Will China Ever Be Safe Again?

It's not easy being a bull on Chinese growth stocks these days. A few meaty trends and news events this year are disrupting the allure of some of the market's fallen darlings.

Playing horseshoes with a crooked horse
The first shoe to drop picked off small Chinese growth stocks. Cynical bloggers and small newsletters raised fraud allegations. Skeptical investors bailed, even when the companies defended their stances. Why risk trusting the financials of some obscure company at the other end of the world, even if it meant letting the shorts win?

The second shoe to drop was the great Alipay swindle. China's Alibaba -- one of its most endearing dot-coms and a champion of consumer- and corporate-facing e-commerce -- transferred its valuable PayPal-like financial transaction platform to a new entity without compensating minority investors Yahoo! (NAS: YHOO) and Softbank.

The parties ultimately settled their differences, but not before investors outside of China saw how even a respected company could attempt to cheat its foreign investors.

There weren't too many stocks left standing tall after these two waves of credibility smackdowns, but there were a few darlings sill holding up. Search leader Baidu (NAS: BIDU) was faring well given its heady growth and undisputed market leadership. SINA (NAS: SINA) was rocking on the booming popularity of its Weibo micro-blog platform.

Well, that changed once reports began surfacing of China looking into the variable interest entities structure, the corporate structure employed by many stateside-listed companies to circumvent rules restricting foreign ownership.

In other words:

  • You don't know what you're buying.

  • Even if you know what you're buying it can be taken from you.

  • Guess what? You may not even be able to own it at all!

If you thought that it couldn't get any worse, the galloping you hear is the fourth horseman of the Chinese stock apocalypse.

Listen for hoofbeats
Baidu and SINA -- along with portal operator Sohu.com (NAS: SOHU) and video-streaming website Youku (NYS: YOKU) -- are off by double digits this afternoon.

Reuters is reporting that the Justice Department is joining the SEC and FBI in actively probing allegations of accounting fraud in U.S.-listed Chinese companies.

There are no names being revealed, but investors appear to be selling because it's better to be safe than sorry. Even if most of the companies are ultimately cleared, a bad actor or two in the probe will be enough to once again distance growth investors from the allure of Chinese investments.

It's a pity because investors who buy into the companies that are ultimately cleared will come out nicely -- if the Chinese government allows variable interest entities to continue.

At its intraday low today, Baidu was trading at just 24 times next year's projected profitability. Before you argue that a forward earnings multiple in the mid-20s isn't cheap, keep in mind that the pros feel that China's dominant search engine will grow its bottom line by 90% this year and more than 50% come 2012.

Online gaming leader NetEase.com (NAS: NTES) -- one of the few Chinese dot-com darlings that is holding up relatively better today -- is now trading for just 10 times forward earnings.

Do the right thing, China
There is nothing that China can do to change the facts. If the stateside probe uncovers dirty accounting, credibility is going to be a problem. However, China can also help by going public with its decision on variable interest entities.

China can't just play it cool as the new speedster in town. Even China's once red-hot economy is showing signs of simmering down.

Copper imports, for example, are down 26% so far this year. Unlike the more "precious" metals, copper is a popular gauge of economic health given its popularity in everything from wiring to plumbing. In other words, even the rightfully cocky China can't afford to be shooing away outside investors these days.

China will do the right thing, and many of these beaten-down Chinese stocks will bounce back. How confident am I about that last statement? Well, I'm not as sure as I used to be, but I guess that's part of the problem.

If you want to see where these Chinese stocks go from here, add them to My Watchlist to track news as it happens.

At the time thisarticle was published The Motley Fool owns shares of Yahoo!.Motley Fool newsletter serviceshave recommended buying shares of Yahoo!, Sohu.com, Baidu, NetEase.com, and SINA. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.Longtime Fool contributor Rick Munarriz calls them as he sees them. He does not own shares in any of the stocks in this story. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

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