Geoff Gannon February 5, 2011

Why I Don’t Invest in Chinese Stocks

A reader sent me this email:

Hey Geoff,

Let me start this off by saying I am an almost brand new investor (rather than speculator), or at least I hope to become one. I read Warren Buffett’s biography the Snowball, which led me to the Intelligent Investor, and now I am trying to learn everything I can about value investing….I have only been in stocks for a few weeks.  I have bought some well known companies that looked cheap like MSFT, SKX, and RSH, but I am increasingly fascinated by the possibilities of small and micro caps. There are 2 Chinese companies that I have bought and I keep looking at the numbers and they almost seem too good to be true….They do not appear to be associated with the same fraud as a lot of the Chinese reverse mergers, and their P/E ratios and returns on equity look pretty awesome. Do you think I’m crazy to call these companies “investments”?

I don’t invest in Chinese stocks.

Since I look for net/nets, I often end up with a list of Chinese stocks. And my initial impression of Chinese net/nets has been extremely negative. I have seen things literally within seconds of opening their 20-F that turned me off. Things that made me feel there was a chance you could lose everything in the stock.

I could look at the specific stocks you mentioned if you really want. But, honestly, I work at this investing thing pretty hard. I spend a lot of time thinking about investments. I’ve read thousands and thousands of SEC reports. I started when I was 14. I’ve been writing about investments for the last 5 years. And I don’t trust myself to analyze Chinese stocks. I don’t trust my own judgment enough to let me go through the filings and try to separate the good ones from the bad ones. So I’m not sure why you should trust my judgment on any Chinese stocks.

I’m not just saying don’t consider Chinese stocks because you’re a new investor and I’m being overly protective and blah, blah, blah. I’m saying I personally have banned myself from ever considering Chinese stocks because I have seen things you wouldn’t believe in these filings. I don’t like to talk about it because I don’t short stocks. I don’t want to get into controversies over shorting stocks. And I don’t want to come off as racist or anti-China or something. But there are frauds in U.S. listed Chinese stocks. There are some very, very obvious frauds.

I have read press releases from Chinese net/nets where I honestly believe they are saying an event occurred that did not occur. I think they made the whole thing up. I don’t mean they shaded the truth one way or another. I mean they flat out lied about why their CFO left. I’ve seen this more than once.

I think there are Chinese companies out there that are consciously and actively lying to their investors day after day. I think that’s why they listed in the U.S. in the first place. I’m not talking about Enron or Worldcom or something. I’m saying I think the plan was always to lie. It wasn’t something they backed into because they had the tiger by the tail. They wanted to perpetrate a premeditated fraud and America was just the most convenient place to do it.

Again, I don’t want to name names. I don’t want to point to specific press releases. I don’t want to say I think this guy lied about why his CFO left.

I don’t want to get dragged into that kind of thing. I don’t think it’s my job to point out frauds. And I know it would upset a lot of people if I did. There are folks who own these stocks. And the way the human mind works – those folks aren’t going to believe me if I tell them, and they are going to hate me for telling them. So, I don’t see the point in talking about specific Chinese stocks that look like frauds.

But, no, I would never buy a Chinese stock.

This is not specifically an anti-China thing. Companies that do business in China but are listed elsewhere in Asia are different. Companies that are listed in China may be different. But Chinese companies that trade in the U.S. are something I will not touch.

I didn’t get a negative view on these companies from reading press reports, or other blogs, or from short-sellers. I got my negative views from cracking open an SEC report when I wanted to love the company and buy their stock and finding within seconds that I genuinely believed they were actively and intentionally misleading investors about the nature, prospects, and possibly even existence of their business.

So I have completely sworn off investing in Chinese stocks.

And like I said, I don’t normally talk about it because it’s ugly to eliminate an entire group of companies from consideration just because they share the same nationality as other companies that are frauds.

I want to make clear that I’m not avoiding these companies because they’re foreign. There are just some areas of the market you want to avoid because the risks are so high.

The example I’ll give is New Jersey. It’s my home state. I love it. I’ve lived here my whole life. I’ve invested in stocks from New Jersey. All my experiences have been wonderful – and profitable.

Now, you may have heard there’s organized crime in New Jersey. And a lot of public corruption that comes along with that organized crime.

New Jersey is my home state, but…

There are certain counties and certain cities in New Jersey where if you told me you were working on developing some property, I’d wish you luck but I would refuse to invest with you at any price. Because there’s a very real risk that you’re going to be put in a position where you either compromise the project or you compromise your ethics.

So the best answer is the simplest answer. Don’t get involved in an area of investing that has that kind of potential “game over” risk. I would just draw a red X on those places in New Jersey. And I’d draw a red X on China.

It’s not about China being foreign. I find Japan very strange and very foreign and yet not corrupt. There’s no place on Earth as familiar to me as New Jersey. It’s home. And yet I know parts of it are corrupt.

I don’t bet on situations where I can lose everything.

And even after doing a lot of analysis, I could lose everything on a Chinese stock.

Having said that, Warren Buffett owned PetroChina and still owns BYD.

My advice to you is the same advice I give myself about Chinese companies. I don’t need to own any Chinese stock to compound money at a crazy fast rate. I do need to avoid catastrophic losses to compound money at a crazy fast rate. So, I don’t even tempt myself by looking at Chinese companies anymore.

I want to stress that there’s no reason you have to own these companies. You can ignore entire corners of the globe and still do very well investing. Chinese stocks are definitely not in my circle of competence.

Speaking more generally about frauds, I don’t actively look to find them. It’s not like I start reading a company’s annual report wondering if it’s a fraud. But there are certain things I don’t like to see when I look at a stock. And this is very different from whether or not a company has “good corporate governance”. I don’t get worked up over whether a company splits its Chairman and CEO roles.

I do get worked up about these things:

1. Why is the company public?

There are 3 ways to go with this. Why is Microsoft (MSFT) public? To reward its employees. That kind of answer is normal for most public companies of all sizes. There was once a legitimate reason for going public. An investor wanted out, they needed to raise capital, they wanted to reward employees, they thought it would increase their public profile, etc. All fine reasons. The other 2 ways this can go is my favorite answer and my least favorite answer.

My favorite answer is that I have no clue why the company is public. It should be private. It’s a perfectly decent business, but it’s family controlled, it doesn’t need capital, and the market isn’t giving it any love. It went public a long time ago. That’s the good answer.

The bad answer is when I can see why the company’s public but I can’t figure out how it’s a business. If it started off in one industry then entered a new business two years later and then a third business the next year and I can’t see how it ever made an operating profit – that’s a bad answer. You shouldn’t be in mining then cell phones then medical research. How is this the same company? If you’re using cash from one venture to fund the next that’s one thing. But if you’re selling off business A to go into B to go into C.

Now, there are legitimate reasons for a business to do what I just described. For example, you had to exit business A because of permanently deteriorating economics or the passage of some law or something. If you ran pawn shops in a state and then that state outlawed interest charges above 33% a year – fine, that’s a totally legitimate reason to exit business A and enter business B.

Likewise, sometimes there’s a good legal reason. For instance, there may have been a permanent liability issue with business A that could never really be resolved. Also, if your original product becomes obsolete – whaling, telegraphs, trading stamps, dial-up internet, etc. – you get a free pass to pursue new ventures. Same thing if production needs to be offshored and you want to stay onshore. Or you manufactured something of your own but now just do contract manufacturing.  Also, changes made for tax reasons are fine. As are changes made because an operating business built up an investment portfolio or real estate assets over time.

All of those are totally legitimate reasons for switching businesses while staying public. If you trace the history of some public companies – going back decades – you’ll find they do switch into completely different industries sometimes. But it happens over time and usually as a result of some natural evolution. You’ll often find they used their existing assets, technology, facilities, or even customers to transition into something new. Or they became a conglomerate through happenstance and then shed their original business.

Anything like that is totally fine.

But switching to a new venture because it’s the hot thing to be in right now is not fine. Capital redeployment is fine. Switching businesses to spark investor interest is not fine.

2. How promotional is the company?

Is their website meant for investors or customers? The right answer is customers. Decentralized companies and brands are exempt from this requirement. Are press releases meant for investors or customers? I would rather see a press release about this year’s new product model than about how the company signed some big deal to explore some exotic sounding location for some possibly valuable shiny thing.

3. How old is the company?

The older the better.

4. How boring is the product?

If you nod off reading the business description, the company is probably legitimate.

5. Who is on the board?

Google them. If they’re business people from the local community, that’s perfectly fine. If they’re basically unpaid, I like that even better. What if they’re well paid and semi-famous? If you pay the president of some college $300,000 to serve on your board, I’m going to think less of both of you. Tons of very legitimate public companies do what I just described – they aren’t frauds but they are nauseating.

If I was made dictator for a day, I’d outlaw paying directors anything.

I obviously have a different view of what a good board is from most people. Badly paid business people with a reputation to uphold make the best directors. They have nothing financially to gain and everything reputationally to lose.

6. Does the company seem like a psychopath?

This sounds like a joke. But it’s not. Frauds, like psychopaths, exploit people’s tendency to let very superficial stuff influence them especially if it’s got some emotional color to it. Look at Robert Hare’s psychopathy checklist. You could basically go through that list with any suspected fraud:

  • Glibness/superficial charm
  • Pathological lying
  • Failure to accept responsibility for own actions
  • Need for stimulation/proneness to boredom
  • Lack of realistic long-term goals
  • Many short-term relationships

The most obvious sign of a fraud is that the person doing the talking seems to be saying the right things from your perspective, but not from theirs. Everything from their word choice to their presentation strikes the right note with you at first, but then you think: “That can’t be how they talk to themselves? Why are they talking to me that way?”

Because it’s a con. They’re just slapping on a different skin to be the person you want them to be. To be the company you want to invest in.

The kind of frauds you’re worried about are very superficial. Things make perfect sense when you read the press release today. But not when you think about the press release tomorrow.

Finally, you should separate your own feelings about whether what a company is doing is good or bad from your analysis of whether their activities are consistent with a fraud.

So, for instance, both political and charitable contributions are obviously consistent with a fraud. It may be wonderful that a business gives a lot to charity. I’m not saying it isn’t. I’m just saying that giving to charity is exactly what I would do if I was perpetrating a fraud.

Put art on the walls, throw parties, give to charity – that’s all Fraud 101.

Giving to charity isn’t itself a sign of a fraud. Legitimate companies do it too. But if you find yourself thinking a company is more legitimate because it gave to charity – yeah, that’s why they did it.

The bottom line is the ratio of sizzle to steak.

If a company is overly concerned with how it’s perceived – especially by investors – it’s more likely to be a fraud.

Talk to Geoff About Why He Doesn’t Invest in Chinese Stocks