Serious Doubts About Investing in China

|
 |  Includes: ALBCF, BIDU, GOOG, SNOFF, YHOO, YOKU
by: Intelligent Speculator

China is still considered an emerging market by most, but it is quickly becoming a leader both in the world economy and in the financial markets. There are so many different angles to look at it and most of them are fascinating: The population, size, economy, the yuan, etc. China’s influence is already up there with the US, and few doubt that it will soon be the one market that matters above all others.

Baidu (NASDAQ:BIDU), China’s top Internet brand, was the name that helped us win the first annual stock picking competition two years ago and we have traded the name along with others very often. In fact, I made a very broad claim recently that leading Chinese Internet stocks would greatly outperform US Internet stocks in the next few years. To this day, I stand by that claim. However, given some recent events, I’m having a lot more doubts about the idea of trading Chinese stocks, either long or short. Here are a few things that I currently have on my mind regarding Chinese stocks:

Google (NASDAQ:GOOG) and Others Struggling in China

Google made a move that few other companies would even consider when it challenged the Chinese government, refusing to abide by its censorship laws. We had found out that a big part of the problem was the fact that Google was constantly being attacked from inside China with little help from the government. Pulling out was certainly a risky alternative. However, Google recently confirmed that these attacks are still happening; it is easier to combat these now that Google has pulled out.

Its recent announcements and complaints about the Chinese government are something that very few companies would dare attempt. I’m not sure how involved the Chinese government is in these attacks, but it is certainly worrying to see what is happening. If Western companies are having so much issues (I’m sure that others are having as many complaints but they are staying quiet), can you imagine what kind of guidelines and restrictions are put on Chinese Internet firms?

Intellectual Property

China is a land where intellectual property laws have little influence, as copycats are openly sold. The situation has improved in recent years, but it is still the Wild West compared to any other “Western” country. That has some advantages for Chinese companies that compete with Western ones like Baidu against Google.

Why? Baidu can offer illegal music downloads to its users without much fear. However, this becomes a problem when Chinese companies start thinking about moving to foreign countries. Another problem is that given the “quasi-absence” of the rule of law in China, it becomes much more difficult for companies to protect their own turf at home.

Scams

If you have been to China, you know very well that scams are a dime a dozen in China. Go to the Imperial City in Beijing and you might be invited for some tea -- but you likely will be asked to pay a hefty price once it is over. These types of scams happen a lot, and it’s difficult to imagine that the same thing is not happening online. The recent issue between Yahoo (NASDAQ:YHOO) and Alibaba (OTC:ALBCF) could probably never happen in any Western country; while they might agree on a settlement, be sure that Yahoo has learned its lesson about doing business in China the hard way.

Accounting Standards

Can info be trusted? Given everything we know about the rule of law, do you really trust the balance sheets of companies that are solely listed in Hong Kong or as pink sheets in the US? A company like Tencent Holdings (OTCPK:TCEHY) is publishing its financial statements based off of Chinese laws. Should these be trusted?

I don’t pretend to know the answer, but it’s certainly very questionable. If companies like Enron were able to go through massive frauds with the much more strict US system, should we be worried?

Questionable Structures

This part is a bit complex, but I’ve been reading about the different structures used by many Chinese companies listed in the US, including many Internet ones. They have a very unconventional structure that makes it unclear what could happen and what control the shareholders actually do have over the critical company assets. You can see an interesting example about one stock that we discussed recently, Youku (NYSE:YOKU), on StoneStreetAdvisors. It’s quite complex and certainly a bit scary. I’m sure that there are fiscal reasons behind these structures as well, but could there be other motivations?

Fraud

There have been numerous reports of fraud in Chinese listed stocks; you can see some of these at Business Insider. Some issues have occurred because of lax Chinese regulations, trading issues in China, outright fraud, etc. These are clearly issues in some Chinese stocks but it’s very difficult to predict where the issues will come from.

Not Only Chinese Stocks

At the start of June, we got another reminder that these issues did not only impact Chinese-listed stocks. Many Chinese companies were able to get listed in the US or Canada using reverse takeovers, which make it much easier to get listed than going through more complex IPO procedures.

Earlier this month, Sino-Forest (OTC:SNOFF), a Canadian-listed company that was trading at $20, suffered major stock price declines following a research report that valued the stock at less than $1 as the research described SNOFF as a massive ponzi scheme, a multi-billion dollar fraud, etc.

It was far from the first time that this happened. These are certainly worrying trends and I have to wonder: If these things are happening with Chinese companies that ended up being listed on North American markets, how many of them are pulling off similar stunts while only being listed in China?

Government Official Figures

It’s well known that the public economic indicators reported by the Chinese government are often questionable. There are very few verifications being made by external parties and trading Chinese stocks based off of unreliable data is certainly a problem.

Is China Just Like Any Other Emerging Market?

I think one of the main questions I have is the following: Is China worse than any other emerging market? Is China simply being singled out because it is under the microscope, or are things significantly worse in China? I really am not sold either way at this point, but I would say that all of these aspects certainly make me think twice about making larger investments in China in any form (single stock or even index).