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SEC Ruling May Be a Death Knell for Chinese Stocks

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bank_2 February 2014 (Chinavestor) American and Chinese stocks closed out one of their worst month in more than a year in January. U.S. equities had a banner year in 2013 and a technical correction is inevitable, some may argue. We are not sure either if decline in January was a start of a general pull back or just a hiccup but we continue to ask investors to exercise caution.

The Dow Jones Industrial Average (INDEXDJX:.DJI) fell 4.5% in January. The Hang Seng Index (INDEXHANGSENG:.HSI) slid –5.6% while the China ADR Index, compiled by Chinavestor, declined –6.2%. Only mainland Chinese stocks did a little better, declining –3.6%.

 

Expanding our horizon from one month to a year, see chart above, it is obvious that emerging market stocks failed to benefit from the quantitative easing in the U.S. It was only the Dow on the chart that advanced in 2013 while Chinese stocks in Hong Kong, Shanghai and New York, suffered for most of the year.

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The sharp January fall in prices among U.S. listed Chinese stocks is no surprise given a generally negative market sentiment coupled with a SEC probe banning certain auditors to conduct audits of respected Chinese companies. We will talk about this issue extensively in subsequent pages.

Looking back in January, basic materials, utility, and capital goods stocks managed to advance while the rest fell. Transportation, financials and energy stocks suffered the most among notable sectors. See chart on this page for details.

sectors_SEC_week_Jan22_2014

Technology and energy stocks fell the hardest in the second part of January. Technology stocks were hit hard by the SEC rule announced January 22nd. while energy stocks fell globally.

Woes for Chinese tech stocks are significant. The argument goes that as long as Chinese authorities outright ban Chinese companies from submitting required information to the SEC, such audits are not acceptable. So far Chinese companies have circumvented such requirement by submitting audits conducted by the big four auditor firms’ Chinese affiliates. But again, the SEC said those audits done in China, even by the big four auditors’ affiliates, are not good.

And this raises an interesting issue. Major Chinese companies, as well as smaller ones, are in jeopardy meeting the deadline to submit quarterly and annual reports on time.

We argue that there are three different sets of Chinese stocks.

One group is “safe” from the SEC action. These are cross-listed large cap blue chips whose home market is not the NYSE or the NASDAQ. Petrochina Co. Ltd. (NYSE:PTR) is a prime example of this. Shanghai is the home market for China’s largest oil producer and prices set in there act as indicator for prices for its Hong Kong listings. Now, Hong Kong acts as a proxy for Petrochina’s ADR prices (NYSE:PTR) on the NYSE. So ADR prices are really not determined by SEC or US related news but are driven by actions and news in China. So these stocks are inherently safe from an SEC action.

The second set of stocks are those quality trading stocks that have large volume on the NYSE or the NASDAQ and are not listed anywhere else. These include China’s search engine giant Baidu Inc. (NASDAQ:BIDU) and Sina Corp. (NASDAQ:SINA) just to name a few. These companies have hired services of the big four Chinese affiliates and as such are vulnerable to the SEC action.

This has been clearly demonstrated on January 22-24, 2014 when the SEC announced such changes. Shares of Baidu Inc. (NASDAQ:BIDU) and SouFun Holdings (NYSE:SFUN) experienced a free fall following the SEC announcement. See chart below.

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The second chart on this page displays the effect of the SEC announcement. Right when the SEC announced changes to Chinese audits, the China ADR Index experienced a free fall.

Major indexes November 2013 - January 2014

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We have long been arguing that bookkeeping is not necessarily considered Vangard among Chinese listings. The last time we dedicated a whole issue of our Newsletter was back in April 2012. There we noted that a large number of Chinese listings, especially those that went public via reverse merger, are potentially trouble. We created a “safe list” from Chinese stocks listed on the NYSE and the NASDAQ. We sincerely hope investors paid attention to that and thus avoided some very costly mistakes.

After almost two years, we recreated a similar list of Chinese stocks for both markets. We have three categories on those lists. The first one in green background are considered ”good” stocks, e.g. companies that have relatively large trading volume, market cap, and are able to afford first tier auditors.

The second group, colored in yellow, are stocks that may be good for investment but carry higher risk.

And finally, the red list consists of stocks that we at Chinavestor don’t recommend for investment purposes.

Visit Page 4 for NYSE listed Chinese stocks and Page 5. for NASDAQ listings.

Not surprisingly, the NYSE has a longer list of “good” Chinese companies than a loosely regulated NASDAQ. Still, not every NYSE listing is considered investment grade.

Wish you successful investing, Blaze Fabry.

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