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Why You Can't Trust Chinese Stocks

For Safety's Sake, Buy American

Written by Briton Ryle
Posted February 2, 2015

It was the hottest IPO in recent memory. The share price ramped on the first day of trading as investors clamored for a piece of the high-growth company.

No, I'm not talking about Friday's Shake Shack (NYSE: SHAK) IPO, where shares more than doubled on the first day...

I'm talking about the September 18, 2014 IPO of Chinese Internet commerce company Alibaba (NYSE: BABA).

At $25 billion, it was the biggest IPO ever. Alibaba often gets called the "Chinese Amazon" because it is the biggest e-commerce site in China, much like Amazon is far and away the biggest in the U.S.

The growth estimates for Alibaba make it look like a no-brainer investment...

Out of 1.37 billion Chinese, barely half — 632 million — use the Internet. Half of those people — around 300 million — shop online. And a whopping 84% of Chinese who shop online use Alibaba.

In 2013, a ridiculous 2.6% of Chinese GDP went through Alibaba.

Net profit tripled to $3.7 billion for 2013, and revenue is growing at a ~50% clip...

That type of growth is incredible for a company that's bigger than General Electric and Wal-Mart. I can understand why investors have dollar signs in their eyes.

But for me, I'd rather own shares in a regular old burger joint like Shake Shack (though I'd wait a bit for IPO hype to calm down). And it's because I just don't trust Chinese companies.

Chinese Company Deceit

Now, any investor should know that when a company goes public, the owners, insiders, and early investors are cashing out.

If you buy an IPO, you are buying their shares. They are selling their ownership to you. They become millionaires or billionaires overnight with your money.

After his company's IPO, Alibaba owner Jack Ma is now worth around $30 billion, making him the 19th richest man in the world. And of course, Wall Street banks made out pretty well, too. The Alibaba IPO paid them more than any other IPO last year: $291 million.

I'll admit, I don't really want to support a company founder's billionaire ambitions with my cash. And I'm well aware that a Wall Street bank will say anything to take in a $291 million underwriting fee. But those aren't the only reasons I was uninterested in the Alibaba IPO and am still uninterested in the stock today.

For the full reason, we have to go back in time a little bit...

It was 2009, Chinese stocks were hot, and I ran across a Chinese coal company called Puda Coal. The story was good: China burns a lot of coal, and the Chinese government was forcing consolidation of small, fly-by-night coal mines for safety reasons. Puda was handpicked to take over a bunch of smaller mines, so growth looked assured.

I knew the corporate structure — Puda was a holding company that held the shares of the coal mining operations. Nothing unusual in a holding company structure — unless, as it turns out, it's Chinese.

In August 2011, investors learned that all of the stock in the coal-mining operations had been transferred out of the holding company. Puda Coal was now an empty shell.

Puda chairman Ming Zhao and former Puda chief executive officer Liping Zhu had effectively stolen the company from U.S. investors.

There are plenty of other examples of Chinese company fraud on U.S. stock markets. Short-sell firm Muddy Waters uncovered a few, as did Citron Research. And you can Google "Chinese company fraud" if you want more examples.

Now, let me very clear about this: I am not accusing Alibaba of any kind of fraud. I have no evidence the company has misled investors.

Not Even with Your Money

With that said, I don't like Chinese stocks as investments. And that includes Alibaba. Trade 'em when their hot if you want, but I wouldn't invest in them long-term with your money.

Investors don't seem to remember what Alibaba did back in 2009...

The People's Bank of China issued new rules about foreign ownership of payment services (and by payment service, I mean things like PayPal, iPay, or Square). So Alibaba transferred its Alipay payment services company out of Alibaba Holdings and into a business controlled by Alibaba CEO Jack Ma.

Now, to be fair, Alibaba had to comply with new rules from the People's Bank of China. After all, Yahoo owned a large portion of Alibaba (and it still does). The problem: Alibaba made the transfer in August 2009... and Yahoo didn't find out until March 2010.

At the time, Alibaba's PayPal-like service, Alipay, was worth around $5 billion. Yahoo owned 43% of Alibaba at the time, so the Alipay transfer would have cost Yahoo $2.5 billion if a settlement hadn't been worked out.

My problem with this chain of events is somewhat obvious: Alibaba transferred an important part of the company that was 43% owned by Yahoo to the CEO without discussion.

Was it a mistake? I don't know. But some people have suggested that the People's Bank of China's rules were issued specifically to get foreign companies like Yahoo out of Chinese companies.

At the time, people also suggested that Alibaba CEO Jack Ma used the PBOC decision to take control of Alipay, though there's no way to know if that's true.

Cashing Out

It seems to me that Chinese businessmen see the U.S. as a way to get rich. Either they cash in by listing their company shares on a U.S. exchange or they steal corporate secrets from U.S. firms that do business in China. The Chinese government hacks our computers.

All this may — or may not — reflect on Alibaba. Maybe the company is too sophisticated to sink into the "us vs. them, U.S. vs. China" mindset. But maybe lax financial regulation in China makes it way too easy for Chinese companies to cash in on unsuspecting U.S. investors.

Just last week, the Chinese government issued a report that accused Alibaba of bribery and allowing the sale of counterfeit goods on its websites. The report stated that just 19 of 51 items the agency bought on Alibaba's Taobao.com website were genuine. Interestingly, the government regulatory agency that produced the report downplayed the significance after a meeting with Alibaba.

Shenanigans? Maybe. But the counterfeit issue has been around for a while...

Columbia Sportswear monitors counterfeit Columbia sales at Alibaba. In test purchases from 2013, Columbia found that 80% were fake. Columbia says it alerts Alibaba to as many as 3,000 counterfeit Columbia products a month.

Between 2008 and 2011, the Office of the U.S. Trade Representative labeled Alibaba's Taobao as a "notorious marketplace" with "widespread availability of counterfeit and pirated goods."

What's more, the Chinese government's counterfeit report was actually completed in July 2014 but was held back so as not to interfere with Alibaba's September 2014 IPO.

Personally, that's information I'd like to have before I invest...

Now, if you missed it, Alibaba stock just got creamed after reporting Q4 earnings. Earnings per share were good, but revenues missed by a good bit, coming in at $4.2 billion when analysts were expecting $4.5 billion. The stock sold off 10%.

My question is this: Will Alibaba really crack down on counterfeit goods when such a crackdown would further impair revenue?

I don't know. But with a forward price-to-earnings (P/E) ratio of 31, the stock is priced to perfection.

Call me crazy, but I will be surprised if Alibaba does indeed execute to perfection.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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