and foreign private equity money in China. It is quite easy for well-run companies to raise money which begs the questions: why do these companies need to do a reverse merger to raise money? How good can a company be if no other Chinese or foreign investors want to put money in?
Second, many companies go public in the U.S. because they are not profitable and thus are not allowed to go public in China. Companies must be profitable for three full years there before they are allowed to go public on the Shanghai A-share market. Therefore, many Chinese firms going public in the U.S. are doing so simply because they aren't qualified to go public in China.
Think of recent companies like Youku (NYSE:YOKU), a Chinese Youtube-like site, and Dangdang (NYSE:DANG), an online retailer, that both have billion-dollar market caps. Youku lost about $30 million last year and is forecast to lose more in 2011. Dandang only eked out $2.4 million in profit after eleven years of operations. 80 percent of its revenue comes from selling books that cost less than $3.
Of course, not all reverse mergers or Chinese firms listed in America are bad. Many, like Baidu (NASDAQ:BIDU) or Ctrip (NASDAQ:CTRP), are very well-run but everyday investors should still be careful. Valuations and volatility are high because hedge funds control large portions of the companies.
Investing in Chinese firms often has even worse odds than gambling. At least in gambling you know the odds - with many Chinese investments you not only have to deal with business and regulatory risk, but outright fraud.
You'd be better off taking your money to Macau or Las Vegas for a weekend at the tables.
China is the greatest growth story of the next decade, and a lot of money will be made there. However, only the cautious investor who does proper due diligence will make fortunes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.