What do You Need to Look for before Investing in China-Based U.S. Public Companies?


China Direct Industries, Inc.

Since late 2010, many China-based U.S. listed public companies have undergone a veritable swoon – one brought on by a confluence of company financial restatements, auditor resignation, delisting, trading halt, accusations of fraud, fears over the Chinese economy, and extreme volatile capital markets worldwide. This swoon has induced both pain in the pocketbook and the theft of personal sanity of many investors as each is left to consider whether the current systemic depression in the prices of China-based U.S. listed public companies is indicative of the true problem: fraud, or is it rather the result of short-term noise that is hiding the true value of these companies.

Let us look at the positives:

Over the past thirty years, China’s economy has grown over 250%. China’s GDP has grown at an average annual rate of nearly 10.0% reaching as   high  as 14.2%; the per capita GDP grew at an average annual rate of 8.1% and reaching as  high as 12.0%. Furthermore, the emerging middle class in China has grown from 65.5 million in January 2005 to 80 million in January 2007 and is forecasted to be 700 million by 2020. According to estimates by Deutsche Bank’s Chief Economist for Greater China, China will be the world’s largest economy in the world in a decade.

China’s budget deficit is mild compared with that of the Western countries such as U.S.,  and many within the European Union. Its population is much younger especially when compared to Japan and its economy is growing much faster.  In addition, China’s primary educational system is really good, and so is its infrastructure such as roads, bridges railroads, and communications and they are getting better each day. Furthermore, the Chinese have strong work ethics, and its government is determined to make China a world-class competitor.

The worldwide economic crisis of the past three years proved to the world that the economy China has been developing over the past three decades is both strong and resilient. . China held up better than most developed countries. In 2009, for example, China’s GDP increased 10.7 percent. That compares with a growth rate of 0.1 percent in the U.S., shrinkage of 3.9 percent in Japan, and shrinkage of 2.4 percent in Germany.

Many of the Chinese stocks trading in the U.S.  are shockingly undervalued.  If you want to make money on China while minimizing downside risk, the best way is to  invest in China through buying Chinese public companies that are listed on U.S. stock market exchanges.  Of course, due diligence is a must before you invest these companies.   I believe it’s wise  for U.S. investors to put a portion of their assets in China. I suggest 10 percent to 15 percent for most investors and 20 percent for those with higher risk tolerance.

There are over 700 Chinese firms that have listed on U.S. exchanges and they vary widely in terms of size and sector. These firms include the online search giant Baidu (NASDAQ: BIDU).  These Chinese companies also notably vary according to the means by which they achieved listings on U.S. exchanges. Some, such as the online travel services provider Ctrip (NASDAQ: CTRP), was brought public through the traditional IPO process by notable Wall Street firms. Companies such as these hold vaunted statuses and command rich valuations. Countless other firms came to market through a process known as a reverse merger – a transaction whereby a shell company – an incorporated legal entity that is already listed on the Over-the-Counter Bulletin Board, merges with the Chinese private entity.  The result is that the Chinese company is effectively made a publically traded entity at a much smaller cost than a traditional IPO and much more quickly. After become publically listed, the Chinese company can then raise capital through a share offering or a Private Investment in a Public Entity (“PIPE”) transaction.

What do you need to look for before you feel comfortable investing inChina-based U.S. public companies?

First, does the company have one of the top 15 PCAOB registered auditing firms based in the U.S., with offices or operations in China as auditor?  The key is that the auditing firm must be based in the U.S., because PCAOB is then able to audit the auditing firm once every three years.  The Big Four auditing firms have their Chinese subsidiaries in China to perform audit for China-based U.S. public companies, however, PCAOB is not allowed to audit their work paper.  In addition, you need to check if the auditing firm has its own offices or operations in China.  If not, it is more likely that the auditing firm has to hire a third party, often a Chinese accountant, to do field auditing.  The auditing quality is questionable.

Second, does the company have a reasonable business model?  You should carefully read the company’s 10Q and 10K to understand the company’s business.  The most important is to understand why the company is making or losing money.  Use common sense, if it is just too good to be true, just walk!

Third, does the company have adequate investor relations presence in the U.S. such as U.S. representative (not IR contact), U.S. offices, U.S. website, up to date press releases, road shows and conferences, English speaking CFO, social media, and so on? These particular details can tell if the company is serious about its shareholder value.  A professional website with detailed information in English and contact links with individuals that will actually respond are very important.

Fourth, does the company have sales contracts with U.S. corporations, multinational corporations or corporations outside of China?  Because those contracts and the income they provide can be confirmed. A U.S. firm utilizing a Chinese company’s products also provides some indication of the quality of the goods and services being provided. The more contracts outside of China, the better you should feel.

Fifth, is the company willing to provide its Chinese tax return filings including valued added tax, income tax and its SAIC filings? Basically, these filings in China should be consistent with its SEC filings.  Keep in mind that some China-based companies may have  exporting businesses through their offshore entity, in which case, their Chinese filings may vary from their SEC filings.

James Wang, Ph.D.

Chairman and CEO

China Direct Industries, Inc. (NASDAQ: CDII)

431 Fairway Drive, Suite 200

Deerfield Beach, FL 33441

Phone: 954-363-7333

Fax: 954-363-7320

Mobile: 561-212-5029

Website: www.cdii.net

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