How To Avoid Becoming Victims Of Shenanigans In Chinese Stocks

| About: New Oriental (EDU)

Today, New Oriental Education & Technology Group (NYSE:EDU) revealed that the company is under SEC investigation for subsidiary ownership restructuring. The stock dropped 28% on heavy volume as of this writing. This is not the first time that foreign companies surprised investors with accounting or managerial irregularities. In 2011, Sino-Forest (listed at the Toronto Stock Exchange under the ticker TRE) was under investigation for accounting fraud. Among its high profile investors, billionaire hedge fund manager John Paulson sold his holdings at a $720 million loss.

How can investors avoid this kind of disaster? How to spot possible shenanigans in problematic companies? There are at least two things investors should pay attention to, especially for firms from emerging economies with loose regulations.

1. Insider ownership structure

This is the most important thing when deciding whether to invest in a Chinese company. It is very common for Chinese private enterprises to have an owner who controls a huge portion of the company's shares. For example, New Oriental's founder, Michael Yu, still owns more than 30% of the company's shares. Imagine the kind of power Mr. Yu has on the company. Joined with a few other key members of the company, they can do virtually anything with the company that they please. Plus, since it's a foreign company, the SEC is often one step behind in its investigations. When investors realize something fishy might be happening, it might be already too late.

With a heavy (and sometimes controlling) insider ownership structure, a common shenanigan is to move the company's assets out of the company and into the insider's sole custody. This is the reason New Oriental has been investigated by SEC. New Oriental is changing its Beijing subsidiary, perhaps the most valuable entity in the company, to be under the full control of Michael Yu (and perhaps another company he owns). Without more information, it is not entirely clear yet if the SEC investigation will yield convincing evidence any time soon.

How about ownership risk of some other notable Chinese companies listed in the United States?

Sohu's (NASDAQ:SOHU) founder and CEO Charles Zhang owns more than 20% of the company. In 2010, Sohu split off Sougou, its search engine business. The deal kept 68% ownership of Sougou to Sohu, while Charles Zhang and an outside investor own 16% each. With that deal, Sohu's share price dropped from above $71 to approximately $55 within a matter of days.

Baidu's (NASDAQ:BIDU) CEO Robin Li and his wife together own about 20% of the company. The founder of Renren (NYSE:RENN), Yizhou Chen, owns more than 20% of the shares and more than 50% of the voting rights. While we have not seen assets-transition style events with these companies, their insider ownership structure is certainly something investors should be very careful about -- there is no mechanism to prevent asset transitions from happening. To be extra cautious, investors of these companies should pay close attention to their up-to-date SEC filings and related news. In order to follow the news closely, understanding Chinese wouldn't hurt either.

Are there Chinese companies with safer ownership structures? Examples include PetroChina (NYSE:PTR), the company Warren Buffett was formerly invested in, Sinopec (NYSE:SNP), China Mobile (NYSE:CHL), China Unicom (NYSE:CHU), and China Life Insurance (NYSE:LFC). Sina's (NASDAQ:SINA) shares are relatively non-concentrated. It is noteworthy that the safe bets are more often big state-owned enterprises, where the biggest owner is the Chinese government.

Some American companies have heavy insider ownership/voting rights as well. For example, Google (NASDAQ:GOOG) and Under Armour (US) both have a small number of people controlling more than 50% of the voting rights. But regulations tend to be much stricter and more mature in the U.S.. Such ownership structure, albeit an imperfect situation for investors, is usually not a big problem.

2. Account receivable

Actually, American companies use this to hide short-term business downturns as well. By adding inventory and account receivables on the balance sheet, companies can legally 'iron out' their current revenue, at least for a few quarters. This trick is especially common for companies selling products, but not so much for companies providing services (such as New Oriental).

But building up inventory or account receivables cannot last forever. If businesses don't improve, eventually bad revenue will show up. An example is to check out how fast Research In Motion's (RIMM) account receivables and inventory built up between 2010 and 2012 while its revenue shrank. Its actual operating performance over the past year or two was in fact much worse than its earnings reports.

When it comes to foreign firms not well regulated, this kind of aggressive accounting can happen on a much larger scale, last much longer, and the fallout can be much worse for investors. The aforementioned Sino-Forest is such an example.

Finally, there is always risk when investing. Sometimes the risks are very high but known, such as the case with Arena's (NASDAQ:ARNA) FDA approval. Sometimes, they are unknown. That is the worst kind of risk. The ultimate risk an investor can take is to buy into companies that s/he does not trust at all. If someone tells you your local grocery store often sells poisonous milk, would you still buy milk from there? Well, if not, why should you invest in a company that may very likely be lying to you?

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

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