The Only – And I Mean Only – Move to Make with Chinese Stocks

Shah Gilani|July 29, 2021

I’m going to let you in on a little, make that big, secret – one that may actually be an outright stunner to all the trading/investing veterans and newbie retail traders checking this out today.

Here it is: I still love the giant Chinese tech stocks that trade on American exchanges.

More importantly, I believe you can make money on these stocks.

Lots of money – and on the “long” side, no less.

I realize this flies in the face of the conventional wisdom when it comes to U.S.-listed Chinese tech stocks – but it’s what I believe.

There is a “catch” here, however.

You see, there’s only one way to play this – only one strategy that makes perfect sense.

It’s the one way to grab the latest upside I see here, while avoiding the slaughter that will ensue if the escalating U.S.-China spat “goes nuclear” – which it could.

I’m going to show you this “one strategy” for U.S.-listed Chinese tech stocks and EV plays.

And I’m going to tell you everything you need to know…

What You Don’t Know Can Hurt You

U.S.-listed Chinese tech plays, and more recently EV stocks, aren’t showing U.S. investors a whole lot of love as of late.

Stocks like Baidu Inc. (Nasdaq:BIDU), Alibaba Group Holding Ltd. (NYSE:BABA), JD.com Inc. (Nasdaq:JD), newly listed DiDi Global Inc. (NYSE:DIDI), and my favorite Chinese EV company NIO Inc. (NYSE:NIO) are taking it on the chin. And while they may look like they’re at or approaching bargain-basement trading levels – where you and I ordinarily would want to really load up on them – I have to say that the odds of more selling are quite high.

What’s going on with this group of stocks has little to do with the usual financial metrics.

The truth is there’s an increasingly heated cold war being waged between the United States and China, and securities trading is one of the front-line battlegrounds.

So, the problem with Chinese stocks is one of politics – not profits.

Here’s what’s undermining otherwise solid Chinese-tech and EV stocks traded in the U.S., what they’re facing in terms of a “nuclear option,” and what your options are as an investor in any of these stocks.

Let’s start with a crucial foundational factoid – one many American investors aren’t aware of: Foreigners aren’t legally permitted to directly own the “A” shares of Chinese companies listed on Chinese exchanges. While there are reasons for that, the core objection is Beijing doesn’t want foreigners gaining influence over the Chinese economy, over the Chinese population – which is why regulators have a particular issue with outsiders owning stakes in ventures in the media or telecom sectors, which reach deeply into everyday life there.

Even so, these China companies want access to the capital that flows through Wall Street – so they use a loophole that allows them to list their shares on foreign exchanges like the New York Stock Exchange and Nasdaq, where foreigners, especially Americans, are free to buy and sell vast quantities of shares every day.

To list on foreign exchanges, Chinese companies establish Variable Interest Entities (VIEs) in “offshore” locations like the Cayman Islands. VIEs contract with the home-based company to transfer control of the company to its VIE, which then seeks to go public on a foreign exchange. Some companies list themselves on multiple exchanges, with Hong Kong being one of the common-exchanges a company would dually list on.

Though such moves blatantly sidestep China’s rules on foreign ownership of important companies, various state regulators have routinely looked the other way – because the country’s ruling communist party recognizes the benefits of these transactions. It allowed – make that wanted – foreign investors to bid up the value of growing Chinese companies, especially when trade between China and the United States was friendly and growing rapidly.

In turn, U.S. regulators – principally the Public Company Accounting Oversight Board (PCAOB), which is directly overseen by the U.S. Securities and Exchange Commission (SEC) – looked the other way, too. They simply didn’t hold Chinese companies listed on U.S. exchanges to the same strict “disclosure” requirements that every other firm (including U.S.-based ones) are held to.

The PCAOB, established as part of the 2002 Sarbanes-Oxley Act in the face of devastating investor losses courtesy of Enron’s failure the year prior, requires all U.S. listed companies submit “audited” financials, which the PCAOB has access to.

The fact is Chinese companies listed in the U.S. have never submitted audited financials to any U.S. regulator. They claim they’re not allowed to, that China’s national-security laws prohibited Chinese companies from turning over audit papers.

Now, under the threat of an escalating trade war, the formerly live-and-let-live attitude U.S. regulators and Chinese regulators had is dying on the vine.

Wrecking With Rhetoric

In 2020, when then-U.S. President Donald Trump wanted to put trade pressure on China, he signed the Holding Foreign Companies Accountable Act, a move that strengthened the PCAOB’s ability to demand audited financials. Under the new rules, a company could be delisted from U.S. exchanges after three consecutive years of audit-inspection noncompliance. But it could also return by certifying that it had retained a registered public accounting firm approved by the SEC.

The three-year clock won’t start ticking until the SEC drafts rules for how the law will be carried out – something the commission has yet to finalize. Even while its working on that, politicians are saying the three-year period should be reduced to two years.

We’re already seeing some fallout, or flak, emanating from both sides.

As new cold war rhetoric heats up between the U.S. and China, China’s internet regulator, the Cyberspace Administration of China, enacted new rules on “security reviews” as part of its framework for “safeguarding the nation’s digital infrastructure.”

The revised internal Chinese rules say a security review would be mandatory for any business possessing information on more than one million users that seeks to list its shares abroad.

Rules mandating security reviews aimed at addressing the risks to national security and business continuity posed by the servers, software, cloud services and other products that major tech companies use are being seriously beefed-up. New rules take more direct aim and require overseas listed, and domestic listed Chinese companies directly address the possibility that important data could be “stolen, leaked, damaged and illegally exploited or moved overseas,” and that data could be “influenced, controlled or maliciously exploited by foreign governments” overseeing listed companies or after an overseas initial public stock offering.

Mutual Interests or Mutual Destruction?

Even though it looks like Chinese regulators are punishing their own companies, there’s zero intent to ruin them. Beijing wants a measure of absolute control over the massive amounts of illuminating data that Chinese tech “platform” ventures generate and store – whether it’s “what-did-they-buy” data from Alibaba or “where-did-they-go” data generated by ride-hailer DiDi.

And while many investors believe it’s the clamp down by Chinese regulators that’s pounding U.S.-listed shares of otherwise gigantic and profitable Chinese companies, that’s not the case.

Not at all.

It’s the U.S. rhetoric on PCAOB (sometimes pronounced “Peek-a-Boo”) compliance that’s pounding the shares.

All of this is setting up a scenario of “mutually assured destruction,” or MAD – not unlike the one that had the United States and the Soviet Union squaring off during the first cold war.

Call it the “nuclear option.”

And that “MAD-ening” scenario would play out like this.

Since Chinese companies aren’t submitting audited financials, U.S. regulators could, maybe would, delist all Chinese stocks trading on U.S. exchanges.

Given that threat, China’s state regulators are threatening to delist their companies anyway, because they could all trade on the Hong Kong exchange, which allows foreign investors to buy as much of those shares as they want.

What’s being called “Hong Kong happy talk” says that if Chinese companies delist from the United States and trade in Hong Kong – the No. 3 financial hub in the world – it would drive more foreign capital, including U.S. capital, towards Hong Kong and Mainland China, too.

The impact on U.S. investors would be huge on account of the fact that there are Chinese VIE companies listed on U.S. exchanges, including Alibaba, Baidu, JD.com, and PetroChina Co. Ltd. (NYSE:PTR), and NIO, with cumulative market capitalization of almost $2 trillion.

“If a delisting is imminent, the stock price is going to plummet and those who control the company can buy out public investors for a bargain, go private, and relist in Asia at a much higher valuation and make a ton of money-at Americans’ expense,” Jesse Fried, a Harvard Law School professor who’s been studying the issue, told Barron’s.

U.S. regulators don’t want to hurt American investors who own hundreds of billions of dollars’ worth of U.S.-listed Chinese stocks. The mere whispers of a delisting wave have already eradicated billions in shareholder value. And actual delisting would nuke those values and leave American investors with pocketfuls of “stranded” securities – shares that can’t be sold easily.

On the Chinese side of the wall, whether U.S. regulators do the delisting, or the Chinese call their companies home, delisting turns off the capital flows that come with American listings.

That would kill their share prices and hamper them operationally, since the U.S. financial system’s relative efficiency gives players here access to lower costs of capital.

The “One Move” to Make

A few weeks ago, I would’ve told you that a true “MAD” scenario was a longshot – and that cooler heads would prevail.

Today I’m not so sure.

And that means there’s really only one way play all this MAD rhetoric.

While you can stay invested in Chinese companies by putting money into mutual funds or exchange-traded funds (ETFs) that own the companies you like, that approach really waters down your returns – which is the entire point of doing this … since I believe Chinese firms are already trading at a bargain levels compared to what they’re really worth.

That brings us to my “action to take” – the “moneymaking” strategy I promised.

Because – as surprising as it sounds – there is one.

First, if you currently own any of these stocks, you can sell them now to keep any profits you have, or to halt losses you may be incurring. You can use stops if you’re not already out of most of these positions. We’ve been stopped out of almost all Chinese plays we’ve been making money with in my subscription services.

Here’s how to play these bargain-basement would-be/could-be rocket riders back to the moon

Since these stocks have come down hard and fast, the “implied volatility” in their call options have come down a lot faster than the implied volatility in their put options, which obviously have risen.

The smart way to play a monumental bounce in these otherwise profitable and must-own stocks is simply to buy call options on them – even all of them, if you like.

To do this – to really make it work – you want to take this trade out at least six months. More if possible.

The downside risk is limited to the premium you pay for the options – which is easily quantifiable and manageable on a risk/reward basis especially given the huge upside if this spat gets resolved, since share prices of these gems will shoot up in a near-vertical ascent.

If you want to play the potential resolution – if you believe there will be no “MAD” scenario – this is the way to go.

This is a smart risk/reward play – one that limits your downside and gives you all the possible upside.

And if you really consider it carefully, it’s really the only way to play this.

Cheers,

Shah