China: Why U.S. investors should steer clear

Joshua Brown, contributor June 16, 2011: 7:32 AM ET

Investors should be wary of U.S. traded Chinese stocks. Shares of Sino-Forest fell off a cliff when its business was called into question. Click chart for more.

CNNMoney (NEW YORK) -- Who's making money in China?
Kentucky Fried Chicken owner Yum Brands (YUM, Fortune 500) is, as the Colonel's 11 herbs and spices capture the taste buds of every province in the land. Nike's (NKE, Fortune 500) not doing badly there either and Apple (AAPL, Fortune 500) is quadrupling its sales to $5 billion this year in the Middle Kingdom.

Joshua Brown writes about the markets at his blog, The Reformed Broker. Click the photo to go to that site.

That's great for U.S. companies but it's a mighty different story when it comes to U.S. investors.
The U.S.-traded China stock landscape is a post-apocalyptic wasteland, littered with the charred remains of those who dared venture in with only half of the information they needed prior to hitting the "Buy" button.
You see, investors have found that no matter how much due diligence they've done using the corporate filings of China Inc., it hasn't mattered. Because when a company's filings contain make-believe or exaggerated data, your analytical prowess is for naught.
Our story so far... This past winter, two of the most widely-traded Chinese stocks, China MediaExpress (CCME) and Rino International (RINO) were revealed to be frauds when professional short-sellers did the homework that the auditors were supposed to be doing themselves.

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Nimble traders were able to get out quickly on the rumors. Most investors, however, were stuck in these stocks during a market halt. And when the stocks resumed trading, they became smoldering craters in the ground where once investment capital existed.
CCME had dropped from $24 to under 2 bucks a share and RINO sank from $19 to 50 cents.
A few months pass and all is once again sanguine, until smaller-profile Chinese blow-ups start piling up.
One after another, these stocks are taken down by short-seller research and the resignations of their auditors. By April, China stocks are popping like fireworks. Even the larger-cap issues like Longtop Financial (LFT) are being vaporized right before our eyes.
Most recently, shares of Sina Corp. (SINA), a multi-billion dollar Chinese Internet "blue chip," lost 40 points during a 5-day spate of investor doubt about whether it might be playing fast and loose with its financials.
This was followed by a massive raid on the shares of Sino-Forest (SNOFF), a timber company whose acreage of forest was being called into question.

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It should be noted that both Longtop and Sino-Forest were both very heavily owned by large hedge funds and institutional investors, meaning hundreds of millions in losses for the big boys.
The implication here being that if the most powerful and knowledgeable pros can't avoid being fooled, what chance does an individual investor stand?
Many of these fraudulent companies were originally reverse merger stocks, meaning they were penny stock shells that Chinese companies had folded themselves into, kind of like a backdoor IPO.
There is a whole cottage industry of lawyers, accountants, bankers and stock promoters here in the U.S. that aids and abets this type of thing and there are now hundreds of public Chinese companies on legitimate exchanges like Nasdaq as a result of it.
The problem for investors is that the origin of these stocks is not always immediately apparent.
Bloomberg has a Chinese reverser merger stock index and the carnage across the entire group is unfathomable. The index is down 48% from January through early June and the pain shows no signs of abating as more and more villains are unmasked every week.
I've been calling this the Red Collar Crime Wave and have been counseling that investors find a better way to play China or to skip the theme entirely until we get a handle on just how poorly these companies are treating their investors.
The good news is that regulators are on the case. Last week, the Securities and Exchange Commission issued a bulletin to investors about the risks posed by these types of stocks and this week the agency began "stop order proceedings" against two of them, China Intelligent Lighting and Electronics Inc. (CIL) and China Century Dragon Media Inc (CDM).
I never give investment advice on the Internet to total strangers but in this case I think it would be irresponsible of me not to offer the following: Be very wary of these misfortune cookies and take all disclosures and claims these companies make with a teaspoon of soy sauce.
I say this as someone who is awed by the opportunity and potential of the Chinese growth story longer term. Right now, it's just too difficult to tell the good from the bad.
Joshua Brown is a New York City-based financial advisor at Fusion Analytics and the author of The Reformed Broker blog. The commentary above is for informational purposes only and does not in any way constitute a solicitation to buy or sell any securities.