"China" Stocks—Look Beyond the Name Before You Invest

Economic growth in China and strong performances by the Shanghai and Shenzhen Composite Indices are fueling the touting of low-priced "China" stocks. But some of the companies being touted all too often have no actual connection to China's stock markets.
 
As with other market sectors, there are legitimate and not-so-legitimate ways to invest in China.  We are issuing this Alert to warn investors about phone, fax, email and even cell phone text message scams that promote the certain "hot" China stock and to provide information on how to invest wisely in China.
 
Spotting "China" Stock Scams

 

One fax promoted a China stock with the headline, "Grabbing massive profits in China has never been easier than right now!"  It went on to promote a company whose shares were "ripe to pop" for "a low price that's unheard of, and quite temporary." The fax went on to urge investors to "load up on the stock now!"  Fraudsters use these efforts to pump up the stock's price, then sell off their shares, usually leaving investors with a stock valued at much less than when they purchased it. 
 
As with other types of stock scams, unsolicited phone calls, faxes and spam about "China" stocks may include:
 

  • Price targets or predications of swift and exponential growth.
     
  • The use of verifiable demographic facts to bolster claims of a price run-up, such as making a direct link between a stock's growth prospects and China's growing middle-class population.
     
  • Claims that making profits in China are "easy."
     
  • Mention of associations with, or actions by, the Chinese government that bolster a company's product or service.
     
  • The use of headlines from respected financial news sources regarding China, which can easily be taken out of context.
     
  • Mention of the names of major investment banks to give the air of credibility.|
     
  • Statements correlating growth in the touted company with growth success stories of other Chinese companies. Sometimes the only similarity is the use of "China" in the company name.
     
  • Statements about how much easier it is for lower-priced stocks to skyrocket in value in comparison to higher-priced stocks.
     
  • Pressure to invest immediately.

 

Look Beyond a Company's Name


The fact that a company has "China" in its name can be misleading. The company might not be incorporated or based in China, and it may be very difficult to assess how much, if any, business the company actually derives from China.

 

Also be advised that stock promoters often change a company's name and trading symbol in an apparent attempt to align it more closely with a current event or issue. The company referenced above went by five different names and trading symbols in five years, with none of the previous names even remotely suggesting an affiliation with China. It also changed the jurisdiction in which it was incorporated, shifting from California to British Columbia, Canada to Nevada.

 

You can learn more about a company by checking the SEC's EDGAR database. If the company is registered and files reports with the SEC, read those reports carefully and independently verify any information you have heard about the company. Changes in a company's name, trading symbol, and articles of incorporation—and other key corporate events—are reported through SEC Form 8-K.

 

Be sure to take a look at the company's description of its business, which you'll find in the company's Form 10-K (or, for small businesses, Form 10K-SB). Again, each time the company cited in our example above changed its name it also changed its business focus—from 3-D video editing, to oil and gas exploration in North America, to mining in the U.S. and China, back to oil and gas exploration in North America and ultimately to fax machine distribution in China.

 

Find Out Where the Stock Trades

 

Most unsolicited spam recommendations involve stocks that can't meet, or choose not to meet, the listing requirements of The NASDAQ Stock Market (NASDAQ), the New York Stock Exchange (NYSE) or other registered national securities exchanges.  Instead, these stocks may be quoted on an OTC quote platform (e.g., the FINRA-operated Over-the-Counter Bulletin Board (OTCBB) and the platform operated by OTC Markets Group, Inc., formerly known as the Pink Sheets).  As of April 11, 2011, over 300 companies with "China" in their name are currently quoted in the OTC market.  In contrast, just over 50 companies with "China" in their name trade on NASDAQ, 27 trade on the NYSE Equities and 12 on the NYSE Amex Equities.

 

There are important differences between trading OTC securities that are not exchange-listed and trading securities that are formally listed on exchanges such as NASDAQ and the NYSE:
 

  • Generally, there are no minimum quantitative standards that a company must meet to have its securities quoted in the OTC market. While OTC market companies have no obligation to file annual or quarterly reports with the SEC, certain OTC quote platforms require quoted companies to file timely financial reports.
     
  • Foreign issues must generally be registered with the SEC and file financial reports to trade in the OTC market, but may also be eligible for specific registration exemptions.
     
  • Many of the securities quoted in the OTC market, including securities quoted on quote platforms operated by the OTC Markets Group, Inc. do not have a liquid market. They are infrequently traded and can move up or down in price quickly. This may make it difficult to sell your security at a later date.

 

Don't Be a Scam Victim

 

To avoid potential stock scams, make sure you look beyond a company's name to get the information you need to make a wise investment choice.
 

  • Investigate before you invest. Never rely solely on information you receive in an unsolicited fax or email. It's easy for companies or their promoters to make glorified claims about new products, lucrative contracts, or the company's revenue, profits, or future stock price.
     
  • Always ask: "Why me?" Another tip-off that you're potentially being scammed is that the message is unsolicited, which raises the obvious question: Why would a total stranger send you an email about a really great investment opportunity? The answer is that there is no such opportunity for you. In many email and fax scams, those who tout the stock are corporate insiders, paid promoters, or substantial shareholders who stand to profit handsomely if the company's stock price goes up. If you're suspicious about an offer or if you think the claims might be exaggerated or misleading, please contact us.
     
  • Read a company's SEC filings, if available. Most actively traded public companies file financial reports with the SEC. Check the SEC's EDGAR database to find out whether the company files with the SEC.Read the reports and verify any information you have heard about the company. But remember that just because a company has registered its securities or has filed reports with the SEC, it doesn't mean that it will be a good investment. Be alert to changes in the company's name and trading symbol, reported through SEC Form 8-K. Stock promoters often change a company's name and trading symbol in an apparent attempt to align it more closely with a current event or issue.

 

Touts and outright scams come in many forms and involve many types of investments. Right now, you would do well to avoid unsolicited promotions of low-cost "China" stocks. They spell high risk in any language.

 

Be Wary of Reverse Mergers

Investors may come into contact with China stocks that trade in U.S. markets as a result of a reverse merger. How does a reverse merger work? A private operating company merges into a non-operating or shell public company. In the merger, the operating company shareholders are issued shares of the shell in exchange for the operating company shares. Post-merger, the former operating company shareholders own most (80-90 percent) of the shell, which now contains the assets and liabilities of the operating company. The remaining shares continue to be owned by the shareholders that controlled the shell before the merger. The shell company’s name is then changed to the name of the operating company, with shares trading on a U.S. exchange or—as is more often the case—quoted on an OTC market quotation system. For example, this is how a public shell company that once operated gaming concerns in Nevada might re-emerge as a Chinese company that makes bamboo carpet in Beijing.

There are legitimate reasons why a Chinese company might engage in a reverse merger, including the hope of tapping the U.S. market for capital or an attempt to build U.S. exposure and a U.S. investor base. That said, reverse mergers rarely raise any capital for the operating company, and may subject it to dilution and transaction costs, as well as the ongoing expenses of being a reporting company. Furthermore, investors run the risk that the new company will fail or lose value. The stock may also be subject to manipulative trading or financial fraud, as recent SEC actions underscore. For instance, in April 2011, the SEC suspended trading in the stock of a Nevada corporation that previously had been involved with gaming but recently purported to have become a Chinese mining entity, with headquarters and operations in the People’s Republic of China. And in July 2012, the SEC charged a New York-based investment manager and two of his firms with numerous securities law violations related to activities involving a Chinese reverse merger company.

 

Understand the Risks of Investing Internationally

 

International investments, including China stocks, are subject to political, economic, and social risk factors, accounting and regulatory standards that may differ from those in the U.S., as well as currency fluctuations that can affect investment return. Also keep in mind that your risk increases when you invest in a single country, and when you invest in emerging market economies. Foreign stock investing carries additional risk, including:
 

  • currency risk;
     
  • the risk of inadequate or imperfect disclosure of financial information;
     
  • differing legal procedures;
     
  • differing stock market operations; and,
     
  • potential lack of liquidity.

 

If, having taken these risks into account, you decide to seek exposure to the Chinese market, you might find these tips helpful:

 

  • Don't put all your eggs in one basket. As with domestic investing, diversification is a tried and true way to balance risk and reward. While you may be tempted to invest in a single stock, investing through a mutual fund or exchange traded fund (ETF) that focuses on Chinese companies can help spread out and lower your risk. As with any mutual fund or ETF, take the time to research fees and other expenses, as well as the expertise of the fund's manager or management team. Read the fund's prospectus carefully and considering enlisting the help of an investment professional before you invest.
     
  • Know your direct investment options. U.S. investors may invest in individual stocks that trade on Chinese stock markets through ADRs, U.S.-traded foreign stocks, and directly through "B" shares of stocks that trade on the Shanghai and Shenzhen stock exchanges and "H" shares that trade on the Hong Kong Stock Exchange.

    • ADRs are issued by U.S. depositary banks and must meet listing requirements of the U.S. exchange on which they trade or otherwise be eligible for public trading in the OTC market. While ADRs can, and do, trade on the OTCBB and may be quoted through the Pink Sheets, these companies often have not registered with the SEC. U.S.-listed ADRs clear and settle in U.S. dollars, with the price of the ADR closely corresponding to the price of the stock in its home market. For more information on advantages and disadvantages of ADRs, see the SEC's brochure, International Investing, Get the Facts. U.S.-traded foreign stocks trade in the U.S. markets in the same form as they do in their home market. Foreign stocks are identified by a trading symbol with a fifth character "F." Be aware that while some "China" stocks do indeed trade in Chinese markets (for instance as "H" or "B" shares), others trade in non-Chinese markets such as Canada and as such may have little direct Chinese connection.
       
    • Chinese "B" shares list and trade on Chinese stock markets and are designated for the non-Chinese investor. "B" Shares that trade on the Shanghai Stock Exchange are listed in U.S. dollars, while "B" Shares listed in Shenzhen Stock Exchange are listed in Hong Kong dollars. "H" shares are issued by companies that are incorporated in Mainland China and listed on the Hong Kong Stock Exchange and may be purchased by non-Chinese investors. To garner the attention of the international investor, "B" and "H" shares may use enticing company names, including the word "China" in the name, to pique investor interest. 

If you choose to invest in any of the investment vehicles listed above, it is prudent to work with a registered U.S. investment professional with experience making Chinese investments and a positive track record of doing so. Also be aware that it's against the law for unregistered foreign brokers to call you and try to sell you securities. You can check out a broker or brokerage firm by using BrokerCheck.
 
In short, while international investing can open up growth and diversification opportunities, be aware of the additional risks that come with it, and be prepared to do your homework.
 

Additional Resources


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Last Updated: 8/1/2012