Sino-Forest Corporation, the Chinese forestry company in which hedge fund Paulson & Co was the largest investor, lost about two-third of its share value in the past few days after a little-known research firm alleged that the sales it reported would have required 50,000 trucks driving on two-lane roads through the mountains from a remote region, which is beyond belief 

Where do you get your information? Do you trust it? Accurate, timely and complete information is essential for investors, yet few investors have the clout to go out and collect their own information. Worse, there are large economic incentives to lie. So, most of us play a game of follow the leader. We like to pick large investment banks, star investors, celebrity analysts, or Nobel laureate economists and trust them, but in certain countries, even this doesn't work.

Paulson & Co, the hedge fund run by the legendary investor and billionaire John Paulson. Paulson is one of savviest and best informed investors on Wall Street. The hedge fund has $37 billion under management. His fund made $4 billion betting against subprime mortgages. The result, some of his bets helped the demise of Lehman Brothers.

But for all of Paulson's expertise, he is helpless in China. His hedge fund made an investment in a Chinese forestry company called Sino-Forest Corporation. In fact, the fund owns 14.13% of Sino-Forest's outstanding shares and is the largest holder.  But it is not just Paulson. According to the Financial Times, Sino-Forest's shares are also owned by other large fund managers including Hartford Investment Management (3.2%), BlackRock, Vanguard and Henderson Global.
 
Paulson & Co's investment was worth $646 million. Not anymore. This month, the Sino-Forest stock which is listed on the Toronto Stock exchange, dropped over 71%. The share price crash was the result of a report by a Canadian research firm called Muddy Waters.

Muddy Waters alleged, among other issues, that the sale of $231.1 million in timber in Yunnan by Sino-Forest was largely fabricated, because "transporting the harvested logs would have required over 50,000 trucks driving on two-lane roads winding through the mountains from this remote region, which is far beyond belief [and likely road capacity]." It also pointed out that Sino-Forest overstated its purchases by over $800 million and its corporate structure utilised over 20 British Virgin Island entities.
 
But Paulson & Co are not the only ones. The Carlyle Group is one of the largest and most famous of the private equity firms with $106 billion of capital under management. It is known for its ability to attract the best connected people in the world, including former US president George HW Bush and James Baker III, the former US secretary of state.

Carlyle is one of the most successful private equity groups in China. Some of its investments have, at least on paper, generated some excellent returns for its grateful investors. But even Carlyle has problems. China Forestry, a Chinese lumber products firm like Sino-Forest, received an investment of about $55 million from Carlyle before it went through its Hong Kong IPO in December 2009. By May 2011 it posted a $417 million annual loss, and its auditor, KPMG, stated that it could not vouch for the accuracy of the group's financial results, because of incomplete books and records.

But China Forestry was not the only dud investment by Carlyle in China. China Agritech is a Nasdaq-listed fertiliser maker in which Carlyle has a 22% stake. Its shares reached an all-time high on 1 February 2010 at $31.21 a share. It is now trading at $2.81 a share, a fall of 91%, after a failure to file its accounts.

David Rubenstein, the co-founder of Carlyle, defended its investments in China and claimed that most of the 50 deals it had done in China were apparently profitable. Others weren't so sure. According to an executive at another big international private equity group, "To have two go wrong in such quick succession is somewhere between careless and unlucky."

It wasn't just the investments of Paulson and Carlyle that went bad. In the first six months of 2011, over 25 New York-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign. In May of 2011 Nasdaq had suspended 19 stocks from trading, 15 were Chinese.

Many of these stocks were once Wall Street darlings. China Agritech jumped over 1000% from 2007 to its height in 2010. The China 'story', the unending growth of China, and all things relating to China seemed like a sure bet.

Yet, the foolishness continues. A Chinese stock named Yongye, an agricultural nutrient company, fell 60% along with Sino-Forest, but rebounded 64% as soon as it received the OK from Morgan Stanley Private Equity Asia.

The reason why these highly experienced, connected, and professional firms are making mistakes is because the bright young things who do the analysis are assuming that the same rules apply for Chinese firms as for firms in more developed markets. They have not taken into account the lack of any meaningful legal disincentives and the active suppression of information. Until they figure this out, investors would be wise to take their advice with a large grain of salt.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)