Why you must tread carefully in emerging markets

One classic feature of recessions is that people discover just how much fraud and dirty dealing was going on during the boom times. Asia’s no exception, and some of the stories below illustrate why you really need to take your due diligence seriously when you’re investing in emerging markets.

During the good times for example, the Singapore Stock Exchange (SGX) made a big effort to attract listings from Chinese companies. Now a series of scandals among these S-chips is hurting its image as a high-quality market.
 
Take the saga of waste recycler Sino-Environment. You can find the details here, but it involves shares secretly pledged against a hedge-fund loan to the CEO, allegedly missing cash and a public fight between the executives and the independent directors conducted through company news releases. Where the truth lies isn’t yet certain, although a Hong Kong judge’s conclusion [pdf] that the CEO “had exhibited a very low degree of commercial morality indeed” may be a clue.
 
Other disasters include China Printing and Dyeing, FerroChina, FibreChem, China Sun Bio-chem and Oriental Century. Some of these were complete frauds, others may have simply been adequate companies undone by the crisis.
 
These blow-ups raise questions about how the SGX has handled S-chips, from the screening of potential listings to the failure to stop shares in Sino-Env from trading when it was clear something was wrong. The exchange is planning some changes in response, partly because it fears the best-quality listings will flee to Hong Kong.
 
Still, the SGX shouldn’t take all the blame. Caveat emptor applies with stocks like these. Asian small and mid-caps are under-researched and offer plenty of opportunities, but it’s best to focus on established ones with a long trading history. With new, obscure stocks, there’s only room for a couple in a portfolio and they need to be bought cheap to offset the risks.

And watch out for the warning signs. With Sino-Env, the CEO’s weakness for risky finance was apparent even though his loan wasn’t public. The firm had issued a convertible bond with an attached derivative that in effect turned Sino-Env into a bet on its own share price. I ran an eye over the stock before the scandal and that was a big red flag.

• Every Monday, Cris Sholto Heaton writes MoneyWeek Asia, the free weekly email of news and investment ideas covering Asia.
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