Partnering In China Can Turn Into A Wild West Shoot Out: Caterpillar Inc. (CAT), Yum! Brands, Inc. (YUM)

It Started with Reverse Mergers

That the legal and regulatory framework in China is less rigorous than in the United States shouldn’t come as a surprise to anyone. Several years ago, Chinese companies made a big show of entering the U.S. market with reverse mergers, in which a U.S. shell company was purchased simply because it was listed on a U.S. exchange. Once bought, the Chinese company could claim that it was listed in the Untied States.

Two niche research shops, Muddy Waters and Citron, helped lead the way to discovering some of the most egregious problems. Citron’s website makes some startling claims: “Citron has been covering stocks related to China since 2006. Over that time, we have researched and published about 20 companies. Of these, 16 have suffered losses of 66% to 100%, which we would deem catastrophic, and 7 have been delisted.” Many of the company’s this pair of investigative researchers highlighted were reverse mergers.

So, the problems that Cat and others are seeing in China aren’t really that new.

Long-Term Issue

This issue has long-term implications because of the restrictive nature of the Chinese market. There is, no doubt, huge potential in China. However, it can be something of a wild west because of the less stringent regulatory controls. However, you can’t just walk into the country and set up shop. The government, generally, won’t allow it.

This leaves companies with no choice but to partner with local companies or purchase them outright, if they are allowed. For example, PepsiCo, Inc. (NYSE:PEP) recently teamed up with a Chinese bottler in its effort to gain scale in the Chinese soda wars. It basically gave its operations to the bottler for a sizable ownership position in the company. If irregularities were to show up, Pepsi’s position in the country could, overnight, be materially impaired.

Watch and Diversify

Investors should be looking to benefit from the transition of Chinese citizens from poverty to the middle class. While there are long-term population headwinds that the country will face, its industrialization still has many years to run. However, it’s best if conservative investors take a balanced approach to China. It simply isn’t like investing in the United States. If companies like Cat can get duped, the risks for individuals is that much greater. It’s probably best to stick with U.S. companies looking to expand in that giant nation, while making sure to keep a close eye on the results.

The article Partnering In China Can Turn Into A Wild West Shoot Out originally appeared on Fool.com and is written by Reuben Gregg Brewer.

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