3 Reasons I Don’t Trust Chinese Stocks

Recently, shoe company Ultrasonic (ETR:US5)(FRA:US5) made an astounding announcement. The CEO and the COO of the company had both vanished… along with most of the company’s cash! The CEO has since reappeared and denied wrongdoing, but still: how could such a thing happen to a German company?

Well, the answer is that the company isn’t really German. Even though it is traded on the Frankfurt stock exchange, the company itself is Chinese: “China’s Urban Footwear Company,” according to its website. And therein lies the problem: If you ask me, you just can’t trust Chinese stocks.

You can’t trust the executives

A vanishing pair of C-level executives is unheard of in Germany, but in China, such shenanigans are all too common. Earlier this year, in fact, another German-listed Chinese company, Youbisheng Green Paper (ETR:YB1)(FRA: YB1), started insolvency proceedings after its CEO vanished without explanation.

Of course, two incidents don’t make a trend, but in China, corruption — especially in the form of bribery — is also more common than it should be, especially in the government. And with more than 90%of Chinese companies receiving government subsidies, there’s a huge incentive to play along. While this doesn’t necessarily mean that every employee of the Chinese government or a Chinese company is corrupt, it does mean that the likelihood of a corrupt executive inflicting damage to his company is substantially larger there than here.

Take, for example, another Chinese outfitter listed in Germany, Kinghero (ETR: KH6)(FRA: KH6), which accused its former CEO of breach of trust back in January and tried to delist. Or Chinese gold miner Real Gold, whose founder, Wu Ruilin, pledged the company’s (and thus, the shareholders’) assets as security for loans to his other businesses. Ultrasonic’s CEO Qingyong Wu has denied the accusations, but it’s possible that he and COO Minghong Wu may have been part of this trend.

You can’t trust the numbers

Two years ago, a major accounting scandal erupted in China. It was discovered that many Chinese companies were keeping two sets of books: one to show their auditors and shareholders, and another revealing the actual numbers. Is it any surprise that the actual numbers were far less rosy than their public counterparts? Many Chinese companies – big ones like “the Twitter of China” Sina (NASDAQ: SINA)(FRA: YIN) — lost more than half their value as nervous investors realized their books couldn’t be trusted.

This followed many similar scandals, in which Chinese companies’ books were found to have a host of accounting irregularities, including contracts with nonexistent customers (China Public Procurement, 2010), false sales and nonexistent cash (Hontex International, 2009), and phony debtors (Moulin Global Eyecare, 2005).

Although reforms have been enacted since then, the scandals continue. Take company Siwei, acquired by American heavy equipment manufacturer Caterpillar in 2013. Caterpillar had to write down $580 million of the purchase because Siwei turned out not to have most of the equipment it listed on its books.

You can’t trust the system

The recent IPO of Alibaba (NYSE: BABA)(ETR: 4AL) — the largest IPO in history — highlights a third, and often overlooked, issue with investing in Chinese companies. Often, you can’t actually buy shares in the companies themselves. If you buy stock in Alibaba, for instance, you would not technically own part of Alibaba. Instead, you would get the rights to profits which are sent to a Cayman Islands holding company known as a Variable Interest Entity. Sound complicated? It is.

It’s a common arrangement with Chinese companies because of Chinese laws prohibiting foreigners from owning “sensitive assets,” which include technology, banking, energy, and food. But there are no real guarantees that this contract would be upheld if challenged. And if there were a breach of the agreement and Alibaba refused to pay, what then? Where would such a case even be litigated?

As Motley Fool analyst Tim Hanson said in an interview on The Motley Fool’s Market Foolery podcast, “At the end of the day, the key parts of this structure for foreign shareholders have never been declared actually legal in China, and they’ve never actually been tested. So you are putting a great deal of faith in the management team to do it the right way, and… the people running Alibaba have a very checkered history of honesty, so I wouldn’t necessarily give them the benefit of the doubt.”

So who can you trust?

China is an attractive investment, and even though its growth rate has declined in recent years, its economy still sports an annualized 7% growth rate, compared with Germany’s relatively anemic 2.7% or the overall EU’s 0.2% . But with an untrustworthy government, accounting system, and stock structure, how can one take advantage of this without getting burned?

The answer is to find and invest in German corporations that are active in China, like Volkswagen (ETR: VOW)(FRA: VOW), for example. Volkswagen recently announced has sold 2.72 million vehicles in China so far this year, up 15%, making China the company’s largest global market and making Volkswagen the best-selling foreign automaker in China. There are plenty of other companies in the same boat.

While I don’t think it makes sense to dismiss any investment out of hand just because it is based in a country with an — ahem — spotty record of forthrightness, I do think that it makes sense to go in with your eyes open so you’re fully aware of the risks. And, if you ask me, don’t invest in China with money you can’t afford to lose.