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China’s appeal for investors takes a hit Add to ...

The allegations that Sino-Forest Corp. inflated its revenues and assets are drawing attention to one of the most exotic and treacherous sectors of the equity market – the hundreds of Chinese companies that trade on North American stock exchanges.

There are about 200 companies with listings in the U.S. and Canada that have almost all of their operations in Asia, with a combined market capitalization of approximately $50-billion, according to estimates from the University of Toronto’s Kevin Mak. Lately, however, their value has been shrinking amid a cloud of scandal.

Investors may have lost more than $10-billion in recent months as several of these companies have been exposed as frauds or discovered to have questionable accounting, said Mr. Mak, manager of the financial research and trading lab at the university’s Rotman School of Management.

In the case of Sino-Forest alone, more than $3-billion in paper wealth was lost in the space of two days last week – even though the allegations were brought against it by an admitted short-seller who lacked hard evidence.

Among the Chinese companies that have recently taken tumbles are Duoyuan Printing, whose trading has been suspended by the New York Stock Exchange after the company failed to bring regulatory filings up to date, and China Electric Motor, whose trading has been halted in the U.S. since late March, apparently for similar reasons. Both stocks have tumbled sharply since last year.

Most of these Chinese companies haven’t done conventional initial public offerings as a first step to attract investors. Instead, they have followed a backdoor route to North America by taking over nearly defunct shell companies whose only valuable assets were stock market listings.

This manoeuvre, known as a reverse takeover or RTO, means the Chinese acquirers aren’t subjected to the full due diligence requirements required of initial public offerings, making it easier for unscrupulous operators to get listings.

Still, investors eager to get a piece of one of the world’s fastest-growing economies have flocked to the Chinese RTO sector, a move some experts say has been unwise.

“If you’re buying it because of the [China] brand, that’s a huge mistake,” says James Kaplan, director at GovernanceMetrics International Inc., a firm that evaluates corporate governance.

Mr. Kaplan conducted a study last year evaluating a group of North American-listed Chinese companies. He found that close to 60 per cent per cent had what he termed “very aggressive” or “aggressive” accounting. Only 15 per cent engaged in practices considered conservative or average.

The finding “is just horrible. It means they’re the bottom tier of all companies,” he said of the Chinese companies.

Although some Chinese companies adhere to high standards, it’s very hard for investors “to separate the wheat from the chaff,” he says.

Other experts also urge investors to be cautious on the sector.

“I think individual investors should be staying away from Chinese RTOs given that even regulators and auditors are having a difficult time understanding and uncovering their fraudulent activities,” the Rotman School’s Mr. Mak said.

To be sure, many Chinese firms have legitimate operations. Sino-Forest, which is managed out of Hong Kong but has been listed in Toronto since 1994, is fighting back against allegations made by Muddy Waters, a little-known advisory firm that has shorted the company’s stock.

Sino-Forest said in a statement Friday that there are no material changes in its business “or inaccuracy contained in its corporate reports and filings that need to be brought to the attention of the market.” It also warned against relying on allegations from a short seller, who makes money if share prices fall.

However, the company’s effort to reassure investors did little to help the stock, which plunged 64 per cent to $5.23 at Friday’s close on the TSX. As recently as the end of March, the shares were as high as $25.85.

The collapse in Sino-Forest follows a number of other high-profile cases in which Chinese companies listed in North America have had serious declines while fending off allegations of accounting or other problems.

“Right now, every single Chinese RTO is basically being painted by the fraud brush,” Mr. Mak said.

Sino-Forest, the largest forest sector company listed in Canada before the recent allegations, as measured by stock market value – it’s still the third-largest – has a large number of big-name institutional investors, including U.S. hedge fund Paulson & Co. But most of the Chinese firms are smaller, speculative ventures purchased mainly by retail investors.

Some investment advisers have been surprised by the influx of money into the Chinese stocks in North America, because it is easy to get indirect exposure to that country’s rapid growth through the purchase of North American commodity producers, and through established companies on the Hong Kong market, which is considered to have high listing standards.

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