The Mystery of the China Discount


by: Ian Wyatt September 08, 2010    [tweetmeme]

There’s been a lot of muttering in 2010 regarding the under-performance of small cap China stocks. If you invest in this space, you know what I’m talking about. But hopefully you’ve made more than you’ve lost over time investing in China since, after all, the country has hosted some of the best performing small cap stocks ever to hit the exchanges.

So what’s all the fuss about?

As we know, once the froth starts to settle down in any market, the protagonists take to the streets with hatchet and pitchfork. Blood is on their mind – whether it be because their sitting on truckloads of useless tulip bulbs or single family homes worth less than the cost to build them. After the recent slide in shares of highly volatile China small caps it’s not hard to find support for the “Sell China!” rally cry.

But the big time investment banks have been saying China’s market correction is way overdone. At the end of July, Fidelity fund manager Anthony Bolton argued that the time was ripe to buy into the Chinese stock market. Morgan Stanley (MS) agreed, stating that China stocks represented a buying opportunity.

Yet the slide continued. Investors endured months of diluted offering after diluted offering. And despite robust revenue and earnings reports – China small caps couldn’t catch a bid. People started wondering; are these companies for real? How can a small cap company that’s growing earnings by 100 percent year-over-year trade with a current PE below 10?

I’m calling it the “China Discount,” and it’s not all good.

I’ve been a big proponent of investing in China stocks, so I’ve seen more than a few companies trade at a deep discount to companies in similar industries in the US. And while the temptation exists to value these foreign firms just as we would their US based competitors, doing so overlooks a critical element of investing in them.

What’s this critical element? It’s called risk.

It’s the risk that these companies actually aren’t as good as they appear (surprise!). Risk that management is cooking the books. Risk that production capacity and inventory levels are grossly misstated. It’s the risk that these companies actually are beyond the reach of US market regulators. Risk, risk, risk.

About a week and a half ago, many of these risks – that had been conveniently swept under the rug during the 2009 stock market rally – reared their ugly head and reminded investors that the China Discount should not be forgotten.

Barron’s magazine recently published a story, “Beware This Chinese Export,” that called into question the level of trust we should have for a certain segment of China-based small-cap stocks – more specifically, those that came to be through a reverse-merger.

In a nutshell, a reverse-merger occurs (in this case) when a China based company merges into a US listed shell company, thereby gaining access to the US capital markets. In short, the reverse-merger process is a short-cut for Chinese companies to get listed on American exchanges.

The Barron’s article summed up some of the risks investors face with the following excerpts:

Financial filings the companies make with the Securities and Exchange Commission often diverge from those filed with the Chinese government-by drastic amounts. Investor and analyst visits to corporate facilities in China reveal operations smaller and less impressive than shown in US presentations. The companies too often select auditors who have previously signed off on the financials of companies that turned out to be busts…

These companies fall between the cracks of market regulation. The SEC’s enforcement staff can’t subpoena evidence of any fraudulent activities in China, and Chinese regulators have little incentive to monitor shares sold only in the US.

The authors continued with a warning regarding auditing standards:

….The Public Company Accounting Oversight Board…recently warned against lax auditing of US-listed Chinese businesses. The PCAOB plans to ask Congress to lift restrictions on the disclosure of its disciplinary proceedings against accountants. China is one of several nations that won’t let the PCAOB inspect the local auditors used by US-listed companies.

In short, the above article outlines many of the vaguely recognized, but frequently overlooked risks inherent to investing in a communist-capitalist country such as China including, among others: questionable corporate governance, money hungry stock promoters and discrepancies between financials filed with the Securities and Exchange Commission (SEC) and those with the Chinese State Administration for Industry Commerce (SAIC).


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