Some Chinese stocks that trade in the United States may disappear. What there is to know.

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The giant “attention” sign for investors who own Chinese stocks has been blinking for months. It is about to become a resounding warning signal.

Individual investors who still own, or plan to own, individual stocks of Chinese equities listed in the United States should heed this warning. Barron wrote about the challenges Chinese companies face on multiple fronts: Beijing has steadily stepped up regulatory oversight of its biggest tech companies, as US-China tensions escalate and result in investment restrictions and legislation that create new ramifications in the market.

Yes, the case for investing in China is strong, especially in the long term. China’s rapid economic growth is generally attractive and has led to a burgeoning middle class which has, in turn, enabled many infant industries to flourish. Additionally, many Chinese tech companies are benefiting from government investment and US-China tensions. But as Barron wrote earlier this month, the way to navigate this landscape is to hire a tour guide in the form of a mutual fund or exchange-traded fund manager who can handle the growing complexities.

Each week makes this case even stronger. Owning individual stocks of Chinese companies listed in the United States, whether traded over-the-counter (rather than on a major exchange) or as American Depositary Receipts (ADRs), could increasingly become a proposition. risky. Institutional investors who have the option of owning stocks on a Hong Kong or mainland stock exchange are on track for this transition, which could increase pressure on US-listed stocks and potentially cause trading problems. liquidity.

The heavy ADR

Invesco Golden Dragon

Exchange Traded Funds (PGJs) are down 13% in the past three months. IShares MSCI China (MCHI), which also owns shares listed in Hong Kong, is down 4%, and iShares MSCI China A-shares (CNYA), which focuses on listed companies in China, is up 7%.

The latest cloud hanging over Chinese companies listed in the US is uncertainty over how US regulators will enforce last year’s Holding Foreign Companies Accountable Act, which requires foreign companies to adhere to standards. ‘American audit in order to trade on the American stock exchanges. The Chinese government has long prevented Chinese companies from providing the information necessary to comply with US audit requirements.

The application process is underway; the feedback period for a Public Company Accounting Oversight Board (PCAOB) proposal ends this week, and policy watchers expect a rule to be released soon. A spokesperson for the PCAOB declined to comment. The rule will pave the way for the Securities and Exchange Commission to enforce the legislation. Currently there is a three year window for compliance; Last month, the Senate passed a bill that would speed up the deadline to just two years, another indication of bipartisan support for Chinese measures.

Despite the urgency of policymakers, policy watchers note many outstanding questions. There are some 248 Chinese companies listed on the US stock exchanges with a combined market value of over $ 2,000 billion, so the delisting process could be complicated and painful. “If a delisting is imminent, the share price will drop and those who control the company can buy out public investors for a good deal, go private and re-register in Asia at a much higher valuation and earn a ton of money. ‘money – in Americans’ “spending,” says Jesse Fried, a professor at Harvard Law School who has studied the regulation of Chinese companies trading in the United States.

There is also no precedent for the kind of massive radiation that could unfold in a worst-case scenario, a factor that could lead to an elusive compromise between the two countries. “Despite the continuing and heightened tensions between the United States and China, this could be the final salvo bringing the two sides to the table to find a deal where there will be just enough access to audit staff and documents. work to avoid the nuclear option and the PCAOB will be able to meet its core obligations under Sarbanes-Oxley, ”said Shas Das, legal counsel at King & Spalding, who was the chief negotiator of the PCAOB with Chinese regulators between 2011 and 2015. Past negotiations have resulted in some cooperation and access to audit working papers, but not systematically, he adds.

Investors would be ill advised to wait and see if a compromise materializes, especially as US-China tensions continue to mount. On Thursday, the Senate passed a bill banning products imported from China’s Xinjiang region amid allegations of forced labor practices, and the United States added Chinese companies to a blacklist, cutting them off from investment Americans.

Investors had a painful glimpse of the havoc these measures can wreak when widely spread

China mobile

was delisted in January by the New York Stock Exchange, following an executive order by President Donald Trump banning investments in companies that the United States says had ties to the Chinese military. Institutional investors have been able to convert to Hong Kong-listed stocks, but many retail investors have been left in limbo – even now, many investors cannot execute a sale at their current broker, and some are urged to look for foreign brokers. Others have found themselves in a bind with no idea where to turn for help and face loss. The SEC did not respond to a request for comment.

While regulators can find a way to compromise or help small investors, it’s best to avoid getting into a potentially sticky situation. “It puts people in this Kafka situation where they can’t move forward,” says Andy Kapyrin, co-head of investments at RegentAtlantic, which oversees $ 5.5 billion in assets. “For typical people with Chinese ADRs, there is a risk: if they are not aware of the evolution of this legislation, they may end up owning a written off ADR which becomes very difficult to negotiate. Kapyrin uses an ETF for the China allocation of its clients.

Many large Chinese companies, including

Alibaba Holding Group

(BABA),

JD.com

(JD), and

Yum China

(YUMC) have looked for secondary quotes closer to home, and many U.S. fund managers have turned to these quotes. It’s a relatively easy decision for mutual fund managers; less for retail investors because some brokerage firms do not allow direct access to foreign markets.

One more reason to avoid Chinese stocks: The long controversial corporate structure used by many Chinese companies to bypass Beijing’s restrictions on foreign ownership, known as variable interest capital, receives renewed attention as Chinese regulators tighten control over foreign listings. Most analysts don’t expect the structure to be turned upside down, but increased attention could highlight the risks and compress the valuations of Chinese stocks listed in the US.

In the short term, these clouds are sufficient for Kapryin to reduce clients’ allocation to China from an overweight to a market weight. He is not alone. The weight of China in Cathie Woods

Arche Innovation

The ETF (ARKK) is down to less than 1% from 8% in February.

Short-term volatility, however, can be a good opportunity to build long-term positions. Investors should stick to China-focused mutual funds and exchange-traded funds that can navigate the lingering complexities of the US-China relationship and spot companies that may be less vulnerable to blacklists and regulatory changes. .

Write to Reshma Kapadia at reshma.kapadia@barrons.com


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