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In the midst of scandals involving North American-listed Chinese companies that came public via reverse takeovers (RTOs), Investor's Business Daily published an article titled The 6 Rules For Successful Investing In Chinese ADRs, which identified the risks involving in Chinese ADR investing and presented 6 key questions that investors should address for successfully investing in Chinese ADRs.

The questions are as follows:

  1. Are they industry leaders in China?
  2. Do the companies use any of the "Big Four" global accounting firms (KPMG, PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young)?
  3. Do they have the sponsorship of big investment funds?
  4. Is there serious backing from venture capital funds?
  5. Are sizable chunks of equity owned by management?
  6. Are Americans on the board?

The list seems reasonable, because it covers most of the issues involving Chinese RTOs, such as industry standing, poor auditing, low insider ownership, and lack of support from major investment firms and VC firms. But Chinese ADR investing, or investing in general, is not as easy as doing a checklist. Before I scrutinize each key point, I would like to present readers with a brief history of Chinese ADRs in North America.

Currently there are over 300 Chinese companies with a combined market cap of approximately $900 billion listed in the major North American stock exchanges. Almost all of them are listed in the US, with about 40 companies - with a combined market cap of $15 billion - listed in Canada’s TSX and TSX Venture Exchanges.

Over the past fifteen years there has been a dramatic shift of the type of Chinese companies filing for listings on the North American exchanges. The first wave came in the mid 90s, when major state-owned enterprises (SOEs), such as China Eastern Airline (NYSE:CEA), Huaneng Power (NYSE:HNP) and Guangshen Railroad (NYSE:GSH), filed for listing to not only raise capital but also promote brand awareness among foreign institutional investors.

Later, another wave of SOEs, such as China Life (NYSE:LFC), China Mobile (NYSE:CHL) and PetroChina (NYSE:PTR) became public in the US. The SOEs are all considered government-backed monopolies in their respective industries. For example, China Mobile is the largest mobile carrier in the country and has over 700 million mobile subscribers, which is more than twice the population of the US and Canada combined. PetroChina is China’s biggest oil producer and the third largest company in the world by market cap, behind Exxon Mobil (NYSE:XOM) and Apple Inc (NASDAQ:AAPL).

Back then, investing in Chinese ADR was easy in that these large SOEs are leaders within the so-called “strategic industries”, have transparent business operations, and are considered safer investments than non-SOEs in that they are unlikely to be bankrupt, since they are backed by the government. In addition, the SOEs have attractive dividend yields of 3% - 5%.

After China’s private sector started to gain traction, non-SOE companies that were leaders of the non-strategic industries, such as technology, consumer discretionary, consumer staples, and healthcare, began to be listed in North America. This list included companies with strong presence and brand awareness in China, such as Baidu (NASDAQ:BIDU), Ctrip (NASDAQ:CTRP), New Oriental Education (NYSE:EDU), Home Inn (NASDAQ:HMIN), NetEase (NASDAQ:NTES), and Focus Media (NASDAQ:FMCN).

The successful listings of the SOEs and non-SOEs generated a lot of interest among institutional investors and this new demand for gaining exposure to the fastest growing economy in the world spurred another wave of Chinese ADRs, which included companies that wanted to capitalize on both investor demand for exposure to China and the lack of knowledge regarding China to raise money overseas. Some of these companies had questionable accounting practices, obscure business operations, and fraudulent intentions. The managements of some of these companies hoped to use China’s economic growth as a façade to deceive investors located over 4,000 miles away.

Raising capital via IPO was difficult for these companies because considerable regulatory and company disclosure are required. In addition, the large number of Chinese professionals in the US financial service industry allowed investment banks to conduct extensive due diligence on the companies, making it easier for them to be exposed as frauds. The other option was to list via reverse takeover, or RTO, which allowed the companies to get listed without the complex and regulated process of an IPO. Some of the investment banks that specialize on RTO transactions are Rodman & Renshaw and Roth Capital.

These RTOs negatively impacted the US financial market and its investors after short-sellers, such as Citron Research and Muddy Water, exposed several high-profile frauds in both the US and Canada, which prompted the SEC put out an investor bulletin, warning the world of potential fraud involving RTOs. The SEC is now working with China Securities Commission to set up an agreement that gives US securities regulators the right to investigate companies within China. The increased regulatory oversight could decrease the number of accused fraudulent companies listed in the US but it is far from being a silver bullet. China’s financial market is still heavily regulated and more firms will seek to raise capital overseas to capitalize on the growing economy.

While IBD’s article raised several key questions, simply checking off the list of criteria will not guarantee successful ADR investing because a considerable amount of due diligence is still required.

For example:

1. Are they industry leaders in China?

Every Chinese company claims in some way that it is "a leading company" in its industry. Duoyuan Global Water (DGW) used to claim that they were the leading water treatment equipment maker. China MediaExpress (OTCPK:CCME) claimed that they were the leader of television advertising in China’s inter-city buses. And the most recent Longtop Financial (NYSE:LFT) claim to be the leader in providing software for financial services. Statements made by the companies in the prospectus are said to be verified by third party consulting firms, which are paid by the companies before the IPO. Therefore, it is important for investors to understand that there are conflicts of interest in the prospectus.

There is no way for individual investors to completely verify the company’s claim or third party research but one thing investors can do is conduct due diligence by researching the company within the Chinese media, such as China Daily, Sina.com, or China Finance Online. Usually, a leading Chinese company would have positive media exposure, whereas companies that are accused of frauds usually do not until they have been exposed. For example, Fuqi International (OTCPK:FUQI), Sino-Forest (OTC:SNOFF) and China MediaExpress (OTCPK:CCME) all had almost no media exposure within the Chinese media until they had been accused by the short-sellers.

For those investors who are not fluent in Chinese, my recommendation is to invest in companies that operate in China’s technology and consumer discretionary sectors, which have direct exposure to Chinese consumers (whose verification of the company’s existence is a good first sign). In my opinion, investing in what you know or what other Chinese people know could be the most critical criteria when investing in Chinese ADRs.

As I stated in my article on TAL Education Group, brand matters in China, and investing in Chinese brand name companies that are recognized by people who are familiar with China is often a better initial step than investing in companies that have just a good growth story.

For example, Focus Media (FMCN) has its LCD screens in numerous commercial and office buildings across major cities in China. Likewise, frequent air travelers can notice large advertising LCD screens from AirMedia (NASDAQ:AMCN) in major airports around the country. However, the advertising screens from China MediaExpress are not as prevalent as its peers’, as it stated on inter-city buses.

Investing in brand name Chinese companies might not be as exotic as investing in small-cap Chinese names that could double or triple in a matter of weeks. As matter of fact, it could even be boring because the return that a small-cap achieves in 4 weeks might take brand name company years to achieve. However, investing in large and well-known Chinese companies could give investors a peace of mind that the companies are real and are leaders in their respective industries in the world’s fastest growing market.

2. Do the companies use any of the "Big Four" global accounting firms (KPMG, PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young)?

While having a big four audit firm is a good sign, investors should still be aware that these firms also made mistakes when conducting audits on companies. For example Deloitte Touche Tohmatsu was the auditor for China MediaExpress, ChinaCast Education, and Longtop Financial, while Ernst & Young was the auditor for Sino-Forest.

3. Do they have the sponsorship of big investment funds?

Tiger Global Investment owned 4.75% of DGW as of the end of 2010. A vote of confidence is nice but not so much when the stock went from $20 to $4 in less than 6 month. LFT is 14.55% owned by Fidelity as of the end of 2010. Yet LFT still dived from $40 to $20 over the same time period.

Earlier this year, ChinaCast Education was attacked by OLP, an independent China research firm in New Jersey, claiming that the company has done several questionable transactions. The stock is down 35% so far this year, and its top holders are Fir Tree Partners (12.9%), Fidelity (5.7%), and ZS Fund (5.2%).

4. Is there serious backing from venture capital funds?

I personally cannot comment on venture capital backed companies, but I know that China Agritech (CAGC) was backed by Carlyle Group, which owned 22% of the company.

5. Are sizable chunks of equity owned by management?

Insider ownership shows that the interest of company management is aligned with that of investors’, but checking off the list that insider ownership is greater than 20% isn't enough to prove that the company is a suitable investment. DWG was 48% owned by the management, CCME (50%), CAGC (25%), and LFT (25%).

6. Are Americans on the board?

Having an American on the board of a Chinese company could provide the company with foreign expertise and insight, but it is also important that this American is qualified and has good knowledge of the business environment in China. The audit committee chairman of China Shen Zhou Mining (NYSEMKT:SHZ) is Gene Michael Bennett, who, according to the company filing, graduated from Michigan State University and had prior experience at Grant Thornton LLP. However there was no prior record of his employment with Grant Thorton.

Furthermore, Mr. Bennett served on the board of several RTO companies that are accused of frauds, such as Kunming Shenghuo Pharmaceutical (KUN), China Architectural Engineering (NASDAQ:CAEI), China Pharma Holding (NYSEMKT:CPHI), China Agritech (OTCPK:CAGC), China Fire & Security Group (NASDAQ:CFSG), and Duoyuan Printing (NYSE:DYP). So before feeling safe after confirming that an American is on the board, investors should also research the individual to see whether he is qualified. Often time, foreign companies hire an American on the board as a marketing tactic to gain investor recognition. Investors need to conduct additional due diligence on the individual American to confirm whether his experience qualifies him to be on the company board. Lack of experience in the home-country where the company is based and operates can be interpreted as a red flag.

Investing in Chinese companies requires that investors see beyond the financial statement numbers and ratios and pay close attention to the company’s brand. Brand equity is often overlooked due to the difficulty of quantifying its importance but, in my opinion, it is equally as important as the company’s industry position, management, or technology, and it is essential for investors to consider it as a factor when making informed investment decisions.

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

Source: Investing in Chinese ADRs Is Not as Simple as Following IBD's Checklist