China is a murky mar­ket for U.S. in­vestors. What to know if you dive in.

The Washington Post Sunday - - BUSINESS - Matos is an as­so­ciate pro­fes­sor at the Univer­sity of Vir­ginia Darden School of Busi­ness. Emir Hrn­jic and Lianting Tu are with Na­tional Univer­sity of Sin­ga­pore. — Pe­dro Matos, Emir Hrn­jic and Lianting Tu

The big idea: The ex­treme volatil­ity in the Chi­nese stock mar­ket is chal­leng­ing for­eign in­vestors. China has emerged as the world’s sec­ond-largest econ­omy, but does this mo­men­tum trans­late into in­vest­ment op­por­tu­ni­ties?

The sce­nario: One such op­por­tu­nity might be the Chi­nese media mar­ket, which has a po­ten­tial au­di­ence of more than 1.3 bil­lion peo­ple. But gov­ern­ment re­stric­tions on di­rect for­eign own­er­ship and on con­tent mean that in­vestors must in­vest in Chi­nese-based com­pa­nies. In 2005, Fo­cusMe­dia Hold­ing was the lead­ing dig­i­tal media net­work in China. When it went public that year, it was the largest ini­tial public of­fer­ing of a Chi­nese com­pany on the Nas­daq com­pos­ite in­dex. The num­ber of China-based firms on U.S. stock ex­changes peaked in 2010; at that time, Chi­nese firms rep­re­sented more than 25 per­cent of all IPOs.

In 2011, Muddy Wa­ters, a U.S. short-seller fund and eq­uity re­search firm, ac­cused Fo­cusMe­dia of over­stat­ing the size of its busi­ness and de­lib­er­ately over­pay­ing for ac­qui­si­tions. Muddy Wa­ters had been in­volved in un­cov­er­ing some of the most high­pro­file cases of fraud al­le­ga­tions in China. Four of the first five firms it tar­geted had to delist. Muddy Wa­ters was named af­ter the Chi­nese proverb “muddy wa­ters make it easy to catch fish,” which sug­gests that non­trans­par­ent mar­kets al­low for op­por­tunis­tic be­hav­iors.

The res­o­lu­tion: Fo­cus Media’s stock price fell sharply at first but re­bounded as the com­pany coun­tered Muddy Wa­ter’s at­tacks. In 2012, the SEC launched an in­ves­ti­ga­tion and pres­sured Fo­cusMe­dia to amend some of its fil­ings. Fo­cusMe­dia was taken pri­vate in a deal val­ued at more than $3.7 bil­lion — China’s largest-ever buy­out. In the fol­low­ing months, sev­eral Chi­nese com­pa­nies fol­lowed suit and delisted from the Nas­daq.

As of 2015, pri­vate-eq­uity in­vestors in Fo­cus Media are look­ing to exit from the deal. Go­ing public in Hong Kong ap­pears to be the pre­ferred op­tion, but the sit­u­a­tion re­mains murky.

The les­son: Cases such as Fo­cus Media, and the chal­lenges and op­por­tu­ni­ties sur­round­ing Alibaba’s high-pro­file IPO in 2014, il­lus­trate how at­ten­tion to cor­po­rate gov­er­nance and an un­der­stand­ing of reg­u­la­tory dif­fer­ences will con­tinue to be a pri­or­ity for in­vestors in the Chi­nese mar­ket.

In­vestors should keep sev­eral ideas in mind:

Don’t make the as­sump­tion that fi­nan­cial state­ments and fil­ings can’t be changed; in some cases, fraud­u­lent prac­tices, in any coun­try, do not be­come ob­vi­ous for some time.

Be care­ful about bas­ing an in­vest­ment de­ci­sion purely on the fa­vor­able-look­ing eco­nomic or GDP-based growth char­ac­ter­is­tics of a coun­try or re­gion.

Un­der­stand gov­ern­men­tal and reg­u­la­tory re­stric­tions on own­er­ship as part of your re­search and be sure to un­der­stand ex­actly what you’re in­vest­ing in.

In other words, make sure the wa­ter is clear.

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