Ian Nar­ine

How would you feel if you lost US$500 mil­lion in one week? What would you say if I told you that the per­son who ex­pe­ri­enced this loss is the same per­son who is cred­it­ed with the great­est trade ever? The great­est trade ever was at­trib­uted to hedge fund man­ag­er John Paul­son, who made US$15 bil­lion in 2007 by plac­ing trades against the sub-prime hous­ing mar­ket. In 2008, he fo­cused on the banks that dealt with the sub-prime and made a fur­ther US$5 bil­lion. Paul­son has the dis­tinc­tion of mak­ing the biggest prof­it from the fi­nan­cial cri­sis of 2008.

Fast for­ward to last week and Paul­son's share­hold­ing of 34.7 mil­lion in a Chi­nese com­pa­ny list­ed on the Toron­to Stock Ex­change went from a price of Cdn$ 19.80 on Tues­day, May 31, to an in­tra­day low of Cdn$4.81 on Fri­day. The stock is Sino For­est Cor­po­ra­tion (TRE.TO) and the sharp drop in price was as a re­sult of fraud al­le­ga­tions against the com­pa­ny re­sult­ing in the sell down and the tem­po­rary halt­ing of trad­ing in the stock on the Toron­to Ex­change dur­ing the week.

This is just the lat­est ex­am­ple of fraud al­le­ga­tions fac­ing a num­ber of Chi­nese com­pa­nies trad­ing on the US (and, in this in­stance, Toron­to) Stock Ex­changes to the point where one in­vest­ment fund has racked up gains of 300 per cent net of fees and 405 per cent gross since its in­cep­tion in Ju­ly 2009 by trad­ing against a num­ber of these com­pa­nies. I know on­ly too well that a num­ber of T&T in­vestors are propo­si­tioned by US bro­kers to par­tic­i­pate in the "next big trade" and so this is quite lit­er­al­ly in­tend­ed to make the point that in­vestors should be very care­ful of deals that seem too good to be true.

In­vest­ing in Chi­na

The sto­ry be­hind Sino For­est re­al­ly high­lights just how care­ful in­vestors need to be pri­or to mak­ing an in­vest­ment and the John Paul­son el­e­ment to the tale shows that large so­phis­ti­cat­ed in­vestors are not im­mune. In­vest­ing in Chi­na has over the past few years been the trade that of­ten catch­es the at­ten­tion. As a coun­try like Chi­na de­vel­ops, the first de­mand is for in­fra­struc­ture ma­te­ri­als such as ce­ment, then comes steel, cop­per and alu­minum for build­ings and, fi­nal­ly, wood for res­i­den­tial homes and con­sumer fur­ni­ture.

It's a com­pelling sto­ry and Sino For­est is sup­posed to be in the busi­ness of cul­ti­vat­ing and har­vest­ing tim­ber with the aim of sup­ply­ing the huge Chi­nese de­mand for wood rang­ing from home con­struc­tion to chop sticks. I al­most had deal­ings with the com­pa­ny a cou­ple years ago while work­ing on a re­al es­tate project with a Caribbean-based in­vestor. How­ev­er, a re­port re­leased on June 2, 2011, sug­gests that Sino For­est is "one of the rare frauds that is com­mit­ted by an es­tab­lished in­sti­tu­tion" and "was ag­gres­sive­ly com­mit­ting fraud since 1995."

The full re­port can be found here: http:// www.scribd.com/doc/56950336/MW-TRE, and makes for very in­ter­est­ing read­ing. Ef­fec­tive­ly, it is al­leged that the mul­ti-bil­lion-dol­lar rev­enue stream is vast­ly over­stat­ed and the US$989 mil­lion of eq­ui­ty raised via share sales since May 2004 is noth­ing more than a ponzi scheme. Ap­pre­ci­ate that at this time these are just al­le­ga­tions but huge rep­u­ta­tions are on the line.

Long list

Sino For­est is not the on­ly Chi­nese com­pa­ny with these types of al­le­ga­tions but, rather, it is just the most re­cent in a long and grow­ing list. Most of these com­pa­nies have a com­mon fea­ture and that is they list­ed on the US ex­changes through a process known as a re­verse merg­er. This is how the process works. There are a num­ber of pub­licly trad­ed com­pa­nies list­ed on the US ex­changes, such as the Nas­daq, where, de­spite the fact that they are not con­duct­ing ac­tive op­er­a­tions, con­tin­ue to file the nec­es­sary doc­u­ments to re­main com­pli­ant with the Se­cu­ri­ties and Ex­change Com­mis­sion (SEC).

The shell com­pa­nies are then ap­proached by Chi­nese com­pa­nies op­er­at­ing in main­land Chi­na and are of­fered to pur­chase the Chi­nese com­pa­ny by is­su­ing shares that are then tak­en up by the Chi­nese com­pa­ny. The Chi­nese com­pa­ny is now the ma­jor­i­ty share­hold­er in the US-list­ed com­pa­ny and easy as that they are now list­ed and trad­ed on the US ex­change with­out hav­ing to go through the ini­tial screen­ing of the SEC.

Aside from the use of re­verse merg­ers to gain ac­cess to the US cap­i­tal mar­kets, a num­ber of these com­pa­nies have had to an­nounce the sud­den res­ig­na­tion of their chief fi­nan­cial of­fi­cer as well as their au­di­tors. On Fri­day, the Wall Street Jour­nal re­port­ed that the US SEC is in­ves­ti­gat­ing some ac­count­ing firms over their au­dits of Chi­nese re­verse merg­er com­pa­nies so, fi­nal­ly, it seems the reg­u­la­tors are be­gin­ning to take no­tice of the is­sue.

Growth sto­ry

An­oth­er key warn­ing flag that is of­ten the bane of many in­vestors is the claim of unique com­pet­i­tive ad­van­tages, whether this is through ac­cess to sup­plies as in the case of Sino For­est, tech­nol­o­gy or "sound" fi­nan­cial per­for­mance. The re­al­i­ty is that these are the fac­tors that in­vestors rel­ish and get­ting in on com­pa­nies that have these sorts of ad­van­tages ear­ly enough pro­vide the op­por­tu­ni­ty for the once in a life­time 10 dig­it gain. Think of Ap­ple at US$4 in 1998 com­pared to its cur­rent US$350 price.

Take, for ex­am­ple, the case with Sheng­da Tech (SDTH) a stock that I per­son­al­ly owned at one time. Man­u­fac­tur­ing a prod­uct that is used in tire, PVC, paint, poly­eth­yl­ene, etc, and op­er­at­ing from Chi­na at a time when the coun­try is ex­pe­ri­enc­ing dou­ble dig­it growth seemed a very good propo­si­tion. It had an in­dus­try lead­ing gross prof­it mar­gin of 41 per cent and a net prof­it mar­gin of 22 per cent, low debt and strong growth prospects. What's not to like, right?

Fraud­u­lent in­for­ma­tion

Af­ter an an­a­lyst re­port that al­leged that the com­pa­ny was is­su­ing fraud­u­lent in­for­ma­tion to in­vestors Nas­daq delist­ed the com­pa­ny on April 20 and its chief fi­nan­cial of­fice re­signed on April 21. Thank­ful­ly, hav­ing been fol­low­ing this is­sue for some time I got out of the stock long be­fore that event. An­oth­er prime ex­am­ple is Chi­na Agritech Inc (CAGC). Imag­ine a fer­tilis­er com­pa­ny which, in 2009, laid claims to a 60 per cent mar­ket share in Chi­na.

I ac­tu­al­ly man­aged to make some mon­ey off this stock as the shares post­ed an over 50 per cent gain dur­ing the course of last year on the back of ris­ing agri­cul­tur­al com­mod­i­ty prices. On March 14, the Nas­daq an­nounced that trad­ing was halt­ed. I of­fer my per­son­al ex­pe­ri­ence to high­light the fact that these stocks were not wild, ran­dom picks, but were ac­tu­al­ly stocks that were broad­ly rec­om­mend­ed, that on pa­per, car­ried strong fun­da­men­tals and boast­ed of sound busi­ness mod­els. As it turned out, the on­ly prob­lem was that it may all have been a lie.

Frauds v re­al op­por­tu­ni­ties

An­oth­er ex­am­ple of a stock I once owned was Chi­na Me­dia Ex­press Hold­ings (CCME). This firm was au­dit­ed by De­loitte Touche Tohmat­su (KP­MG and E&Y were in­volved with some of the oth­er com­pa­nies men­tioned) and, just like Sino For­est, had a sig­nif­i­cant US in­vestor in the form of a large pri­vate eq­ui­ty firm. The com­pa­ny's busi­ness mod­el was not out­landish in that it in­stalled tele­vi­sions on pub­lic trans­port ve­hi­cles in Chi­na and sells ads on those sets.

In the end, even with a Big 4 ac­count­ing firm the sto­ry did not add up and it has since been delist­ed. There are re­al and prof­itable op­por­tu­ni­ties in the Chi­nese mar­ket and, once again I speak from per­son­al ex­pe­ri­ence, but the chal­lenge is to fig­ure out what is re­al from what have clear­ly been frauds. Own­ing shares in the largest Chi­nese search en­gine Baidu at a time when Google was in dis­pute with the Chi­nese gov­ern­ment have since gen­er­at­ed a re­turn of more than 400 per cent.

Like­wise, the on­line me­dia com­pa­ny, Sina, which of­fered a sim­i­lar re­turn over the past 12 months. There are com­pa­nies with unique busi­ness mod­els, such as New Ori­en­tal Ed­u­ca­tion and Tech­nolo­gies (EDU), that pro­vides on­line ed­u­ca­tion ser­vices in Chi­na. Over­all the Chi­nese mar­ket is not the most buoy­ant mar­ket at this time with a num­ber of sell sig­nals show­ing up. The point to this ar­ti­cle is to raise the aware­ness of a re­al is­sue fac­ing in­vestors: that of a num­ber of Chi­nese com­pa­nies that have been ac­cused of fraud­u­lent re­port­ing.

Once these al­le­ga­tions come out the stock is short­ed or sold and the price falls sharply. Chi­na is a cap­ti­vat­ing in­vest­ment sto­ry but, that by it­self, does not guar­an­tee re­turns. Seek out an ex­pe­ri­enced ad­vis­er so that the odds are more in your favour.