Cru­cial sniff test for in­vestors in Chi­nese com­pa­nies

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

With as­set prices around the world con­tin­u­ing to rise, low­priced Chi­nese eq­ui­ties now look at­trac­tive to value in­vestors. But in­vestors should not check their skep­ti­cism at the bor­der. Many in­vestors in seem­ingly vi­brant Chi­nese pri­vate sec­tor firms have be­come vic­tims of fraud, of­ten later ex­posed by short sell­ers.

How­ever, the fear of fall­ing for such scams is no rea­son to avoid in­vest­ing in all Chi­nese firms. Straight­for­ward checks could have un­cov­ered many of the prob­lems ex­posed by short sell­ers. The good news is that in China es­sen­tial due dili­gence steps are easy, in­ex­pen­sive and le­gal.

The first and most im­por­tant step is to dou­ble-check all firms ma­te­rial to a com­pany’s suc­cess—sub­sidiaries, sup­pli­ers, clients, dis­trib­u­tors, pay­ment chan­nels. In early 2014, ba­sic in­for­ma­tion on all com­pa­nies in China be­came avail­able on the web­site of the Ad­min­is­tra­tion of In­dus­try and Com­merce (AIC). Any­body with a browser and the abil­ity to read Chi­nese can con­firm that a com­pany is reg­is­tered, where it is lo­cated, how much start-up cap­i­tal it has, what its li­censed busi­ness scope is, and other ba­sic facts. Pre­vi­ously, only lawyers could ac­cess that in­for­ma­tion by phys­i­cally vis­it­ing govern­ment of­fices.

This kind of ba­sic due dili­gence could have warned in­vestors in a trou­bled Chi­nese com­pany called NQ Mo­bile which claimed to de­rive 20% of its rev­enue from one ser­vice provider. In Oc­to­ber 2013, short-seller Muddy Wa­ters ac­cused that ser­vice provider of be­ing a nonex­is­tent “ghost com­pany.” A sim­ple check on the AIC web­site re­vealed where the com­pany was reg­is­tered, but a site visit showed it had no op­er­a­tions there, nor at an­other ad­dress pro­vided by NQ Mo­bile. Muddy Wa­ters ap­peared right. As of to­day, NQ Mo­bile has not yet filed its 2013 fig­ures to the SEC, the head of its au­dit com­mit­tee has quit, and its ac­count­ing firm has “ex­panded the scope of its 2013 au­dit work.”

Chi­nese in­ter­net and tech­nol­ogy com­pa­nies are of spe­cial in­ter­est to in­vestors, but also present spe­cial chal­lenges. Be­cause many of these com­pa­nies are tech­ni­cally barred from re­ceiv­ing for­eign in­vest­ment, pub­licly-traded firms of­ten use a work­around called a “vari­able in­ter­est en­tity,” or VIE, a do­mes­tic com­pany that op­er­ates in the reg­u­lated busi­ness, and has con­tracts re­quir­ing it to send its prof­its to the listed com­pany. There is po­ten­tial for con­flict be­cause the own­ers of the VIE and the pub­lic com­pany are of­ten not the same, and Chi­nese courts have shown that they will not up­hold VIE con­tracts.

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