by Robert Hsu | December 22, 2010 9:20 am
As the number of Chinese companies listed on major U.S. stock exchanges grows, it is more important than ever to identify pitfalls associated with investing in China stocks.
Here are three potential risks that can hurt Chinese companies in 2011 and how to avoid them:
#1 Short-Seller Attacks: One of the most significant pitfalls in investing in China stocks today is attacks by short-sellers. Numerous successful short-seller attacks this year showed how easy it is for shorts to profit by making accusations — no matter whether true or not — against Chinese companies and drive share prices lower. And in 2011, I expect to see more short-seller attacks against Chinese companies.
Because most of the companies targeted by short-sellers are companies that were listed in the U.S. through reverse merger, we can sidestep most short attacks in the future by largely avoiding reverse merger companies next year. It is also increasingly important to invest in companies backed by top-tiered global investment banks that can fight off attacks from short-sellers.
I think reverse-merger stocks that improve their credibility by hiring top-notch auditors, taking corporate governance seriously and improving operational transparency will recover from the sell off. It would also help if senior management buys more stock in the company.
#2 Corporate Frauds: Although most Chinese companies listed in the U.S. capital markets are legitimate, like anywhere else China does have its share of fraudulent companies. One way to reduce the risk of investing in frauds is to invest in companies backed by well-regarded institutional investors that can lend support to the company. Goldman Sachs, Morgan Stanley and Sequoia Capital are some of the firms with substantial investment in Chinese companies.
Another strategy to reduce risk of fraud is to visit target companies in China and check out their operations — exactly what my associates and I do for our China Strategy[1] subscribers. Next year, we plan on visiting even more companies and bringing back updates.
#3 Monetary Tightening: Inflation is accelerating in China, with November CPI numbers coming in at 5.1% over the same period last year. As a result of the higher inflation numbers, Beijing has recently announced that it would be switching to a “prudent” monetary policy from the “moderately loose” policies we’ve seen over the past two years.
Not surprisingly, many China stocks have come under some slight pressure as a result of the news — and the uncertainty regarding speculation of more PBOC tightening and increased efforts by the government to make sure inflation doesn’t get out of hand has introduced extra volatility in the major Chinese market indices, as well as U.S.-listed Chinese companies.
Policies designed to combat inflation, such as monetary tightening, can hurt stock market valuation, which is a potential pitfall for 2011.
But with that said, monetary tightening is not necessarily bearish for China stocks, especially considering that tightening is often a sign of strong economic growth. For example, Beijing raised interest rate six times between 2006 and 2007, yet the Chinese stock market rose with every rate hike during the period. I will be watching the situation closely.
These are the three biggest pitfalls associated with investing in China stocks that I currently see for 2011. Although these problems may arise, I think that with a solid strategy in place investors can avoid most of the damage from these issues.
Start by closely examining your China stocks holdings to determine which stocks make sense to carry with you into the New Year.
Next: 2 China Stocks to Sell Now[2]…
With that in mind, here are two China stocks that offer limited upside potential going forward.
After the abrupt firing of its auditor, its CEO and its CFO on Sept. 13, the share price of Duoyuan Printing, Inc. (NYSE: DYP[3]) collapsed and has failed to recover. Although the company took steps to improve corporate governance by appointing a new and reputable independent director to its board, share prices have continued to languish.
The recent blow-up of another Chinese company, RINO International Corporation (NASDAQ: RINO[4]), which hurt the reputation of DYP’s replacement auditor Frazer Frost, has only made the situation worse. Although the company continues to deliver strong numbers, the numbers are useless when investors no longer believe in the numbers. At this point, it would be very difficult for DYP to regain its credibility, and although the whole situation is incredibly frustrating, it is advisable to put our money to work in more promising names.
To make matters worse, as collateral damage of the DYP fiasco, shares of Duoyuan Global Water Inc (NYSE: DGW[5]) — founded by the same founder of DYP — also sold off sharply.
Now, I want to emphasize that there is no evidence of wrong doing from DGW, but nonetheless the company has lost credibility as a result of guilt by association. While DGW has been run by a different management team since its initial public offering and has not had any disagreements with its auditor Grant Thornton, a well-respected international accounting firm, the shares have languished.
Although I think the company is a legitimate business, the lack of investor confidence continues to weigh on the share price. Again, considering what happened in the past three months, it will likely be difficult for DGW to regain investor confidence. We waited this long because I expected to see a broad market rally in the past three months and wanted to see if these stocks would participate. I was correct about the rally, but these stocks continued to lag despite strength in the overall market.
I recommend that you exit any positions in DYP and DGW.
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