How Chinese Stocks Can Go to $0 Overnight: Understanding the Risks
Chinese stocks are tempting with their low valuations, but they come with serious risks that could cause your investment to vanish overnight. The biggest threat? The Variable Interest Entity (VIE) structure. This legal workaround lets Chinese companies attract foreign investors, but it’s potentially a ticking time bomb. In this article, we’ll dive deep into the VIE risk and explore other factors that make investing in Chinese stocks both alluring and dangerous.
The VIE Structure: A Legal Tightrope
At the heart of the risk in Chinese stocks lies the VIE structure. To understand why this is such a precarious setup, let’s break down how it works.
What is a VIE?
A Variable Interest Entity (VIE) is a legal structure that allows Chinese companies to raise capital from foreign investors without directly violating Chinese laws that restrict foreign ownership in certain industries, particularly technology and internet services. Here’s how it works:
Offshore Entity: Chinese companies create an offshore entity, typically registered in a jurisdiction like the Cayman Islands. This offshore entity is what gets listed on foreign stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.
Contracts Instead of Ownership: Instead of owning the operating company in China outright, the offshore entity enters into a series of complex contracts with the Chinese company. These contracts give the offshore entity (and thus the foreign shareholders) control over the Chinese company’s operations and profits without actual ownership.
The Problem with VIEs
The VIE structure is a workaround, not a legally recognized ownership method in China. This means it exists in a gray area, tolerated by the Chinese government but not officially endorsed. The risks here are manifold:
Legal Ambiguity: The Chinese government could decide at any time that VIEs are illegal or impose stricter regulations on them. If this happens, the contracts that foreign investors rely on could be declared void. This would sever the connection between the offshore entity and the Chinese operating company, leaving investors with shares in a company that no longer has any claim to the underlying business assets in China.
Total Loss of Investment: In the worst-case scenario, invalidating the VIE structure could lead to a total loss of your investment. With no claim to the company’s assets or profits, your shares could become worthless overnight.
Can You Avoid VIE Risks by Buying Chinese-Listed Stocks?
Some investors might wonder if they can sidestep these VIE risks by purchasing stocks directly listed on Chinese exchanges like the Shanghai Stock Exchange (SSE) or the Shenzhen Stock Exchange (SZSE). However, this isn’t as straightforward as it sounds.
Access to Chinese Stocks:
Limited Access for Foreign Investors: Chinese stocks listed on domestic exchanges (often referred to as A-shares) are generally not available for direct purchase by foreign investors. There are exceptions through programs like the Qualified Foreign Institutional Investor (QFII) scheme or the Stock Connect program, but these are typically reserved for institutional investors and come with various restrictions.
No Escape from VIEs: Even if you could directly buy Chinese-listed stocks, many major Chinese tech companies, like Alibaba and Tencent, are not listed on Chinese exchanges at all. These companies are often only listed on U.S. or Hong Kong exchanges and still use the VIE structure, meaning you can’t completely avoid the associated risks by shifting to domestic Chinese listings.
Regulatory Crackdowns: A Constant Threat
Beyond the VIE structure, investing in Chinese stocks exposes you to the unpredictable nature of Chinese government regulation. In recent years, the Chinese Communist Party (CCP) has shown a willingness to impose sudden and severe regulations on its most successful companies, often with little warning.
Examples of Crackdowns
Tech Giants Under Fire: In 2020, the Chinese government blocked Ant Group’s record-breaking IPO just days before its launch, citing concerns over financial stability and regulation. This move wiped billions off the valuation of its parent company, Alibaba, and sent shockwaves through the market.
Education Sector Overhaul: In 2021, China effectively banned for-profit tutoring, a sector that had been booming. Companies like TAL Education and New Oriental saw their stock prices plummet by over 90% as a result.
Why This Matters: For investors, these regulatory risks are a reminder that the Chinese government prioritizes its political and social goals over the interests of shareholders. This unpredictability means that even successful and profitable companies can be brought to their knees by a single government decree, leaving investors holding the bag.
Geopolitical Risks: The U.S.-China Tug of War
Investing in Chinese stocks also means navigating the complex and often contentious relationship between China and the United States. This relationship has been characterized by trade wars, sanctions, and an ongoing battle for technological supremacy.
Key Geopolitical Risks
Trade Wars and Tariffs: The U.S.-China trade war has led to the imposition of tariffs on hundreds of billions of dollars worth of goods. For Chinese companies that rely on exports to the U.S., these tariffs can significantly increase costs and reduce profitability.
Sanctions: The U.S. government has imposed sanctions on several Chinese companies deemed to pose a national security threat. For example, telecommunications giant Huawei was added to the U.S. Entity List, restricting its access to key American technologies. Similar actions against other Chinese companies could severely disrupt their operations and impact their stock prices.
Delisting from U.S. Exchanges: Under the Holding Foreign Companies Accountable Act (HFCAA), Chinese companies listed on U.S. exchanges must comply with U.S. auditing standards. Failure to do so could result in delisting, which would drastically reduce the liquidity of these stocks and potentially cause their prices to plummet.
Transparency and Corporate Governance: A Black Box
Another significant risk when investing in Chinese stocks is the lack of transparency and weak corporate governance practices. Chinese companies often do not adhere to the same rigorous disclosure and auditing standards expected of Western firms, which can lead to significant information gaps for investors.
Case in Point: Luckin Coffee: In 2020, Luckin Coffee, once hailed as China’s answer to Starbucks, was caught in a massive fraud scandal where the company fabricated sales data. The revelation led to the company’s delisting from the NASDAQ and wiped out billions in shareholder value. This incident highlighted the dangers of investing in companies with poor transparency and governance. Below, you can see how the stock crashed in 2020.
Why This Matters: Without reliable information, investors are flying blind. The risk of fraud, financial mismanagement, or undisclosed liabilities is significantly higher, making it difficult to assess the true value of these companies and their long-term prospects.
Market Volatility and Currency Risks: The Final Nail in the Coffin
Even if you can navigate the VIE risks, regulatory crackdowns, geopolitical tensions, and transparency issues, there’s still the matter of market volatility and currency risk. Chinese markets are known for their wild swings, driven by everything from government policy changes to shifts in investor sentiment.
Market Volatility
Sudden Swings: Chinese stocks can experience sharp and unpredictable movements. For instance, news of a government crackdown or economic slowdown can send markets into a tailspin, erasing significant gains in a matter of days.
Currency Fluctuations: Investing in Chinese stocks also exposes you to currency risk. If the Chinese yuan weakens against the U.S. dollar, the value of your investment can erode when converted back to dollars, even if the stock itself has performed well.
Managing These Risks Given the numerous risks, how can investors protect themselves when investing in Chinese stocks?
Diversification: One strategy is to limit exposure by diversifying your portfolio across different markets and sectors. This way, even if your Chinese investments take a hit, your overall portfolio remains balanced.
Focus on Transparency: Prioritize companies with better transparency and corporate governance. While still risky, companies that adhere to international standards may offer a bit more security.
Stay Informed: Keep a close eye on geopolitical developments, regulatory changes, and market conditions. Being informed can help you anticipate potential risks and make timely decisions.
Just How Cheap Have Chinese Stocks Become Now?
Because of these big risk factors, Chinese stocks are often considered to be “uninvestable.” Some just view the risks as not worth taking, even if the potential rewards can be great. As a result, many investors avoid these stocks altogether, causing them to be cheap.
Here are some examples, and for reference, the S&P 500 trades at a 25.9x forward EPS multiple (using estimates for December 2024):
Alibaba (NYSE:BABA): Alibaba trades at just over 9x forward earnings for Fiscal 2025 (ending March 2025).
PDD Holdings (NYSE:PDD): PDD trades at just under 10x trailing earnings per share, even though its earnings have been growing by triple-digits.
JD.com (NASDAQ:JD): JD.com trades at 6.9x 2024 earnings estimates and 6.5x 2025 estimates.
Tencent (OTC:TCEHY): Tencent trades at less than 15x Fiscal 2024 estimates and 12.5x Fiscal 2025 estimates.
Still, while there are risks, some may argue that they are worth taking at current depressed prices. Maybe they are, maybe they aren’t. You can try to figure this out using our reverse DCF calculator tool and cash-adjusted P/E ratio calculator to figure out if the valuation is cheap enough for your liking.
Conclusion: High Risk, High Reward
Chinese stocks may be cheap, but they come with a multitude of risks that could result in a complete loss of your investment. The VIE structure alone poses a significant threat, with the potential to render your shares worthless if the Chinese government tightens the screws. Combine this with regulatory crackdowns, geopolitical tensions, transparency issues, and market volatility, and it’s clear why these stocks are priced as they are.
For some investors, the potential rewards might outweigh these risks, especially given China’s rapid economic growth. However, it’s crucial to go into these investments with your eyes wide open, fully aware of the dangers that could turn your investment to zero in the blink of an eye.
Investing in Chinese stocks isn’t for the faint of heart, but for those who are willing to take the risk, it could be a wild ride—just make sure you’re prepared for the potential pitfalls along the way.
