"China" Stocks—Look Beyond the Name Before You Invest
Economic growth in China and performance by the Shanghai and Shenzhen Composite Indices periodically fuel the touting of low-priced "China" stocks. But some of the companies 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:
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, hundreds of 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).
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:
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.
Touts and outright scams come in many forms and involve many types of investments. When one comes your way, 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 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:
If, having taken these risks into account, you decide to seek exposure to the Chinese market, you might find these tips helpful:
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.
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