Introducing a Safety/Risk Model for U.S.-listed China Stocks
posted by The Traveller on Sunday, January 30, 2011

The idea is to create a basic and objective safety/risk score based on public, verifiable, and comparable information, as a starting point to identify possible problems with U.S.-listed Chinese companies (here STAGE ONE).

The two stages are important because STAGE ONE is objective, based on publicly available information, using the same sources for all U.S.-listed Chinese stocks. Every individual investor can assess risks and safety with a bit of work in less than one hour. STAGE TWO is subjective, based on personal, individual research that can be time-consuming, costly, also requires profound knowledge of the Chinese language and legal system. Most investors will not be able to pull this off on their own, and those who rely on other people's work will have to trust their judgment and believe in their thoroughness.

The general idea behind this model is that a company that fails STAGE ONE is not "investment grade" unless it passes STAGE TWO. A company that passes STAGE ONE can very well turn out to be a fraud in STAGE TWO, however the risks should be contained with a good score in STAGE ONE. The thesis is that for a standard retail investor a STAGE ONE pass should provide reasonable safety. For investors looking to build a large position in a Chinese stock, for high net-worth individuals, institutions etc. a STAGE TWO pass should be a requirement.

I will introduce the Trading China Safety/Risk Model in a series of posts over the next 2-3 weeks, followed by a few sample companies for STAGE ONE of our model. Be warned, there will be a lot of text to read, often rather dry information to digest. This is the basic structure of STAGE ONE:

  1. Going Public (accounts for 10% of the final score)
  2. Auditors (30%)
  3. Internal Controls (5%)
  4. Chief Financial Officer (7.5%)
  5. Board of Directors (7.5%)
  6. Ownership (10%)
  7. Equity Financings (10%)
  8. Stock-Based Compensation for Services (2.5%)
  9. Legal Matters (5%)
  10. Communications (12.5%)

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