Some China Stocks Could Vanish From the U.S. What to Know.

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Illustration by John Tomac

The giant “caution” sign for investors who own Chinese stocks has been blinking for months. It’s about to become a blaring beacon of warning.

Individual investors who still own, or are considering owning, individual shares of U.S.-listed Chinese stocks need to heed this warning. Barron’s has been writing about the challenges that face Chinese companies on multiple fronts: Beijing has steadily intensified the regulatory scrutiny of its largest technology companies, while U.S.-China tensions escalate and prompt investment restrictions and legislation that create further market ramifications.

Yes, the case for investing in China is strong, especially over the long run. China’s rapid economic growth is generally appealing, and has led to a burgeoning middle class that has, in turn, allowed many nascent industries to blossom. Plus, many of China’s homegrown technology companies benefit from government investment, and U.S.-China tensions. But as Barron’s wrote earlier this month, the way to navigate this landscape is by hiring a tour guide in the form of a mutual fund or exchange-traded fund manager that can manage growing complexities.

Each week makes that case even stronger. Owning individual shares of Chinese companies listed in the U.S.—whether they’re traded over the counter (rather than on a major exchange) or as American Depositary Receipts (ADRs)—could increasingly become a risky proposition. Institutional investors who have the option of owning shares on a Hong Kong or mainland China stock exchange are well on their way to that transition—which could add pressure to U.S.-listed shares and eventually cause liquidity problems.

The ADR-heavy Invesco Golden Dragon exchange-traded fund (PGJ) is down 13% in the last three months. The iShares MSCI China (MCHI), which also owns Hong Kong-listed shares, is down 4%, and the iShares MSCI China A-shares (CNYA), which focuses on China-listed companies, is up 7%.

The latest cloud looming over U.S.-listed Chinese companies is uncertainty around how U.S. regulators will enforce last year’s Holding Foreign Companies Accountable Act, which requires foreign companies to adhere to U.S. auditing standards in order to trade on U.S. exchanges. The Chinese government has long prevented Chinese companies from providing the necessary information to comply with U.S. auditing requirements.

The process toward enforcement is underway; the feedback period for a Public Company Accounting Oversight Board (PCAOB) proposal closes this week, and policy watchers expect a rule to be released soon. A PCAOB spokeswoman declined to comment. The rule will pave the way for the Securities and Exchange Commission to enforce the legislation. Currently there is a three year-window for compliance; the Senate last month passed a bill that would accelerate the timeline to just two years—another indication of the bipartisan support for China measures.

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Despite policy makers’ urgency, policy watchers note a lot of outstanding questions. There are some 248 Chinese companies listed on U.S. exchanges with a combined market value of more than $2 trillion—so the process of delisting could be messy and painful. “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,” says Jesse Fried, a professor at Harvard Law School who has been researching regulation of Chinese firms trading in the United States.

There’s also no precedent for the type of mass delisting that could unwind in a worse-case scenario—a factor that could lead to an elusive compromise between the two nations. “Despite the ongoing, heightened tensions between the U.S. and China, this could be the last salvo bringing both sides back to the table to work out some deal where there will be just enough access to audit personnel and work papers so that the nuclear option is avoided and the PCAOB will be able to meet its core obligations under the Sarbanes-Oxley Act,” says Shas Das, counsel at King & Spalding, who was the PCAOB’s chief negotiator with Chinese regulators between 2011 and 2015. Past negotiations yielded some cooperation and access to audit work papers but not consistently, he adds.

Investors would be ill-advised to wait around to see if some compromise materializes, especially as U.S.-China tensions continue to ratchet higher. On Thursday, the Senate passed a bill to ban imported products from China’s Xinjiang region amid allegations of forced-labor practices, and the U.S. has been adding Chinese companies to a blacklist, cutting them off from U.S. investment.

Investors got a painful glimpse at the havoc these measures can cause when widely held China Mobile was delisted in January by the New York Stock Exchange, following an executive order from President Donald Trump banning investment in companies the U.S. said had ties to China’s military. Institutional investors were able to convert into Hong Kong-listed shares, but many retail investors have been stuck in limbo—even now, many investors cannot execute a sale at their current broker, and some are being told to seek out foreign brokers. Others have run into dead-ends with no clarity on who to reach out to for assistance, and face being stuck with a loss. The SEC didn’t respond to a request for comment.

Though regulators may find a way to compromise or find a way to help smaller investors, it’s better to just avoid ending up in a potentially tricky spot. “It puts people in this Kafka situation where they can’t move forward,” says Andy Kapyrin, co-head of investments at RegentAtlantic, which oversees $5.5 billion in assets. “For typical individuals owning Chinese ADRs, there’s a risk: If they aren’t on top of how this legislation evolves, they may find themselves owning a delisted ADR that becomes very challenging to trade.” Kapyrin uses an ETF for his clients’ China allocation.

Many large Chinese companies, including Alibaba Group Holding (BABA), JD.com (JD), and Yum China (YUMC) have sought secondary listings closer to home, and many U.S. fund managers have shifted into those listings. That is a relatively easy move for mutual-fund managers; less so for retail investors as some brokerages do not allow direct access to foreign markets.

One additional reason to avoid Chinese stocks: The long-controversial corporate structure used by many Chinese companies to get around Beijing’s foreign ownership restrictions, known as a variable interest equity, is getting renewed attention as Chinese regulators tighten control over overseas listings. Most analysts do not expect the structure to be upended, but increased attention could highlight the risks and compress valuations of U.S.-listed Chinese stocks.

Over the near-term, these clouds are enough for Kapryin to reduce clients’ allocation to China from an overweight to market weight. He’s not alone. China’s weighting in Cathie Woods’ Ark Innovation ETF (ARKK) is down to less than 1% from 8% in February.

Volatility in the short-term, however, can be a good opportunity to build long-term positions. Investors should stick to China-oriented mutual and exchange-traded funds that can navigate the continuing complexities of the U.S.-China relationship, and spot the companies that may be less vulnerable to blacklists and regulatory changes.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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