Press reports over the past several months have outlined questions that have arisen about the financials of some Chinese companies, both ones where western hedge funds have made substantial investments and ones that have achieved “backdoor listings” in the US.

(Backdoor listings are  mergers of unlisted companies into already-listed corporations.  They come in two flavors:  merger into a shell company, created solely to be used in this manner; and merger into a once-vibrant firm that has an actual business that has fallen on hard times.  These are “reverse” mergers, in the sense that the acquired firm runs the combined entity.  Typically, the company name is immediately changed to reflect the new owners’ business.)

the more things change…

I don’t find this fact surprising.  This is a typical issue with any emerging market.  It has been a particular issue in China for at least twenty years.

…the more they remain the same

What I do find surprising is that investors continue to fall for the same tricks today that they did back then.  This also happens despite the financial press being filled with stories that recount the fact that financial intermediaries who promote these companies to investors, both in general and in the particular case of emerging markets specialists, have very little regard for their clients’ well-being.  Their main concern is their own profits. The current disputes between government-controlled institutional investors and their custodial banks about systematic overcharges on their foreign exchange transactions is an especially telling example.

In addition, anyone who has read a book on developing countries or sat through the first day of an economics or finance course on this part of the globe knows that a key issue for governments in such areas is to avoid selling their economic crown jewels for a pittance to wealthy foreigners.

Why?

Why, then, do investors repeat the same kind of mistakes over and over again?  I think there are three main psychological factors:

1.  Successful professional investors  often tend to think that the same characteristics that made them winners in their home markets will make them successful elsewhere.  Every marketing person they associate with, from their in-house staff to the institutional salesmen who vie for their commissions business, encourage them in this belief.  So they end up not preparing well for potential differences in new markets they may enter.

2.  Rookie investors tend to underestimate the collective intelligence of the guys on the other side of the trade.  In a similar vein, even professionals entering developing markets sometimes think that because they are wealthier than local investors, they are somehow smarter. The opposite is invariably the case when it comes to securities in the local arena.  As a result, they don’t do enough research.

3.  Investors of all stripes tend to rely too much in developing markets on the advice of the brokers they do business with.  The latter group’s primary allegiance is normally to the political and corporate leaders of the developing country, for whom they hope to do amounts of financial business that dwarf what they can expect from any class of portfolio investors.

what to do?

I think there are for strategies you and I can use to participate in developing markets while limiting the risk of exposure to companies with questionable financial reporting.  They are:

1. use emerging markets index products.

2.  in emerging areas, use actively managed mutual funds run by seasoned management organizations with a long record of success.  The Matthews China-related funds are a good example.

3.  buy companies like TIF that are traded in developed markets and have accounts audited by well-known accounting firms, using accounting principles you understand, but which have significant exposure to–and success in–developing markets.