Crucial sniff test for investors in Chinese companies
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.