Starting To Have Serious Doubts About Investing In China (FXI)… Was Google (GOOG) Right?

By: ispeculatornew
Date posted: 06.13.2011 (5:00 am) | Write a Comment  (6 Comments)

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China is still considered an emerging market by most but it is quickly becoming a leader both in the world economy but also 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. This blog discusses technology stocks quite a bit and we’ve certainly had our share of writing on both Chinese broad names but also its internet companies.

Baidu (BIDU), China’s top internet brand was the name that helped us win the first annual stock picking competition 2 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 do 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 And Others Struggling In China

Google did a move that few other companies would even consider when it challenged the Chinese government, refusing to abide to 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 and while it is easier to combat these now that Google has pulled out. Its recent announcements and complaints towards 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 many 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

It’s no secret; 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 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. I say invited but you 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 and Alibaba could probably never happened in any Western country and 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 that 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 (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

Honestly, 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 (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 reports from business insider. Some issues have occurred because of the 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 makes it much easier to get listed than going through more complex IPO procedures. Earlier this month, Sino-Forest (TRE), a Canadian listed company which 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 TRE as a massive ponzi scheme, a multi-billion dollar fraud, etc. It is far from the first time that this has happened as you can see in these charts. These are certainly worrying trends and I have to wonder if these things are happening on 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).

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6 Comments

  1. Comment by No Debt MBA — June 13, 2011 @ 6:39 am

    I think these concerns are absolutely valid, but they are similar to the concerns investors have in any developing country. Although China is a burgeoning powerhouse, it still has many of the political and regulatory standards of a developing country and investors cannot assume that it has the same protections and grounding as the US.

    China may be slightly worse than other developing countries due to the international demand for investment products there. There is potentially a lot of money to be made off that demand and many Chinese businessmen are acting accordingly. However, Brazil was an investment hot spot recently but did not have the same degree of headlines around corruption that China did. Maybe China is worse or problems in Brazil do not receive the same coverage.

  2. Comment by IS — June 13, 2011 @ 6:09 pm

    @No Debt Mba – Glad to hear your thoughts on this. In your opinion, which would it be on Brazil? Just seems like there is so little focus on Brazil compared to China and I don’t see a reason for it.

  3. Comment by optionsdude — June 13, 2011 @ 7:56 pm

    As mentioned, all these concerns are valid and one has to wonder whether the growth numbers are accurate. What effect will the one child policy have on future potential and will the population of the country decline as it ages, like Japan? Just know that there is risk if investing in China.

  4. Comment by Nathan — June 13, 2011 @ 10:18 pm

    The Chinese, cooking the books? No really? Impossible…

    I’m not concerned, as long as you can pick out the terds from the stew, its a question are the numbers great or just good.

  5. Comment by IS — June 14, 2011 @ 4:21 am

    @optionsdude – Good point but I would think that is still decades away?

    @Nathan – how do you filter the good ones from the bad?

  6. Comment by Nathan — June 15, 2011 @ 3:27 pm

    @ IS

    I can tell you from living and doing in business in China for 3 years corruption and guanxi are a way of life. When the government owns the books it doesn’t matter if the numbers are right, as long as they have the power strictly regulate that information. The communist party isn’t going away anytime soon. Therefore look for companies HIGHLY connected to the party (Sinopec). The better their guanxi the longer and better they can cover up problems. Also, when a company is making REAL money in China it’s often because of beneficial relationships with the party, and the party will want their slice of the pie.

    Picking them can be difficult, look for anecodtal proof of what a company is telling you. Do regular people in China really use taobao (yes)

    http://www.economist.com/node/17460954

    Times are changing, but for the moment, this is China. There will be a day where the communist party will become a victim of it’s own success.

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