What About All the Fraud in China?

For a while, it seemed like the only thing investors would hear about China was the name of the most recent U.S.-listed Chinese stock to have been alleged (or proven) a fraud.

But the media tends to have a short attention span, and as the more pressing concerns of a faltering U.S. economy and the prospect of meltdown in Europe heated up, the focus turned away from the possibly scummy goings-on at some Chinese small caps.

Whew! Glad that's over
Eh, not so fast. I think investors need to take care to not misunderstand the quiet(er) radio waves with any sort of a green light on Chinese small caps.

Although Carson Block's Muddy Waters -- which has become one of the bigger names in identifying Chinese stock fraud -- hasn't published a new report since late June, its takedown of the former multi-billion-dollar Sino-Forest is still ringing in investors' ears. And while CNBC may not be quite as concerned with Chinese frauds right now, many of the other leaders of the charge -- including John Hempton at Bronte Capital, Andrew Left at Citron Research, and the crew at AlfredLittle.com -- have continued at it.

Lately, Harbin Electric (NAS: HRBN) has been a heavily shelled target at Citron, while Alfred Little has taken on Harbin along with SinoTech Energy, Zhongpin (NAS: HOGS) , and Deer Consumer Products. SinoTech's stock has been halted since mid-August, while late last month China Natural Gas also joined the ranks of halted Chinese stocks.

An interesting aspect of this debacle is that it hasn't been just Americans that have been swindled here. An August article from Bloomberg highlighted the billions that have been lost by investors in China that were sweet-talked into pouring huge amounts of money into questionable enterprises. The story is a sad one, but it also comes with some potential foreshadowing -- with few apparent consequences for the villains of this story, I can't see why fraudsters are going to rush to get out of the trade.

The U.S. Department of Justice is trying to rattle its sabre on the matter, but good luck to them in getting anything that requires cross-border cooperation.

What's your point, buddy?
Back in July, I wrote an article reviewing 10 red flags for investing in small China-based companies. The list was meant to be humorous -- it suggested "looking for companies that keep their cash in a padlocked, Plexiglas box that can be monitored by investors via a live feed 24/7" -- but there's truth behind many jokes. The number and diversity of the companies that have turned out to be problematic makes it really difficult to get any sort of comfort when investing in this segment of the market.

We've been spoiled by the way it's been in the U.S. stock market for decades. While there are certainly frauds -- particularly during frothy times -- you probably won't go too wrong starting with the assumption of legitimacy. For Chinese small caps, I think you may need to flip that on its head.

What's an investor to do?
The easiest answer is to skip the China small-cap sector all together. For exposure to China, stick with larger Chinese companies or non-Chinese multinationals that do significant business in China. Examples of the latter include Yum! Brands (NYS: YUM) which got 43% of its 2010 pre-tax profit in 2010 from China and Las Vegas Sands (NYS: LVS) which got 55% of its 2010 pre-tax profit from its Macau operations.

Another option is to stick with your usual fundamental research and find the companies that have the best prospects and are least likely to be frauds. I recently spoke with fellow Fool Tim Hanson about one of his recommendations, Yongye International (NAS: YONG) . He's visited the company on multiple trips to China and is excited about its prospects as it builds a brand among small Chinese farmers. That may not sound like such a big deal for a fertilizer company, but as Tim pointed out to me, these small farmers can't afford to gamble on an unknown or untested fertilizer, so a trusted brand name can be a big advantage for the company. Yongye was the subject of quite a few attacks during the height of the Chinese-stock-fraud wave, but none of the accusations seem to have panned out.

Of course, if you are going to take that tack, a keen eye on your exposure level is a must. Letting overconfidence get the best of you and levering your entire portfolio to the success or failure -- or the legitimacy -- of one or a few small Chinese stocks is just plain nuts.

Finally, as regular readers of mine know, I maintain a portfolio of bargain-bin stocks that trade below half of their book value. Between mid-summer and now, many Chinese stocks have fallen hard and there are a great many now available below that threshold. Controlling your emotions and limiting position sizes is even more important here than above, because these are less likely to be great businesses and more likely just really cheap businesses.

The biggest mistake you can make
In case I didn't stress it enough above, the most important point here is that if you're going to dive in, be mindful of what your purchases mean in the context of your entire portfolio. When it comes to behavioral misfires in investing, overconfidence is right up at the top (particularly for men), and there's plenty of opportunity for overconfidence to burn you badly with Chinese small caps.

If you want to start following any of the stocks above, just click the "+" to add the stock to your watchlist. But if my concerns about Chinese small caps have made you gun-shy about China, why not check out the intriguing Latin American stock that my fellow Fools have labeled "The Hottest IPO of 2011."

At the time this article was published The Motley Fool owns shares of Yongye International and Yum! Brands. Motley Fool newsletter services have recommended buying shares of Yum! Brands and Yongye International, as well as writing puts in Zhongpin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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