Emerging markets have always been perceived as high risk investments. However, over time, the potential payoff could outweigh that risk for many investors. There is a learning curve as countries move into the global market place where, occasionally, major mishaps send investors reeling, driving the market to question the legitimacy of these opportunities and the maturity of the space.
China is one market that is often undervalued because of these fears. Investors often mistrust Chinese companies' transparency or misjudge the Chinese government's ability to fine-tune its economy, thus impacting the greater markets valuation.
While it is not a completely unfounded concern, it can be easily disproved with a mild assessment of the company of interest. That is to say that any company is capable of releasing false information, but due diligence and quality control can quickly sort the quality companies from the "bad seeds." Unfortunately, recent investor attitudes have shown that one sour grape can spoil the bunch, but that needs not be the case.
Consider, for example, Rino International (OTC: RINO). The company's suspicious activity raised red flags not just among its investors, but across the board -- its contracts and earnings just did not add up. What followed was an investigation that halted the company, revealed misstated numbers and led to them being delisted from NASDAQ.
Shareholders suffered a loss of roughly 80% of their investment. At this cost, investors may now proceed with extreme caution, if at all. While this is one way to avoid risk, it is also a way to neglect tremendous opportunity. At an annual GDP growth of more than 9% in the last 30 years in a row since 1980, China's GDP has doubled every 7 years.
Additional factors that have led to undervaluing of Chinese stock are the misunderstood macro economy. An example of such is that "naysayers" of China have been anticipating China's sudden economic meltdown in the last twenty years. Reality is that China's GDP has more than tripled in the last two decades. As China's economy continues to expand and its population continues to grow wealthier, significant China domestic demand for goods and services naturally turn the country into a huge domestic consumer market -- with a population about 5 times as many as in the United States.
Much of such negative perception towards China stems from North American institutional investors' detachment from China -- its language, its culture, and the face-to-face interaction with its companies. A lack of information and the mentioned concerns over transparency and credibility of a company can lead to mispricing.
The opportunity pool in BRIC markets for foreign investors is simply too large to dismiss on weary assumptions.
To mitigate risk and keep the door to China-based opportunities open, consider using the subsequent three tools when considering an investment:
A starting point for investors interested in the large return potential of China-based companies is to compare how the company is trading between the U.S., Hong Kong and mainland China.
For example, there are a number of companies that are trading at 5 times their earnings in the U.S., while companies in the comparable industries in China are trading at 50 times their earnings. It reflects the need for U.S. sources to gain a better understanding of China's macro economy and the underlying segments, but -- for the investor -- it can be a good litmus test for determining which company is a wise investment with a strong potential for future value growth.
2. Research and Due Diligence
Stand-alone, top-line research is not enough when it comes to any form of due diligence, but especially when applied to BRIC investments. Brazil, Russia, India, and China are all hosts to rapid economical growth, flourishing consumer markets, and foreign interest. They are not, however, without risk -- as are most companies with a high ROI.
To mitigate loss and maintain a stable, lucrative portfolio, investor institutions must look beyond balance sheets and earning statements. And, therein lies the crux of local-to-foreign investments. One way to determine whether a retail company's earnings are accurate and whether sales are as promising as stated is to look to its value chain. Is the company ordering quantities of material that agree with its announced sales? Local knowledge and cultural familiarity are often critical to successful due diligence.