CHINA STILL SAFE FOR AMERICAN INVESTORS?

David Griffith Note: Here’s one author’s perspective on the recent meltdown of a highly respected Chinese environmental stock, symbol, RINO that trades on the Nasdaq.

China Is Still Safe for Investors

By Andrew Bond

THE MOTLEY FOOL

November 15, 2010

Last week was tough for China bulls, as two longtime worries have many investors avoiding the country, at least for one day anyway. Investors became worried about inflation in China as the country’s consumer price index showed a 4.4% increase over the same period last year. An overheated economy could lead to slowing actions such as interest rate hikes by the People’s Bank of China. China’s Shanghai Index dropped more than 5% on Friday — the largest decline in more than a year — in anticipation of action by the PBOC.

However, I don’t recommend investors take their economic cues from the daily movements in China’s stock market, which is still more like a casino then a proper functioning capital market. Albert Keidel, former deputy director of the U.S. Treasury’s East Asia office, says, “Chinese stock market clients used the markets more as a gambling mechanism or get-rich-quick vehicle, since those with privileged access to underpriced initial offerings frequently saw the prices of their assets jump considerably on the first day of trading. China’s stock markets thus still cannot and are not taken seriously as well-functioning financial institutions.”

While investors need to beware of this get-rich-quick mentality, there are still some good investment opportunities in China.

Credibility Issues

On a more micro level, RINO International (Nasdaq: RINO), a Chinese maker of pollution-control gear, has seen its Nasdaq-listed share price fall more than 50% since a research report stated that the company severely overstated its earnings in Securities and Exchange Commission filings. The report was filed by Muddy Waters, a two-person research shop in China, and it found that the company declared revenue of $193 million in SEC filings, while its China filings showed revenue of only $11 million. The researchers also did channel checks with RINO-listed customers, many of which reported doing no business with RINO. Muddy Waters also recently released a report showing Orient Paper (NYSE: ONP) was overstating its revenue as well.

These issues highlight one reason that many are bearish on China, including famed short-seller Jim Chanos. The rapid increase in small Chinese companies listing shares in the U.S. through reverse mergers with shell companies is one thing. Chanos believes there is also a fair bit of “financial engineering” even among more established Chinese companies. He finds it interesting that the large profits Chinese companies are reporting almost never seem to show up in actual cash.

Where to invest in China

I don’t believe this means China should be off-limits for investors. There are many reputable China-based companies listed on America exchanges. It just means researching the business practices of these companies is even more important.

Many of the U.S.-listed companies that have come to market through reverse mergers have hired BDO Limited’s Hong Kong office to audit their books. However, investors need to go a step further when investigating Chinese companies. BDO audits the books of companies such as Gulf Resources (Nasdaq: GFRE), SkyPeople Fruit Juice (NYSE: SPU), China Marine Food (NYSE: CMFO), China-Biotics (Nasdaq: CHBT), and Orient Paper. The latter three have been attacked by noted investors for having “interesting” looking financial numbers. The same accounting firm also audited one of China’s largest fraud cases ever, China Expert Technology, which fell apart in 2007. I am apt to stick with companies that are audited independently by one of the Big Four auditors.

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