New Oriental Education Called Into The Principal's Office

If you're a current New Oriental Education investor, Tuesday's earnings must have you scratching your head.

New Oriental Education reported impressive beats on the top and bottom lines. Unfortunately, shares gapped lower and not higher. New Oriental Education is a Chinese company, but investors are liquidating the entire space. (See my recent article Will Bridgepoint Be Held Back a Year?)

BPI data by YCharts

New Oriental Education has lost about 30% of its market cap from Monday's close. New Oriental Education disclosed on its website they are the target of an active SEC investigation.

According to the website:

"On July 13, 2012, the Company was informed that the U.S. Securities and Exchange Commission (the "SEC") had issued a formal order of investigation captioned 'In the Matter of New Oriental Education & Technology Group Inc.' The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company's consolidated financial statements. The Company intends to fully cooperate with the SEC in its investigation."

Only two sentences in an earnings report that is otherwise glowing with positive results. No one wants to read "SEC investigation" about their stock, especially one based in China.

New Oriental Education may not know the full details of the investigation, but there is one thing we do know. The SEC is suing auditors for not providing audit documents. TheStreet's Timothy Collins recently called EDU a short candidate. If you read Collins' article you would have known about EDU before the fall. (You need a Real Money Pro account to read, but Collins' analysis makes it worthwhile.)

New Oriental Education used Shanghai Deloitte as the auditor for the 2011 annual report. Shanghai Deloitte was sued by the SEC about two months ago for failing to submit requested documents to the SEC. Deloitte argues it is caught between two separate and conflicting sets of laws. Deloitte, in its defense, has claimed it is not legally allowed to hand over certain documents because of state secrets laws in China.

The bottom line is, investing in Chinese stocks adds another layer of risk for investors. The risk is further compounded by the current inability of the SEC to impose sanctions against Chinese nationals for securities fraud. U.S.-listed and -traded Chinese stocks are a perfect storm for securities fraud. There is nearly zero risk for a potential perpetrator and a life time of riches for a successful fraud.

I have written about the risks facing investors for about a year now. With so many opportunities available in the North America and Europe, there is no reason to play Russian roulette with your portfolio. In Russian roulette, players use a six-shooter, effectively giving odds of failure at 1 in 6. Based on my experience, the odds of failure with a Chinese company listed in the U.S. the odds of failure are about 1 in 8.