China Growth Stocks

[Rames]

I agree with the need for quality now. With so many stocks looking so "cheap" based on official numbers or guidance, it would be careless not to pick just the best of breed from the space. For now, the doom and gloom faction has succeeded in spreading mistrust in every corner of the China space. That's exactly what they wanted:

- China is a bubble
- Every other U.S.-listed China company is a possible fraud
- Don't trust any of the reported SEC numbers, most companies report vastly different numbers in China
- Don't trust any of the auditors unless they are top-notch and U.S. based
- Don't trust any China company that went public via reverse merger

and so on...

Most investors I know lost all of their confidence now, nobody is buying, most people are still trying to wind down positions in the space but have a hard time finding buyers even at these low prices.

The biggest problem is that none of us can do the kind of due diligence that would be necessary to erase all doubts. What would be the criteria to determine "quality" in the China space? Let's not forget that there were dozens of U.S. companies in the past couple of years which managed to systematically deceive everyone around, analysts, auditors, media, investors. Nobody can come up with enough facts now to prove that some small company from rural China is 100% honest, honorable, and correct in their reporting.

So let's forget about the widespread paranoia about hordes of criminal Chinese companies stealing from their overseas investors. The risk is higher with foreign companies from emerging markets, basically due to a lack of transparency and independent reporting. The risk is higher because commitment to creating shareholder value is often not very strong. Most small Chinese companies go public in the U.S. to access the capital markets, to raise funds again and again and to pay off early investors. But where is the evidence that Chinese companies are more fraudulent on average than U.S. or European ones?

So how do we find "quality" within the ~500 publicly listed Chinese stocks in the U.S.? I guess we could narrow it down by the following criteria:

Stocks that have 2 or more analysts following them, and stocks that have meaningful investments from private equity investment firms have been thoroughly (well more or less) examined by institutions that have reputation and money at stake. We can benefit from their due diligence and it removes some risk. Having no analyst coverage is an extra negative now, especially when the company is not a microcap by definition.

Past actions of management. We should look into things like timely reporting, full and timely disclosure of material events incl. negatives, avoiding shareholder dilution by not repeatedly paying for services and similar with newly issued stock, proper communication with shareholders by regular press releases, earnings calls, availability of management/reps for questions, commitment to shareholder interests by providing EPS guidance, and so on.

Auditing. It's the big theme of the summer. I've made a list of auditors for the CGS space (http://www.fixyou.co.uk/tracker_auditors.php) which can be useful to track if some companies stand out by having hired some no name back alley firm with 3 employees. A small firm doesn't imply they can't do the job, a Big4 auditor does however add to the quality perception.

Liquidity. I believe in this market it is pointless to "invest" in stocks that barely trade $100k a day. Besides that there is an additional risk in case of bad company news, those illiquid stocks will likely not be ahead of the crowd when the market decides to like Chinese stocks again.

That all is of course on top of value criteria and company fundamentals. I'm glad to hear additional ideas for determining "quality" stocks in our China small caps space.