Chinese Market Investors Need to Know

October 29, 2013

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Chinese companies ranked the lowest in a recent survey of public reporting practices across emerging markets, underscoring concern that the PRC government’s anti-corruption campaign may not have taken root in the corporate sector.

The 33 Chinese multinationals surveyed by Berlin-based NGO Transparency International (TI) averaged a score of 2 out of 10 points in TI’s “Transparency in Corporate Reporting” study. The report, which scored 100 companies spread across 16 emerging markets, found that three-quarters of all companies scored less than five points, while two firms posted zeroes. No company achieved a perfect score. Chery Automobile Co., the privately-held carmaker based in Wuhu, China, joined one other company among the 100 surveyed with a score of zero across the three categories measured.

So should investors be over worried about investing in China? Here are some considerations.

Many people think that emerging markets are an asset class, which is a common misconception. Unless you are buying emerging market ETFs or mutual funds, equities in different emerging markets and China are very unique. It is similar to investing in stocks in developed markets, you need to look at each company with a combination of top-down and bottom-up approaches.

There have been high-profile fraud scandals involving Chinese companies with regard to their misconduct in accounting and disclosure. Part of these scandals were driven by  “reverse-merger” companies in China listing overseas which have caught justifiable blame for a bold and entertaining series of lies. But the problem is bigger than inventive spreadsheets. Underpinning the fraud is a combination of lack of homespun capital available to private Chinese businesses and overburdened US regulatory bodies that Chinese firms don’t understand.

Additionally, there is a need for foreign investors to understand the dynamics in China. The macro economy and possible hard-landing, government policies and the family business nature of a lot of Chinese companies are all important factors to reckon with. The market intelligence may not be easily accessible in overseas channels, and investors need to rely on local market experts to get access to the most important data and insights.

So what solutions are on the table?

Investors should conduct thorough due diligence of the companies they are going to invest in, if possible. This includes verifying that clients exist, production facilities and employees are in place and the management team is stable.

Investors should also demand that companies provide them with the information they need to make investment decisions that are consistent with their international accounting and ethical standards. Transparent organisational structures, where each subsidiary, affiliate or joint venture is identified, accompanied by country-by-country reporting, are necessary to understand the company and identify significant risks – economic, political and reputational.

Last but not least, diversification. Investors need to consider different sectors on different phases of economic growth to outweigh potential risks. Regular evaluation of the investment portfolio of companies in China and emerging markets based on the market sentiment is also important.