Two problems with companies in China

There are two major problems with evaluating the performance of companies based in China:  the lack of transparency, and the near-absolute power of the Chinese Communist Party.

Do these problems affect you directly?  They might. 

Roughly what percent of your savings are in stocks in Chinese companies?  If you invest in mutual funds, you probably have no idea. 

China is currently a favorite among mutual fund managers and individual investors who are willing to take risk to maximize their long-term returns.  As one analyst quoted in a January article in US News and World Report put it:  “China is the only major economy in this COVID-pandemic era that’s actually on a growth path.” 

And “there [are] 217 Chinese companies listed on [the three big US stock exchanges – New York, American, and NASDAQ] with a total market capitalization of $2.2 trillion.”  So if you invest in certain types of mutual funds you almost certainly own a small piece of some of them.

If you’re not worried about the first problem – lack of transparency — consider the case of Luckin Coffee, the “Chinese Starbucks.”  When the company went public on NASDAQ in 2019, they had 4,500 stores in China, and reported $413 million in sales for the previous nine months.

The price rose quickly from $17 per share to $50 per share. and a lot of investors made a lot of money.  As long as they sold their stock near the peak.  Because in April 2020, less than a year after the company went public, “it came out that its COO, along with a number of other employees, had overstated revenue figures by some 40%.”  Within a week of this fraud announcement, the price per share dropped to $4.  By June, NASDAQ had delisted the stock.    

Luckin Coffee has agreed to pay a $180 million penalty to the SEC (Securities and Exchange Commission) and in February filed for Chapter 15 Bankruptcy.

Luckin Coffee’s stock price crashed when the company admitted fraud.

Could this type of fraud happen in a US company?  Of course, fraud is always a possibility when humans are involved.  That’s why there will always be accountants. 

But in the US, the PCAOB (Public Company Accounting Oversight Board) oversees external audits which greatly reduce the risk of fraud in publicly traded companies.  Chinese companies traded on US stock exchanges have agreed to be audited by the PCAOB.  But they consistently violate this promise.  Which is an excellent illustration of the first problem highlighted in this post:  Lack of transparency.

Indeed, in general “China’s economy [is] incredibly opaque, not only to foreigners but to the Chinese as well… [The government controls the flow of information including] the massaging of data, faking it outright, turning a blind eye to its misreporting [and] rationing its publication.”  Even worse, “its rules are fluid.”  (China’s Great Wall of Debt, p. 10)

China’s lack of transparency has been “a thorn in the side of the U.S. Securities and Exchange Commission (SEC) for a decade.”  Last year, the SEC issued a warning to investors explaining that “in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse.”

What’s the SEC’s solution?  Be careful out there. 

Or, to use the governmental phrasing of the authors of that SEC report, investors should “consider the environment in which the company operates in assessing whether the company has sufficient controls, processes and personnel to address its accounting or financial reporting issues.” 

How likely is it that the average investor will find time to do intensive background research on each and every Chinese company listed in the prospectus for their mutual funds?  I’d say it’s roughly about 0%. 

And then there’s the second problem:  the near-absolute power of the Chinese Communist Party.

The Party has the greatest impact on state-owned enterprises (SOEs), which are partially or fully owned by the Chinese government.  (13 SOEs are traded on American stock exchanges.)  SOEs are designed to meet specific goals such as driving growth, maintaining employment, and increasing China’s technical expertise in areas that give the country an economic or strategic advantage, such as artificial intelligence, robotics, and green energy.  Note that making a profit is NOT one of their primary goals.  As a result, according to the World Economic Forum: “SOEs are highly over-leveraged and structurally less efficient than their private peers… It is widely argued that the SOEs would not survive in an innovation-driven market environment without the perks they currently enjoy.”

But even companies that are 100% privately owned must be very careful to support the Communist Party.  If you doubt this, just ask Jack Ma.  If you can find him.

According to Forbes magazine’s rankings of billionaires Jack Ma is one of the richest people in the world with a net worth of $38.8 billion.  His fortune grew out of co-founding online shopping giant Alibaba, sometimes referred to as “China’s Amazon.” 

Among many other things, Alibaba owns a 33% stake in Ant Group, an online payment service that resembles a supercharged Venmo plus PayPal, and is used by over 1 billion Chinese. Last fall, Ma was expected to become even richer when Ant Group was poised to offer the world’s largest initial public offering (IPO).  But then Jack made a big mistake:  he gave a speech in October criticizing China’s banking system.

Within days, the IPO was canceled and Ma disappeared.  For three months, journalists speculated that he was under house arrest or maybe even dead.  Ma reappeared January 20 in a video address for a charity event and was seen in February playing golf.  Nevertheless Ma is still keeping a very very low profile.

Another sign of the Party’s power over “private” companies, is its Military-Civil Fusion (MCF) strategy.  According to a US State Department fact sheet, the goal of MCF “is to enable [China] to develop the most technologically advanced military in the world. As the name suggests, a key part of MCF is the elimination of barriers between China’s civilian research and commercial sectors, and its military and defense industrial sectors.”

Do you remember my post on “The biggest theft in human history”  and its discussion of how the government “encourages Chinese who study and work abroad to copy or steal technology and rewards them when they do.”  That’s a natural outgrowth of MCF.

Critics have noted that “As a strategy, MCF is still in its early stages, and its success is difficult to evaluate.”  But there is no ambiguity in the law.  Article 7 of China’s National Intelligence Law reads: “Any organization or citizen shall support, assist, and cooperate with state intelligence work in accordance with the law, and maintain the secrecy of all knowledge of state intelligence work.” And Article 11 of China’s National Security Law states, “All citizens of the People’s Republic of China …. shall have the responsibility and obligation to maintain national security.”

I could cite numerous other legal examples, but you get the idea:  Every Chinese citizen is required to assist intelligence authorities.   

Would you invest in a company’s stock if you thought they prioritized China’s political goals over making money?  How about if you thought its sales numbers might be fraudulent?  Me either.

But there is a counter-argument.  Many financial analysts believe that China’s 1.4 billion consumers offer unique opportunities for growth, and that justifies the risks.  For example, consider these recommendations from three unrelated analysts:

Like everything else in the stock market, it comes down to the “risk-return tradeoff”:  the more risk you are willing to take, the higher your gains may be.  Not to mention your losses. My personal conclusion?  Before I started researching this topic, nearly 10% of my retirement portfolio was invested in companies in China and other emerging markets, based on the advice of our financial advisor.  But my parents lived through the Great Depression of 1929, and I am highly risk averse by nature.  So now that I know more, I’ve sold off almost all of that foreign stock and invested it in US companies instead. 

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