I Will Not Be Buying Chinese Small Caps in 2012

If you want to be a better investor, you must learn from your mistakes. In that vein, I'm sharing with you one of my resolutions for 2012: I will not buy Chinese small-cap stocks in 2012.

Though I'll try to convince you to stay away from the small players, I'll also offer up two alternatives that could give you the exposure you need to the world's most populous country.

You don't even own the company
Because of laws forbidding the ownership of businesses by foreigners, Chinese companies listed on U.S. stock exchanges need to create a complicated web of subsidiaries.

Below, I've shown how one entity, Qihoo 360 (NAS: QIHU) , a Chinese Internet safety and search company, has organized itself. As I'll demonstrate, shareholders don't actually own a stake in the company performing the business they're investing in.

Source: SEC filing.

Here's what the picture means: Everything above the dotted horizontal line represents entities outside China; everything below is inside China.

That big box at the top is Qihoo 360, a company that's actually located in the Cayman Islands; that is what you are buying.

Qihoo has three wholly owned subsidiaries in Hong Kong, but we'll focus on Qizhi Software, the subsidiary that's actually located in China and the only one that dips beneath the dotted line. Qizhi itself is just a holding company inside the country. The three dark boxes -- representing actual entities that carry out Qihoo's business inside of China -- aren't owned at all by Qizhi.

If you read the fine print, it says that these three gray boxes are associated through "contractual arrangements." What would happen if those independent organizations go rogue? It may be unlikely, but if they were to do so, investors would be plain out of luck.

Alarming track record
Though the structure of these Chinese entities is suspect, the arrangement alone isn't enough to scare me off. In theory, it's in the best interest of the Chinese companies to remain faithful to their investors (though that's not always the case), or they'll never have access to American capital.

But theory and practice don't always meet up. The last 12 months have served up more than a few claims of corruption and fraudulence -- including accusations targeting the aforementioned Qihoo 360.

Research firm and short-seller Muddy Waters has made a name for itself completing its own due diligence on Chinese companies. In November, the company's founder and only full-time employee, Carson Block, went on CNBC to explain why Focus Media's (NAS: FMCN) management and accounting practices were raising lots of red flags.

In response to Block's assertions, Focus Media -- which provides advertisements on elevators in China -- "admitted that its disclosures on the number of LCD screens was misleading," Block said.

And even though Focus Media said it has hired independent companies to go around and actually verify the number of advertising screens in the country, Block said we simply can't trust those numbers: "The results of those surveys in China are always questionable because of ... private sector corruption." Focus Media, Block argues, is incentivized to hire a company that will give them the results they want, especially because independent verification by Americans is so difficult.

Whom can you trust?
As you can see, this sets up a situation where it's almost impossible to tell the good guys from the bad. Last February, a recent college graduate and amateur investor was able to cause a huge drop in the share price of Chinese fertilizer maker Yongye (NAS: YONG) .

Had this investor been to China? No, he hadn't. But our own Tim Hanson had visited with management and been to manufacturing plants in China a number of times; he'd even tested out their products for all to see. He believed in the company. And yet, since then, the stock is down 50%.

Legendary investor Peter Lynch once said: "Investing without research is like playing stud poker and never looking at the cards." Because it's so hard for individual investors to find research that they can trust about small Chinese companies, I just don't think this is a game of poker we can realistically win.

Better, safer alternatives
But worry not! There are other ways to get a piece of the growth story in China. One of my favorite pure plays is Baidu (NAS: BIDU) , aka the "Google of China." With more than 70% of the Internet search market, and hundreds of millions of Chinese residents yet to come online, there's still tons of room for growth.

Yes, the company is located in China, and it has the same confusing structure as Qihoo. But both its size and the fact that it's an Internet company (with a Web page we Americans can visit from our living rooms) help me rest easy. I've already made CAPScalls on my profile for Baidu, and am looking for a price point to buy in.

And if you'd like to stay away from Chinese companies altogether, Apple (NAS: AAPL) represents a great option. As my fellow Fools have brilliantly illustrated, growth has been absolutely explosive there: Sales in the first six months of 2011 were six times larger than in all of 2010! As I did with Baidu, I've also made a positive CAPScall on Apple -- in part because of its exposure to China.

If you're interested in international investing and want one more idea, I encourage you to read up on our "Top Stock for 2012." Though the company our top analysts picked is not located in China, it has great exposure to the growing economies of Central and South America, and a very promising future. Get all the details in your copy of the report today, absolutely free!

At the time thisarticle was published Fool contributorBrian Stoffelowns shares of Apple and Qihoo 360, though he plans on selling his shares of Qihoo when trading rules allow. You can follow him on Twitter at @TMFStoffel.The Motley Fool owns shares of Google, Apple, and Yongye International.Motley Fool newsletter serviceshave recommended buying shares of Yongye International, Baidu, Google, and Apple.Motley Fool newsletter serviceshave recommended creating a bull call spread position in Apple. 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.

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