Are These Risky Stocks Lurking in Your Portfolio?

Apr 08, 2022

Regular Money Talks readers know I’m relatively conservative when it comes to investing.

In fact, my two favorite strategies are as simple as they are safe: I love to own shares of the highest-quality companies – what I call “forever stocks” – for the long term. And I love to sell shorter-term options on those same kinds of stocks for extra income.

So you probably won’t be surprised to learn I’ve never been a big fan of investing in Chinese stocks.

But it’s not because I have anything against Chinese companies, per se. And it’s not because I don’t understand that they could have some tremendous long-term upside potential.

Rather, as a risk-averse investor, they’re too “opaque” for my comfort.

The reality is, investors in Chinese companies don’t have access to the same kind of reliable financial data that we take for granted in the U.S. and other Western countries. And this is generally the case even for well-known Chinese stocks that trade on U.S. exchanges as well.

Unfortunately, that means you often can’t know exactly what you own, or how much risk you’re actually taking, when you buy these stocks. And this has led to serious problems for investors.

One of the highest-profile examples was popular Chinese coffee chain Luckin Coffee, which went public on the Nasdaq exchange in 2019.

Once touted as the Chinese Starbucks, the company saw its shares plunge nearly 98% in early 2020 following reports that it “intentionally fabricated” hundreds of millions of dollars of its reported revenue.

But again, this is just one of several similar stories in recent years.

Why do I bring this up today?

Because this situation may finally be changing.

Since 2002, U.S. accounting law has required that all public companies must have their audited financial results inspected by the U.S. Public Company Accounting Oversight Board (PCAOB).

The PCAOB essentially acts as the “auditor” of a company’s auditors, to help ensure the validity of their results.

However, because virtually all Chinese-based companies also use Chinese-based (and likely Chinese-government-controlled) auditors, China has refused to comply with this portion of the law.

In late 2020, the U.S. government apparently had enough. Congress passed the Holding Foreign Companies Accountable Act (HFCAA) that fall, and it was signed into law by then-President Donald Trump on Dec. 18.

While this should ultimately be a positive for investors, it could create some significant short-term problems.

You see, this new law has given more teeth to the existing law. It effectively allows the U.S. Securities and Exchange Commission (SEC) to ban trading in any U.S.-listed companies that the PCAOB is unable to audit for three consecutive years.

Now, it’s important to understand that this isn’t an immediate concern.

The law only took effect for 2021 financial results, which are only now being officially filed this year. This means the earliest any Chinese company could be kicked off U.S. exchanges would be early 2024.

However, there are still a couple of near-term risks investors need to understand.

First, the SEC started publishing a provisional list of noncompliant companies last month.

It has currently singled out 11 individual companies, which has ramped up volatility in those shares and in Chinese stocks in general.

However, there are still roughly 250 U.S.-listed Chinese stocks that are likely to be added to this list in the weeks and months ahead. Which means the volatility in these stocks could get even worse before it gets better.

Second, and even more important, there is a risk that China could take matters into its own hands prior to this deadline.

The Chinese government is currently in talks with U.S. regulators to allow the PCAOB sufficient access to Chinese companies’ financial data while still protecting what it deems to be “national security” issues.

However, given the recent tensions between the U.S. and China, a deal is far from certain.

Rather than bow to U.S. demands, the Chinese government may ultimately decide to preemptively delist some or all of these stocks from U.S. exchanges. (China’s massive crackdown on its own domestic financial markets last year suggests this is a possibility.)

If it does, the market value of those stocks could plunge virtually overnight.

Given this uncertainty, I think the safest course of action is simply to avoid U.S.-listed Chinese stocks entirely until this matter is settled one way or another.

(If you’re a TradeSmith subscriber, you’re probably already doing this; most Chinese stocks have been in the Health Indicator Red Zone for months now.)

However, if you are going to continue to own Chinese stocks in the meantime, I would urge you to be even more conservative than you would normally be.

As usual, using a trailing stop loss is a must. However, these can’t always protect you from the risk of large declines while the markets are closed. So smart position sizing is particularly important.

For example, you might consider risking only half, one-third, or even one-fourth of the money you normally would in any individual position.

Given the overall risks to Chinese stocks, this same logic might apply to the percentage of your total portfolio you invest in these stocks in general.

And in any case, I would recommend investing no more than you can comfortably afford to lose.