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China Stocks: Bargain Buying Opportunities or Value Traps?

Billionaire curmudgeon Jim Rogers has never kept his opinions on the future of the world economy a secret. Rogers sees China and Asia as the next great power, and he's confident enough that

Billionaire curmudgeon Jim Rogers has never kept his opinions on the future of the world economy a secret. Rogers sees China and Asia as the next great power, and he’s confident enough that America is in its decline that he’s moved his family to Singapore so that he can raise his daughters in the midst of what he sees as the next great economic power.

“If you were smart in 1807 you moved to London, if you were smart in 1907 you moved to New York City, and if you are smart in 2007 you move to Asia,” Rogers once said.

However, regardless of whether or not one believes in the rise of China in the long term, the rise of China stocks offers a more pressing question with major short-term consequences. It’s sometimes difficult to go outside of one’s country in investing as it can be harder to find information and living outside the culture of a country means not necessarily being able to keep a finger on the pulse of the underlying supply and demand. China stocks can offer a chance for major growth and a solid investment. They can also be value traps or company’s riddled with fraud.

China Stocks Offer Major Risks

Muddy Waters Research has, interestingly enough, made its reputation by singing the blues. The research firm is a notorious short-seller that specializes in researching Chinese companies to help make things clear for Western investors. The company’s name derives from an old Chinese proverb, “Muddy waters make it easy to catch fish,” or more simply, a lack of clarity can make it easier to make money. Muddy Waters, though, hopes to cut through this Chinese tradition of opaque conditions.

So it was that Sino-Forest (TRE.TSX) became one of Muddy Waters’ most prominent victims. Sino-Forest is a forestry company that plants and manages trees in China while also selling standing timber and wood logs. Sino-Forest was a hot stock to own in early 2011. On April 1 of last year, the company was on a bull run to the tune of 330 percent dating back to late November of 2008. The rebound from the financial crisis was an impressive one, but apparently not a real one either. Carson Block, an analyst with Muddy Waters, released a research report on June 2, 2011 making allegations that Sino-Forest had been cooking its books to show more assets and earnings than actually existed, likening the company to a Ponzi Scheme.

The results were dramatic. Sino-Forest lost about 90 percent, with John Paulson selling his stake in the company for a $720 million loss. By August 25, the company’s shares were suspended from trading and the company was under investigation. Bringing the story to the present, Sino-Forest filed for bankruptcy on March 30 while also suing Muddy Waters Research for defamation.

“[T]he report was not designed to inform the investing public, but rather, to scare them into believing that Sino-Forest was a criminal and fraudulent enterprise,” said Sino-Forest in the suit.

Carson Block, though, didn’t give much merit to the suit publicly. “There’s a large amount of irony in that the day that they file for bankruptcy is also the day they sue us for defamation,” Block said.

Sino-Forest isn’t alone, though. Other Chinese companies have shown a willingness to ignore trading rules that have been commonplace in the United States since the 1930s. Zhongpin (HOGS), a Chinese pork processor with an oh-so-clever ticker, recently saw the assets of seven people frozen after allegations of insider trading of Zhongpin stock. Fushi Copperweld (FSIN), a company that specializes in making copper wiring, was the most recent victim of a Muddy Waters report saying that the company had a “high risk of fraud.” Carson Block, who is the founder of Muddy Waters as well as the director of research there, has prepared a video presentation on how Chinese companies perform fraud, the first part of a series of videos Block has dubbed “Frauducation.”

Mistrust too Much?

The Sino-Forest scandal led to a broad decline for Chinese stocks, particularly small companies that went public via reverse takeovers that require a much lower degree of disclosure. The broad decline ended up pulling some major names into it. Renren (RENN), often described as the Chinese Facebook (FB), declined 73.37 percent from June 1st, 2011 to the beginning of 2012. Online media company SINA Corporation (SINA) fell 56.23 percent, and  even Baidu (BIDU), which Jim Cramer called the only China stock he trusts during the crash, fell 14.18 percent in the same period.

However, while Muddy Waters may have exposed a culture of fraud in some smaller companies, none of the above companies have had such allegations of fraud. So did all these China stocks fall off a cliff in the second half of last year because of a legitimate shift in their value? Or was the sell-off the equities version of a race riot? A widespread panic caused by people grouping people (and in this case, companies) together after an isolated incident? As stated above, investors are most likely going to be much more confident in a company if they live in the culture where that company is based. It’s also entirely possible that this fueled much of the crashing prices for China stocks, with investors jumping out of investments much faster than they might with American companies.

Ultimately, the long-term prospects for the Chinese economy appear to be a relative certainty. With a growing middle class, there’s an expansion of demand in the country for any number of products, and that should buoy many domestic companies as a result. If that’s the case, it could certainly be possible that the immediate panic over Sino-Forest and Muddy Waters Research has created a solid buying opportunity for any number of Chinese companies that don’t have any allegations of accounting impropriety.

The Fed model compares the return profile of stocks and US government bonds.