With the U.S. facing fiscal-cliff chaos and the recent announcement by the Economic Cycle Research Institute (ECRI) that the U.S. entered a new recession starting in July, some analysts believe foreign stock markets will outperform U.S. stocks in 2013. For example, Jeremy Grantham of Boston-based money manager GMO believes that 2013 will be a “dangerous year for stocks,” particularly U.S. stocks, with investors facing a better risk/reward in cheaper emerging markets, Europe, and Japan.

Last Sunday (Dec. 2^nd), we learned that China’s manufacturing index registered its first expansion above 50 percent in 13 months! In fact, the Eurozone and several emerging market economies appear to be strengthening at the same time that the U.S. economy is weakening. But relative outperformance by emerging markets does not equal strong performance. In other words, don’t get carried away and bet the farm on emerging markets – the U.S. Conference Board recently said that BRIC growth rates will never return to the giddy heights of the past.

Jim O’Neill, chairman of Goldman Sachs Asset Management, views China as the best investment among of the emerging-market BRIC countries. Similarly, Nomura and Samsung Securities see Chinese stocks stabilizing and rallying into the first quarter of 2013. The main reason for their bullish thesis is that Chinese stock valuations are super-cheap, down to 9.5 times earnings – the lowest valuation since 1997.

Among emerging markets, China is the wild card which may explain the low valuation of its stock market. New Chinese leadership is now in place, which should remove some policy paralysis, but so far stock investors are unimpressed, recently sending the Shanghai Composite Index to 3 ½-year lows below 2,000 for the first time since January 2009. A subsequent rebound provides some hope, however, that the stock-market bottom is now in.

SEC Sues Chinese Accounting Firms

But even if Chinese stocks have hit a bottom, U.S. investors may not be able to participate – at least those who invest in China via American Depositary Receipts (ADRs) listed on U.S. stock exchanges. The reason? On December 3^rd, the Securities and Exchange Commission (SEC) sued the Chinese affiliates of five U.S. accounting firms for failing to turn over audit work papers on Chinese companies listed on U.S. exchanges. In particular, the SEC is demanding that the accounting firms hand over audit information on nine un-named Chinese companies listed in the U.S. that are involved in “potential wrongdoing.” By refusing to name which nine Chinese companies it is concerned about, the SEC has cast a dark cloud of uncertainty on all U.S.-listed Chinese ADRs because investors can’t be sure that any individual Chinese company isn’t one of the nine under investigation. Thanks SEC! Since the beginning of December, Chinese stocks suffering double-digit declines include New Oriental Education (NYSE: EDU), Youku Tudou (NYSE: YOKU), Shanda Games (NasdaqGS: GAME), and 51job Inc. (NasdaqGS: JOBS).

The SEC lawsuit was brought in an administrative court and the administrative law judge has 300 days to render an initial decision, which would place the deadline around the first week of October 2013. This is not the first time the SEC has sued the Chinese affiliates of U.S. accounting firms over audit work papers. In 2011, the SEC sued Deloitte Touche Tohmatsu concerning its audit work for a Chinese company called LongTop Financial Technologies, which has since been delisted and is virtually worthless.

The accounting firms refuse to comply with the SEC document demand because to do so would violate Chinese law, which considers any information about domestic Chinese companies to be a state secret. PricewaterhouseCoopers Zhong Tian, one of the defendants, released the following statement in reaction to the SEC lawsuit:

Today’s action by the U.S. Securities and Exchange Commission is the result of conflicting laws between the U.S. and China. The fact that the action is being taken collectively against all of the four largest audit firms and one other firm demonstrates that this is a profession-wide issue, not unique to one firm. For its part, PwC China has cooperated with the SEC at every opportunity.

However, PwC China will, and must, comply with its legal obligations under China law. This action involves an issue that needs to be resolved between the US and China regulators as it impacts all audit firms in China serving clients who are registered with the SEC. PwC China hopes for continuing dialogue between those two parties to resolve the matter.

If the SEC Administrative Law Judge rules against the accounting firms, penalties could range from monetary fines to revocation of the firm’s registration with the Public Company Accounting Oversight Board (PCAOB). If an accounting firm is decertified, then its audit opinion is invalid in the eyes of the SEC and any Chinese company relying on such an audit will be found in violation of SEC rules and will be delisted from U.S. stock exchanges.

Chinese Accounting Fraud is a Serious Problem

The reason the SEC is playing hardball is because accounting fraud among Chinese companies is an epidemic and U.S. investors are losing billions of dollars. In a September speech, PCAOB board member Lewis Ferguson explained the problem:

Between January 1, 2007 and March 31, 2010, 159 Chinese companies entered the U.S. securities markets using reverse mergers and generated market capitalization of $12.8 billion. In the same period, 56 Chinese companies, including a number of very large state-owned enterprises completed U.S. IPOs and had an aggregate market capitalization of $27.2 billion.

Beginning in the latter part of 2010, alleged financial frauds and serious accounting issues were revealed at a number of the smaller Chinese reverse merger companies. To date, 67 of these China-based issuers have had their auditor resign, and 126 issuers have either been delisted from U.S. securities exchanges or “gone dark” – meaning that they are no longer filing current reports with the SEC.

Billions of dollars of market capitalization of such companies have been lost in U.S. securities markets and it is fair to say that all of these smaller China-based companies listed on U.S. securities exchanges have suffered serious losses of both market value and investor confidence as a result of the problems of other companies.

The potential for Chinese accounting fraud is arguably even more dangerous today than it was in years past because China has started to limit public access to financial reports Chinese companies file with Chinese regulators. U.S. investment research firms like Muddy Waters successfully flagged potential accounting frauds in China by uncovering discrepancies between the financial filings Chinese companies made with Chinese regulators and the financial filings they made with U.S regulators. Chinese companies were much more likely to be honest in their Chinese regulatory filings because accounting fraud in China can lead to a death sentence. Now that a comparison of regulatory filings is no longer possible, Muddy Waters is scaling back its research on Chinese stocks and moving on to more transparent countries like Singapore.

Chinese ADRs Face the Risk of U.S. Delisting

If a stock is delisted from a U.S. stock exchange, it must trade on one of the lightly-regulated over-the-counter markets like the Pink Sheets. The OTC marketplace is the Wild West of stock trading with varying degrees of business quality and financial disclosure, ranging from blue chips like Nestle (OTC Markets: NSRGY) to First Surgical Partners (OTC Markets: FSPI), a company that provides no financial information.

Although getting delisted from a U.S. exchange is not the kiss of death for a stock, the prices of stocks that get involuntarily delisted and forced to trade over the counter typically decline quite substantially. Consequently, the risk of getting delisted may keep Chinese ADRs in a holding pattern until the issue gets resolved – even if the Chinese economy strengthens and its domestic stock market rebounds. Because any delisting would be based on a diplomatic dispute between the Chinese and U.S. government and not based on any evidence of actual accounting fraud, the negative effects on the largest Chinese ADRs with proven business models may be muted. Below is a list of the Chinese ADRs with the largest market capitalizations that are listed on a U.S. exchange:

List of Largest Chinese ADRs

Source: Bloomberg

Bottome line: Until this audit dispute between the U.S. and Chinese governments is resolved, U.S. investors should limit their Chinese exposure to U.S. companies doing business in China, as well as to the largest and most well-established domestic Chinese companies like those listed above. One should also consider expanding investment horizons into other emerging markets that offer better accounting transparency.

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