15 Due Diligence Red Flags for U.S.-Listed China Stocks

This is a follow-up article to the one that appears here.

In part 1, I discussed how the structure of the company (reverse merger) could be a red flag. Now we look at other aspects that play a role in finding well-managed U.S.-listed China stocks.

Every investor in the U.S. China space approaches due diligence differently. Some look to SEC-filings, some may request information in a detailed manner all at once, while others may simply request information at different times or stages. Regardless of an investor’s method to obtain information on a potential company, it is a proven fact that exercising thorough due diligence is indicative of more profitable returns.

When it comes to doing due diligence, Yibing Wu, President of CITIC Private Equity Funds Management (a subsidiary of the Chinese state-owned conglomerate CITIC Group), says financial statements of Chinese companies tend to be "less trustworthy" than those of western companies. To discover the truth, Wu relies on the global "Big Four" accounting firms to audit target portfolio firms, as well as on CITIC's own due diligence measures.

"We interview the suppliers, we interview the customers, the competitors, and we do cross-checking on inventory," says Wu. "We do cross-checking on receipts and we talk to (employees) at various levels of the company."

The due diligence process mentioned above is hard to achieve if you don't have a sufficiently sizeable due diligence team to do the groundwork in China. So what can we do ourselves to protect our investment?

For value investors, like myself, due diligence is becoming more and more important. Especially after the recent scandals and attacks of short sellers.

Chinese U.S.-listed stocks trading below book value with enough margin of safety built is not enough anymore. Investors in Chinese stocks are faced with cultural differences and unfamiliarity with Chinese (local) business rules. Understanding cultural differences, potential pitfalls and due diligence success factors will help you to approach investing in U.S.-listed China stocks with greater confidence.