Chinese stocks are hot, but what can you really know about a Chinese company? Here's how to tell if a firm is legit or just a flash in the wok. By Jeffrey R. Kosnett, Senior Editor November 7, 2007 On any given day, a bunch of Chinese stocks dominate the list of biggest gainers. The next day the same names are apt to lead the list of biggest losers. How is it that shares of WuXi Pharmatech (symbol WX) are up 138% this year, while those of Tongjitang Chinese Medicines (TCM) are flat? KongZhong sounds like a cartoon character. It isn't. It's a wireless entertainment content and text-messaging company whose stock (KONG) has been anything but kingly in 2007, sinking 36%. However, lots of other Chinese issues have gained 100% or more in 2007, helping push China's stock indexes to staggering gains. After sustaining losses each year from 2001 to 2005, the Shanghai market's 50-stock composite index was up 110% this year through November 7. That comes on top of a 130% advance in 2006. For some investors, that's peanuts. Check out Baidu.com (BIDU). Baidu is China's answer to Google, with 55% of Chinese Internet search traffic and gobs of advertising. Its shares have climbed from $45 in February 2006 to $400 at the close on November 7. U.S. analysts regard Baidu as a serious competitor to Google and Yahoo. And as with Google's stock, they seem to think the sky's the limit. Zacks Equity Research has a buy on Baidu at $400. Advertisement After a run like this, isn't it high time to get at least cautious? Yes, it is. Warren Buffett made news a few weeks ago when, during a trip to China, he said that China's new economy is a stunning achievement, but that doesn't make Chinese securities desirable. The Shanghai market has an average price-earnings ratio of more than 40, meaning that it costs more than twice as much to buy a dollar of earnings from a Chinese company than it does to buy a dollar of profits from a U.S. concern. PetroChina, the world's first company to be valued at $1 trillion, has a price-earnings ratio of 52. ExxonMobil, the largest U.S. company, with a market value of $500 billion, trades at a P/E of 13. Buffett, who made his fortune investing in companies when they could be had at bargain prices, added that he doesn't know details about many Chinese firms. And if he doesn't, or thinks he couldn't learn, how could you or another ordinary investor? Still it would be odd in this age of global investing and dispersed economic growth to ignore all Chinese investments. The stocks are easy to buy now that dozens trade in the U.S. as American depositary receipts. You also can use mutual and exchange-traded funds. Advertisement And Shanghai's gains aren't entirely on blind speculation. As China builds a first-world urban consumer economy on top of its vast backward hinterlands, big money mounts in Chinese savings accounts. The government makes it hard, if not impossible, for the Chinese middle class and the wealthy to invest in the outside world, even in Hong Kong, which is technically a part of China but has a different financial system. The premier in Beijing, Wen Jiabao, said recently that he knows stock prices are high and that the state will intervene to prevent asset bubbles and huge fluctuations in stock prices. He meant this as assurance, but it means China's isn't really a free market. All this leads to a bunch of assumptions: One, worldwide demand for Chinese stocks will accelerate, fed by a powerful marketing machine and a sense that the government can keep shares from crashing. Prices are likely to keep rising and eventually you'll hear more and more commentators talking about the Chinese stock bubble. Then some air, but not too much, will leak, as it did one day last February when Shanghai's index fell 8%. Two, the fast pace of initial public offerings will get faster. That means more obscure names and hard-to-follow companies will list in the U.S., and with breathless promotion. Some IPOs triple in price on the first day (as Alibaba.com, which listed only in Hong Kong, did on November 6). Others lose 75%. The East is wild. Advertisement Three, the Internet will feed your temptation. It's not hard to locate Web sites, blogs and newsletters that flog Chinese stocks with all the subtlety of a Flip and Get Rich real estate infomercial. "Get great Chinese stocks before the market discovers them," says www.ChinaStockReports.com. "Free 32-page report on the seven best Chinese stocks for 2007," shouts www.GrowthReport.com. You get the idea. China Stock Reports says its "golden portfolio" of eight growth stocks has outperformed Standard & Poor's 500-stock index by ten to one since September 2006. For $49 a month, they'll tell you the eight golden ones. Could it be Baidu and the seven dwarfs? Still, it's hard to ignore the remarkable performance of Chinese stocks. And there's no denying that China is one of the world's fastest-growing nations. So is it possible to tell the Baidus from the KongZhongs? Or are Chinese shares a riddle written in an unreadable language? Here are the information sources to tap. Let's see what light they shed. Analytical reports. Duke University finance guru Brian Hamilton started and runs a company in North Carolina called Sageworks. He publishes automated financial analysis of companies, foreign and domestic, that are graded from 0 to 100 on liquidity, profitability, debt and asset quality. Advertisement Hamilton shared his profile of KongZhong, the sagging wireless-entertainment company. KongZhong gets 88 out of 100 for liquidity, as it generates strong positive cash flow, 79 for profitability and 80 for its debt situation. But it scores only 41 of 100 for its efficiency at using its assets, defined by measurements such as return on shareholders' equity. This is a neutral report. For this, or any other vendor's statistical analysis, to be of any value, the analyst must be confident in the accuracy of the data. Hamilton says he trusts financial statements from Chinese companies that trade on the New York Stock Exchange or Nasdaq because that subjects them to U.S. disclosure rules and generally accepted accounting standards. "I really don't see any alarming trends in the data I'm reviewing," he says. KongZhong's books and financial statements are audited by the Beijing office of Deloitte & Touche, which should mean something. A legitimate audit firm is a must for you to even consider a Chinese stock. Morningstar, Zacks, S&P and a few other well-known sources of consumer-oriented investment research have also decided to start reporting on Chinese ADRs. Sometimes, their commentaries are detailed and other times, cursory. So their reports are just starting points. There's much more on the companies' Web sites and in filings with the Securities and Exchange Commission. Company information and investor calls. KongZhong's Web site is in Chinese, but its investor-relations section is in English. It includes the quarterly earnings calls that feature a dialogue with U.S. analysts. On KongZhong's latest call, the chief financial officer, who once worked for KPMG in Los Angeles, said the latest quarter was challenging and otherwise answered questions honestly. Nobody from KongZhong made grand claims or predictions, although the call came several weeks before news that KongZhong had inked an exclusive deal to supply National Basketball Association broadcasts to Chinese mobile devices. The NBA is immensely popular in China, and it's possible that this deal will give a kick to earnings for 2008. All in all, the tone of the call was restrained and informative -- and gave no reason to rush to buy the stock. Neither does KongZhong's annual report. The CEO, who has a master's degree from Stanford University, talks about challenges, such as higher costs to generate new traffic and more competition, as if he were back in California, It's fair to say that this is a reasonably open company. But Chinese firms do not always come across as warm and fuzzy. China Precision Steel (CPSL), which makes high-value, ultra-thin, cold-rolled steel, sounds like a good idea because both China and steel are booming. But in early November, China Precision said it issued 7.1 million new shares (about 20% of the total outstanding) to private investors at $6.75 a share. Since the shares had traded for $10 just days before, either someone got a sweetheart deal or the company suspects it's heading for trouble and has to raise money any way it can. Needless to say, China Precision's Nasdaq-traded shares collapsed quickly, to $5, before settling around $5.50. That's quite a bit of punishment. There was a hint of this disaster-in-the-making on an October 17 earnings call. Having apparently gotten wind of the impending stock offering, an exasperated U.S. investment manager recalled that China Precision Steel had sold shares privately in February at $3 when they were trading publicly for $9.50, and it was now apparently on the verge of pulling a similar stunt. "The stock price doesn't bear much resemblance to what the true value of the company is worth to professional investors?" the American asked. The English-speaking chief financial officer replied that what private buyers are willing to pay to invest in China Precision Steel is different from the public share price. And 80% of the shares are held by insiders. Conclusion: The fundamentals of this business sure are zippy. But China Precision Steel isn't friendly to small investors. The company isn't worth your time or money. All it takes to know that is to listen closely and read diligently. The general rule is that you have know a lot about Chinese companies besides what business they're in and that a billion Chinese are there to buy whatever they make. That's old news. Moreover, P/E ratios can be misleading. China Precision Steel, which closed November 7 at $5.81, trades for only 20 times reported earnings. But with the company's history as a serial share diluter, you shouldn't count on a low valuation to protect you from any future unpleasantness. Speaking of P/E ratios, Chinese stocks may be a lot closer to a bubble than we think. PetroChina, as we saw, has a P/E four times that of Exxon and three times that of Petrobras, a Brazilian oil company that's also based in a high-powered developing economy. Baidu.com, the $400 wonder, is expected to earn $3 to $4 a share in 2008, which puts its P/E ratio in triple digits. Google's is 37. And on and on. In China, even the blue chips are now expensive. The funds. The logical alternative for most people is to invest in China through a mutual fund. One of the best is the no-load Matthews China Fund (MCHFX), which concentrates on established companies, such as China Mobile and China Life Insurance. But it invests heavily in Hong Kong companies, including a big slug of banks and real estate. Because of the holdings in Hong Kong, where the Hang Seng index is up only half as much in 2007 as the Shanghai market, some may find this fund too tepid. However, a talented, experienced fund manager is more likely to exercise common sense than to chase crazy stories, and Matthews's managers have plenty of experience in China. The fund is up 95% in 2007. The closed-end Greater China Fund (GCH) has a similar portfolio to Matthews. Year-to-date through November 2, the fund returned 92% on its assets. It trades at a 15% discount to the net asset value, but it is highly leveraged, with 20% of the fund's assets bought with borrowed money. That adds extra risk to what is shaping up to be a highly risky place to invest.