The Risks of Investing in Chinese Companies

The Luckin Coffee scandal has put the spotlight on Chinese companies. We’re going to look at the risks of investing in the world’s second-largest economy

The issues with Chinese companies listed on U.S. exchanges have long been simmering beneath the surface, and quite fittingly, it took a rogue coffee company to make them boil over. The issue resides with Chinese accounting firms and the lack of transparency and oversight given to U.S. regulators and has been a thorn in the side of the U.S. Securities and Exchange Commission (SEC) for a decade.  

In case you missed it: 

In a warning to investors, the SEC released a report Tuesday on the potential pitfalls involved in investing in emerging markets, with the argument heavily weighted towards Chinese companies. One point championed was the fact that the Public Company Accounting Oversight Board (PCAOB), one of the most important tools the U.S. Government possesses in protecting investors, still lacks the power to inspect audits conducted by Chinese accounting firms. This is one of the big reasons why we’ve just been served a steaming cup of scandal by the guys over at Luckin Coffee (NASDAQ:LK). 

The Luckin Coffee Scandal

For those fortunate enough to be living under a rock for the past month, you may have missed this story, and for those who lost 80%+ on their investments, I’ll try to make this as short and painless as possible. 

Hailed as the Chinese Starbucks (NYSE:SBUX), Luckin was fast becoming a Wall Street darling. It was posting incredible growth figures and with more than 4,500 stores and a market cap of $13 billion, it really looked like China’s burgeoning taste for coffee had forged a new competitor to Starbucks’ crown. That was until it came out that its COO, along with a number of other employees, had overstated revenue figures by some 40%. The news destroyed shareholder value to the tune of $11 billion. 

Investors have always been aware of the risks involved in Chinese companies and the potential pitfalls involved in putting your money in our eastern counterparts start-ups and small businesses, but to see fraud at this magnitude will have long-term effects. For an 11 figure market cap company, traded on the Nasdaq and backed by a number of the top institutional investors in the country, to capitulate in such a way has left a jarring impact on the market. Shares in the company have been halted until Nasdaq’s request for information has been granted. The fact that this request was made over a week ago without a response has investors wondering if Luckin is intentionally hiding it, or perhaps just as worrying, can’t find the information requested. 

What does this mean for Chinese companies?

With notoriously high cultural and regulatory barriers to entry, the Chinese market is largely inaccessible for many companies. However, this is not the case for investors. With more and more Chinese companies listed on U.S. exchanges, over 150 at last count, we have the opportunity to buy into the world’s largest addressable market. Companies like Alibaba (NYSE:BABA), China’s answer to Amazon (NASDAQ:AMZN), NIO (NYSE:NIO), the Chinese Tesla (NASDAQ:TSLA), or Baidu (NASDAQ:BIDU), China’s Google (NASDAQ:GOOG) equivalent, are just three examples of Chinese companies listed on U.S. exchanges that are highly popular amongst investors. The fact that all these are Chinese versions of American companies is a testament to how difficult it is to penetrate the market. 

Perhaps the most significant fallout of the Luckin scandal will be the way in which these Chinese businesses are now perceived by investors. For a business at Luckin’s scale to be caught with its pants down brings into question how they were allowed to get this far. Pulling the wool over the eyes of seasoned investors like Lone Pine Capital and Centurium Capital was made easier by the lack of U.S. oversight and will raise questions about other Chinese businesses in the future. 

I’m not saying corruption is endemic to Chinese commerce, nor am I saying businesses based in the U.S. hold themselves to a higher moral standard, but the fact remains that Chinese businesses receive less oversight and are forced to disclose less than their American counterparts. This is an issue that won’t go away anytime soon in the face of heightened political tensions between the two nations and is a risk investors must take into consideration before buying Chinese equities. 

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold positions in companies mentioned above. Read our full disclosure policy here.