3 reasons why I'm wary of Chinese ASX-listed stocks

If you're thinking of investing in Chinese stocks, are you fully aware of the risks?

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There are a growing number of Chinese companies listing on the ASX, but investors need to have their eyes wide open about what can go wrong.

2 weeks ago, the chairman of Sino Australia Oil and Gas Ltd (ASX: SAO), Tianpeng Shao resigned amid an investigation by the corporate watchdog, the Australian Securities and Investments Commission (ASIC). Mr Shao also happened to be the founder and majority shareholder in the mining services company. Shares in Sino Australia have been suspended and the company barred from trading.

The executives

It seems Mr Shao tried to transfer $7.5 million from Australia to Chinese bank accounts just a day after the company listed on the ASX in December 2013. That seems a bit bizarre, given Mr Shao held 136 million shares, or 62% of the company, worth around $84 million at the time of listing.

In September this year, Ultrasonic, a shoe company listed on the German stock exchange, announced that its CEO and COO had vanished along with most of the company's cash. They have since resurfaced in China, admitted to taking some of the money for 'personal use' and promised to pay it back. But it seems unlikely that the company will ever see the funds again.

The numbers

Two years ago, a major accounting scandal erupted in China. It was discovered that many Chinese companies were keeping two sets of books: one to show their auditors and shareholders, and another revealing the actual numbers. Unsurprisingly, the actual numbers were far less rosy than their public books.

Caterpillar, the US heavy equipment manufacturer had to write off US$580 million off its acquisition of Siwei in early 2013, because the company was found to not have most of the equipment it listed on its books, as well as some serious accounting issues.

To make it even harder for foreign investors, around 6 months ago, China clamped down on allowing foreign access to Chinese company accounts submitted to their local Chinese authorities.

The system

Investors may not realise it, but you can't actually buy shares in the Chinese companies themselves. Instead, you are actually buying shares in another company which holds the Chinese companies as subsidiaries. Sunbridge Group Ltd (ASX: SBB) is an example. Australian investors buy shares in Sunbridge, which owns a Hong Kong company, Mega Rich International Creation Limited, which in turn owns two subsidiaries incorporated in China. Should something go wrong, the legal scenario is a potential nightmare.

The way profits are distributed to Sunbridge is also complicated by strict Chinese currency controls. Sunbridge is a holding company and therefore relies on its two Chinese subsidiaries paying it dividends, which it can then pass onto Australian shareholders.

So, who can you trust?

It doesn't make sense to dismiss any investment out of hand just because it is based in a country with an – ahem – not-so-great record of transparency and forthrightness, but investors need to be fully aware of the risks. Investors may want to consider companies that export goods and services to China, such as baby formula company Bellamy's Australia Ltd (ASX: BAL), dairy producer Bega Cheese Ltd (ASX: BGA) or Australian Agricultural Company Ltd (ASX: AAC) – which is likely to see higher exports of beef to China.

Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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