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Pitfalls of Chinese Equities

You are not alone if you ever considered buying or previously bought Chinese equities. The prospect of making a handsome return while betting on the second- biggest economy in the world is tempting. Large corporations such as Alibaba or JD.com are publicly listed on the NYSE and NASDAQ, readily available for Western investors to pile in. However, what most miss is the fine print of their initial public offerings. After all, it's technically impossible to directly own Chinese stocks or real estate as a foreign investor. The closest thing you receive is a mere promise of entitlement to corporate profits, which is shaky, to say the least. Let me explain and take you on a journey that starts in America, leads to China, and eventually ends in the Cayman Islands.


A few years ago, a friend of mine traveled to Thailand to enjoy some cheap beach holidays while living his best life. Before he flew back home, he stayed for a night in Bangkok. He and some of the other hotel guests went out to a karaoke bar to get a taste of the famed party culture. After he gave his best impression of Leona Lewis, a pretty Thai girl approached him by the bar. One thing led to the other and two hours later they were making out in his hotel room. It was only when they took it a step further, he realized he had been played for a fool. Unfortunately for him, she was as much of a girl as he was a good singer. What happened to my friend, is happening daily to thousands of investors buying Chinese equities: They think they understand what they are getting into until it’s too late, and they already hooked up their hard-earned money with the wrong commodity. They’ve also been played for a fool.

How did it get to this and why? Let’s rewind.


Overview


1 Wall Street's New Darling

Like every good old-fashioned story about money and greed, it all started on Wall Street. In 2006, the publicly listed company “Apex Wealth Enterprises Limited” committed to a reverse merger acquisition, and then changed its name to “China Security and Surveillance Technology” (1). Before that, the firm did not generate any revenue and thus served solely as a legal vessel to bring a Chinese company to the American stock market without going through the extensive due diligence process by the SEC (2). Even though reverse mergers weren’t news to the bankers and brokers on Wall Street, the Chinese element of the deal was novel. This idea didn't go mainstream until the financial crisis of 2007-2008 hit, and Western investors were encouraged to find better returns outside American and European markets.

Wall Street recognized the potential to fill the need, and soon a flurry of Chinese companies started to merge with defunct or blank check American firms. The most notorious deals were underwritten and sold by second and third-tier banks. These "financial advisors on testosterone" sold the Chinese growth story to non-suspecting investors, who happily bought the stocks with hopes of great returns. Shares were soaring, and everyone involved seemed to be getting richer by the day. Most of these companies were virtually worthless and their financial records entirely fabricated. There was for example a company called Orient Paper, which produced and sold paper at staggering growth rates. It later turned out they weren't growing at all and their workers even smoked on the job. Not exactly what you'd expect from a best-in-class paper mill.


Factory premises of Orient Paper’s mill in China. Steadily growing at 127% a year.


Like every scheme, it eventually fell apart and the fraudulent companies were delisted and sued. Overall, the losses are estimated to range from 20 to 50 billion US Dollars. One guy was imprisoned and a documentary dedicated to the fraud was released. At first, it seems like another Wall Street scandal. However, it doesn't quite end here.

Today there are still over 254 Chinese companies listed on US stock exchanges. Many of which have real customers and create real value in China and abroad. By the time of this writing, these Chinese equities combined are valued at over 1 trillion US Dollars. Any investor who holds up the principle of diversification is rightfully tempted to bet some money on China. Too great are the opportunities of the GDP challenger to the United States and its whopping 1.4 billion Chinese customers. At first glance, companies such as Alibaba and Tencent are poised to compete with and even overtake American corporations of the likes of Amazon and Apple. Most analysts give them blue-chip status and send out buy recommendations as if their clients subscribed to a daily noise-letter.

Two years ago, in a mixture of pandemic boredom and nerdiness, I started reading up in- depth on each of my stock holdings. Back then, they still consisted of Alibaba (BABA) shares. Thanks to the SEC and the respective IPO filings, all the necessary information was publicly available. That’s when I realized that the risk in buying Chinese equities isn’t "just" accounting fraud, but is far more profound: politics. Owning a piece of the Chinese economy is simply not possible, legally speaking. The reasons for that are deeply rooted in history and a direct consequence of the Chinese Culture of Distrust towards foreign interference. .


2 Chinese Culture of Distrust

China as an economic superpower is nothing out of the ordinary when looking at world history. In the past two millennia, the country was for the most part a global economic leader. If you had traveled to 16th-century mainland China, you would have been mocked and looked down upon as the lesser developed European counterpart. Not even to mention that America has just recently been put on the map. The compass, gunpowder, papermaking; all inventions by the Chinese. In light of industrialization, power shifted to the West and manifested itself in two Opium Wars (1839-1842 & 1856-1860). The British and French enforced trading rights in the East and easily defeated the Qing dynasty, gaining territory and influence in the region. It marked the end of Chinese predominance and independence, while also signaling the beginning of foreign interference. Although local militias rose once again during the Boxer Rebellion (1899 - 1901), the Eight Nations Alliance invaded China. The British Empire, Japan, Russia, Germany, the United States, France, Italy, and Austria-Hungary split the mainland up for pieces into so-called spheres of influence. Demoted to a pawn, China became another piece in the chess game of the imperial powers. In Chinese history books, this time is rightfully described as the century of humiliation.


China for an imperial lunch.


Many of today’s political issues in the region stem back to this time period when China lost the Korean peninsula and Taiwan to Japan, as well as Hong Kong to the British Empire. During the second world war, Japan invaded once again. The atrocities committed by foreign powers since the opium wars until Chinese independence in 1945 left deep scars on the Chinese people.


After living through the Century of Humiliation and a civil war, the victorious Chinese Communist Party took the logical consequence and isolated itself from 1949 onwards. Nonetheless, the ambition to return once again to the world stage never ceased to exist. When Mao Zedong died, more liberal markets were introduced and the economic growth story of China picked up pace. Today the nation is once again a political and economic superpower. Still, what remains is the legacy of an authoritarian, top-to-bottom political system from the dynasty era, and a deep sense of distrust towards foreign powers. Never again should the Chinese be controlled or owned by outsiders. This defiance of foreign ownership is also reflected in Chinese equities, which are technically neither Chinese nor equities. But simply island profit promises.


3 Cayman Island Promises

There are plenty of different countries and islands which Chinese firms use as a springboard to list on the NYSE or NASDAQ. The concept remains the same, and thus the most prominent and biggest company makes for an intriguing show-by-example: Alibaba. Without a question, Alibaba is huge, has plenty of customers, and offers a wide range of services. E-commerce, artificial intelligence, venture capitalism, Alibaba covers it all. The company went public on the New York Stock Exchange in 2014 and became the largest IPO in history (not just Chinese, but overall). The demand for stocks of the internet giant was huge and the underwriting oversubscribed. While insiders and sophisticated investors understood what the rights of owning BABA stocks entailed, most were blinded by the prospect to get in the action. Although it was an initial public offering, and the name of Alibaba was splashed across it, investors didn’t actually get a piece of the Chinese company but solely a promise to receive profits of the Alibaba Holding Group in the Cayman Islands.


I know. It’s complicated.


Office of Alibaba’s Holding Group on the Cayman Islands. Not a joke.


As pointed out in previous paragraphs, China doesn’t trust foreigners and consequently, Chinese law forbids them to hold strategic domestic assets. No surprise, the nation’s e- commerce flagship belongs to that untouchable group (5). Wall Street and stockbrokers are aware of that. “So why the fuck are Chinese equities even listed on the NYSE if we don’t get shit for it?”, you may ask. Good question and the answer is money. To solve the issue of foreign ownership prohibition and still offer a financial product to investors, there is a "solution" called variable-interest entity structure (VIE). Even though a VIE doesn’t give investors the right to receive a penny if Alibaba would default, it gives the holder of a VIE the right to receive profits from the emitting entity. In simple terms: Alibaba makes a profit and you as the owner of their “stock” are technically entitled to parts of that profit in the form of dividends. If you think this procedure is an isolated incident then let me reassure you: it’s not. Maybe the islands change to the British Virgin Islands or Bermuda but at the end of the day, Chinese equities in their traditional sense do not exist. To go around the domestic rules in China, companies set up an equity interest scheme (or profit scheme) through which investors can partake in the success of a publicly listed Chinese company. To illustrate this please see below Alibaba's Holding setup.


The complexities of Alibaba’s VIE structure which few are aware of.


Technically you can partake in the profits, but it's important to add that in the history of Chinese companies listed abroad, not a single firm has paid dividend interest to its shareholders. Moreover, the PRC could simply impose a rule that strategic assets are obliged to reinvest their profits instead of paying out profits, thus preventing a negative money outflow. Currently, there is no reason for the Chinese government to interfere in these practices as any IPO in the West just brings in billions of US Dollars for Chinese companies using shell setups in faraway islands.


4 Friendly Advice

I bought Alibaba shares because I believed in the business, the numbers, the growth rates. But I sold my shares because these companies were valued at similar rates to their Western counterparts, even though their share structure looked nothing alike. In my opinion, you carry all the risks whilst being subjected to three jurisdictions: the US, the Cayman Islands (or another island state), and China. The complicated setup of onshore and offshore companies also provides countless chances for accounting fraud, thus further reducing the reliability of Chinese corporations' balance sheets. It's virtually impossible to audit or verify their numbers. Alibaba is not worth its market cap. No Chinese company is. And not because their business is bad. It could even be excellent, but the issue lies in their structure, the accounting and the unknown political factor of the Chinese government. At any time the PRC can revoke the possibility that domestic corporations are allowed to engage in certain business practices such as using a variable interest structure. This would imply that, even if Alibaba is constantly growing, their numbers are valid, and investors are anxiously preparing to receive their first dividends, the PRC can just stop these payout, and no one could do anything about it.

I am not condemning the Chinese government to keep such options in place nor am I shocked: The PRC is one of the most consistent governments in terms of reaching its objectives and “Serve the People”. Alibaba, Baidu, JD.com, and the likes are still able to raise foreign capital because foreign investors are willing to buy their so-called equities despite the rather shaky fundament they are built on. Stock markets, banks, and brokers are built to sell financial products and earn a commission, thus profiting from the practice. Still, if an investor believes that Chinese equities function the same way as American or European stocks, they are just wrong.

My advice to you is to sell your Chinese shares and move on. There are better alternatives.



For more helpful books on investment, money & personal finance, see book list.

On the publication date of this article, the author did not own any Chinese stocks nor any related stock options. For more information please see our disclosure policy.


Sources

1 First U.S.-Listed Chinese Firm Plans Switch to China published in The Wall Street Journal in 2013. 2 Form S-1 of China Security and Surveillance Technology published by Securities Exchange Commission in 2007. 3 Orient Paper in $2 mln reverse merger settlement published by Reuters in 2012. 4 The China Hustle distributed by Magnolia Pictures in 2018. 5 IPO Filing of Alibaba published by Alibaba Group Holding Limited in 2014 (see page 48).

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