The dark side of investing in China

Tom Bulford examines the pitfalls of investing in China by highlighting the experiences of three small-cap companies.

I have written many times about some of the potential dangers of doing business with the Chinese, and some readers don't seem to agree with me. Lately I have come across a little more supportive evidence - a juicy murder that may put you off China for good...

Pacific Ores Metals and Chemicals is a Hong Kong-based trading company specialising in rare earth metals. A few years ago the company got into a dispute with a mainland Chinese refinery. These refineries are sometimes run by businessmen whose methods are, to say the least, unscrupulous. Mines are often opened up quite illegally, toxic chemicals are dumped in the local water supplies and estimates suggest one-third of China's rare earth production is smuggled out of the country.

With rare earth prices having trebled in the last year, the profits are worth the occasional run-in with China's supine law enforcement agents or, more likely, a brown envelope passed to the hand of the district chief.

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As a way of settling Pacific Ores Metals' $5m business dispute, the Chinese refinery did not 'put the matter in the hands of its solicitors'. In China arguments are settled in a different way. Thugs abducted the general manager of Pacific Ores, Constant Li, took him to the Hong Kong office one night, bound him to a chair, gagged and blindfolded him and ripped open his throat.

Arriving the following morning for her first day in a new job, a secretary found the body. There was blood everywhere. She never came back.

This was no isolated incident. Take Exhibit B - Chinese travel agent Et-china (LON:ETC)...

How to travel nowhere fast in China

Et-china (ETC) came onto AIM in August 2007, in a flotation that valued the business at £42m and netted various advisers including Seymour Pierce £2m. The Admission document enthused about the prospects for the burgeoning Chinese tourist market but things did not work out quite as planned.

In its first full year as a public company Et-china plunged into a loss of £6.8m - a loss which Chief Executive Matthew Ng strangely chose to describe as a "strong trading performance". And things did not get much better in 2009. That year it lost £3m despite which Matthew Ng, by now president and interim chairman as well as chief executive (nobody would dare argue with him, then!) was able to report that Et had become "the travel services market's dominant leader in South China".

Suitably impressed, the Swiss travel group Kuoni shelled out several million to buy a 32% stake in the business in June 2009. A year later -having, one might assume, got to know the business intimately -it decided to buy out Et-China in its entirety. The share price trebled. And then the fun started.

A month later we learned that Et-China had been unable to file its accounts for 2009. The shares were suspended. Then, before Christmas, Mathew Ng was "detained by Guangzhou police as part of their investigations as a suspect of the crime of misappropriation of company assets". Kuoni dropped its bid, the listing of the shares was cancelled and whether shareholders will ever get any money back, I doubt.

Now consider exhibit C....

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You simply can't reckon with this government

Exhibit C is Oxus Gold (LON:OXS). Oxus has a big gold mining project in Uzbekistan. A year ago it announced that a consortium of Chinese investors had agreed to provide finance of $185m, subject to receiving approvals from the Uzbek and Chinese governments. "Oxus will also be able to draw on the concert party's extensive technical expertise", gushed Oxus chairman Richard Shead, "and we very much look forward to working with them". Here is how matters proceeded.

In June, Oxus reported that discussions regarding the necessary foreign investment agreement with the Uzbek government were "well underway and we anticipate concluding this agreement in the near future". Shortly afterwards, the Uzbek government, possibly afraid of upsetting the Chinese, dropped this condition of the financing. That just left Oxus and the financing consortium needing approval from the Chinese government. "The most critical of the approvals necessary has been granted", investors were informed, "while the other two largely administrative approvals are being processed without any known issues".

The final act came on 30 December. Oxus revealed that these approvals were not forthcoming from the Chinese government. This, according to John Meyer of Fairfax Securities, was "the polite message". "The less polite version", he continues "is that Oxus and the consortium have been strung along by the Chinese ,who may have an alternative agenda in the region." I rest my case.

The truth is that you can't afford to second guess the political games going on along the old Silk Road. There is a very real chance that you will experience a few nasty surprises along the way.

In fact, just about the only sensible way I've heard to invest in China recently was an idea I discussed with Joss Smith of the Zurich Club. I've told you about this idea before - its aim is to 'tap' the thundering traffic volumes passing through Asia's airports and shipping lanes.

It's a chance to gain exposure to the burgeoning network of trade links that support Asian economies.

It's about 30 minutes long, and explains the risks and potential rewards on offer. But it's a smart and engaging idea, so I'm sure the time will pass quickly.

The Zurich Club is a regulated product issued by MoneyWeek Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Customer Services: 0207 633 3780.

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.

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