With the continued uptrend in the Nasdaq and the Dow Jones index each continuously hitting new highs, it is tough to sit and watch some investments consistently underperform when it is clear that there is evident value residing in some of these companies. Many of these underperforming stocks reside in a sector that has been consistently criticized:
the US. Listed Chinese small cap sector.
The following link demonstrates the clear underperformance for the past three months of most of the stocks in comparison to the NASDAQ. (Click here to view the recent comparison of stock performance)
As we can all see, the following is a list of companies that are clearly undervalued based on current P/E multiples, not to mention most have much lower forward P/E ratios and PEG ratios far below 1.
(The current S&P 500 average P/E is 15.7)
| Company Name | Quote | P/E |
| China Clean Energy | CCGY.OB | 6.69 |
| Gulf Resources Inc. | GFRE | 6.70 |
| JA Solar Holdings Co. | JASO | 8.20 |
| Longwei Petroleum | LPH | 4.30 |
| China Media Express | CCME | 6.0 |
| China Information Technology | CNIT | 6.75 |
| China North East Petroleum | NEP | 3.33 |
| Orient Paper, Inc. | ONP | 7.70 |
| L&L Energy, Inc. | LLEN | 4.90 |
| Jiangbo Pharmaceuticals | JGBO | 3.30 |
| China Gerui Advanced Materials Group | CHOP | 5.30 |
It has been apparent to many of us that there is some clear value in many of these companies yet many reasons have led North American investors to shy away from such companies.
The following are some of the main factors affecting Chinese small cap stocks:
1. The Skepticism over Reverse Mergers
The fact is many Chinese stocks have become public companies trough reverse mergers. Which means a private company merges or acquires a public company to bypass the whole IPO process. Reverse mergers have been extremely popular especially for foreign companies since they can do so and easily have access to North American stock markets.
Reverse Mergers should definitely not be associated with fraud. It is simply a legal way of having access to the financial markets and financing trough secondary offerings without the lengthy IPO process. Public companies are also known to be valued at higher multiples than private companies due to their liquidity premium which gives another reason for private companies to list on an exchange.
A recent report suggests that reverse merger activity is increasing in popularity and that a third of these reverse takeovers are Chinese.
Although many private companies are attempting to use a reverse merger deal as an easy way to access capital markets there has been much more scrutiny in the second half of the year 2010 in terms of reverse mergers. The SEC is trying to crack down on poor regulations concerning reverse mergers and increase their monitoring of this type of activity. One of the main reasons for the increase in scrutiny in the reverse merger sector is that many fraud cases and lawsuits have been against reverse merger companies.
As well investors and analysts are not as willing to invest in companies that were not backed by known investment bankers to go public. Many investors view reverse mergers as a cheating way to get on the stock market. Herb Greenberg was seen attacking reverse mergers, LLEN and Red Chip on CNBC.
As a result of Herb Greenberg's comments on reverse mergers and his direct attack towards L&L energy (LLEN), the companies share price went from being at a high of $13.13 to a low $7.51 per share . It is still unknown if his attack on the company was planned or if it was an orchestrated short attack but this is a simple example of how Chinese reverse mergers receive bad publicity which keeps the whole sector down at ridiculous multiples.
2. Investors are Afraid of Chinese "Frauds"
As we all have seen in the example of RINO INTL. (RINO.PK), fraudulent Chinese companies are a fact and frauds are more likely to occur in reverse merger situations such as RINO. Companies of fraudulent reverse mergers try to gain on the scenario that going public helps boost the value of a company and if the company is able to inflate its earnings and get away with it then insiders will reap the benefits of a higher share price. This case is especially true when insiders hold large amount of shares. Not to mention the best scenario for fraudulent Chinese mergers would be to go public with inflated numbers, unknown auditors that "audit their claims", make secondary offerings at inflated stock prices to continue to orchestrate "growth" and "stunning fundamentals", and liquidate insider holdings at the stock peak stock prices. This ultimate scenario would leave shareholders holding on to the hope of growth while this fraud is discovered and the share price falls like a knife.
It is clear that it is quite possible that this "may" occur but some research and due diligence can save investors from falling into such traps. Then again, in these markets manipulation is rampant.
3. Manipulation, Short Attacks and Fraudulent Reports
Fraud or no fraud is the question...
Many CCME investors may be asking themselves the same question. Since Chinese small cap stocks are evidently the ones that have been blamed for much of the recent fraudulent activity as well as having the most reverse mergers on the NASDAQ they are increasingly becoming easy targets for bear raids or short attacks. This is all a play on FEAR and many investors are letting themselves get spooked out much too easily.
In China Media Express's (CCME) case as well as many other stocks, reports by the notorious Muddy Waters Research (.pdf) have accused them of artificially inflating their revenue as well as claiming that the companies are orchestrating a fraud in many areas of their business.
After being continuously accused of fraud the stock ended up falling from its high of 23.87 down to 11.40. Loosing more than half of its value within weeks. While longs are sick to their stomach Muddy Waters which stated in its disclaimer that it was short CCME must have been laughing at the profit it was making.
Although the CCME's case is not completely resolved, evidence has been found that the research reports accusing CCME of being a fraud used false or forged documentation to prove their case. As well, much of the evidence that Muddy Waters brought forward were refuted by the CEO of China Media Express and more recently Global Hunters in a recent thorough research report.In the CEO's Letter (.pdf) refuting the claim that Muddy Waters got its information directly from the company the CEO stated:
We obviously do not know where Muddy Waters sourced this information, but what we do know is that, contrary to what Muddy Waters said in its "report," the information is not the same as our advertising kit.
As stated above, it is evident that companies such as Muddy Waters are taking advantage of investors skepticism and fear towards Chinese small cap stocks to make money trough short recommendations that may go as far as providing false facts. Most of these attacks are usually well planned, in CCME's case research reports were released during the Chinese New Year where the shorts knew the company would not respond quickly. On top of being released during the Chinese New Year CCME's stock was approaching REG SHO day 13 which is where shorts would have been forced to buy back their shares since there was no more shares available to short. For most of the shorts this would have meant buying back at a loss. After the allegations against CCME shorts made money on the downside, freed up some shares from the longs and thus had a win-win situation.
For Investors in the China sector it is a shame that many of these companies may be punished for the wrong doings of a few. Why are Chinese stocks punished for this? After all, when Enron was found to be fraudulent no one screamed lets not invest in all American energy companies. There may be a few other risks by investing in foreign companies but not enough to justify such low multiples on some of these stocks. Many people refer to the SAIC and SEC discrepancies as one of the biggest fears of fraud.
4. SAIC vs. SEC Discrepancy Misconception
This may be one of the most widely disputed accounting issue and was also used in the case of CCME.
To start a Chinese US listed company has to file with three organizations: - China's State Administration of Industry and Commerce "SAIC" is primarily responsible for business registration, business licenses and acts as the government supervisor of corporations. In order to renew their annual business licenses, all Chinese companies must file a Company Annual Inspection Report with the SAIC every year. This report includes financial statements but those numbers are not verified or audited by the SAIC. The agency is mostly concerned with the legal compliance issues and not with operating data or taxes.(http://www.saic.gov.cn)
- State Administration of Taxation "SAT" : Chinese companies pay a variety of taxes; the tax filings made with the SAT are closely related to SEC filings much more closely related than the filings made to the SAIC for business licenses. The SAT requires audited financial statements (balance sheet, income statement and cash flow statement). Financial statements to the SAT are much more reliable than SAIC filings, however they are not publicly accessible and unavailable to investors.(http://www.chinatax.gov.cn)
- And of course the U.S. Securities and Exchange Commission (SEC)
Reasons for non-matching SAIC/SEC Numbers:
- SAIC is a business registrar and not the Chinese equivalent of the SEC (the SAIC does not audit the financial statements submitted for the inspection report, they simply want to know if the company is still in business in order for them to receive their license)
- There are differences in accounting principles. Chinese documents are audited under PRC GAAP while SEC filings are based on U.S. GAAP standards. (some of the differences depend on how revenue is recognized)
- Business Consolidation is treated differently. In China every legal entity has to file its own annual inspection report with the SAIC. Sometimes the parent company report is consolidated while other times it is not. (inter-company transactions are treated differently)
- SAIC filings only reflect business activities in the People's Republic of China. SEC fillings on the other hand have to reflect worldwide financial data for the consolidated US listed company.
For the reasons mentioned, SEC fillings can diverged from SAIC fillings for a multiple amount of reasons. A divergence does not mean the company is fraudulent. If the company is adamant to taking care of these issues they can hire an auditing firm that understands these discrepancies and ask them to reconcile them and make sure they are completely identical.
5. The Chinese Economy is Slowing and Implementing Tightening Policies
The last issue investors may have regarding Chinese stocks is that they fear that China is slowing. Even if the economy grows at 8% from the previous 10% it is still growing at more than twice the speed of the American economy.
Although the PRC government has been working on tightening lending to curve the fear of inflation, what they are doing is good for the economy in the long run. China is quickly approaching the U.S. in becoming the largest economy in the world and the largest consumer of energy resources.
Recent analyst and
articles predict that China will surpass the U.S. economy within 10 years.Even if the short term growth rate slows in China, this slowdown has to happen to keep the economy growing at a healthy pace and to keep inflation under control.
I personally would like to be invested in the economy that is becoming the worlds largest economy, because if the country is growing, so are the amount of people, and so is the growth of the companies in China.
Concluding Remarks
Although there are country related risks, reverse merger risks, fraud and filling related risks as well as the risk of manipulation, Chinese small caps do deserve a chance to shine.
Due to the risks mentioned Chinese small cap stocks are riskier investments but with some due diligence you may experience some very high returns on the right China stocks.
A few tips on choosing the right Chinese stocks would be to check the following:
- Make sure they have a known auditor (top 10 is recommended)
- Make sure management demonstrates they care about shareholders and defend false allegations (if any occur).
- Low or no debt is preferable
- Large cash amounts on the balance sheet and positive cash flow business
- Make sure accounts receivables are not too high relative to sales as high accounts receivables have become notorious of Chinese firms.
- Follow up with suppliers or competitors to confirm the presence of the firm
- Coverage by a research firm is preferable and helps to prove some of the firms legitimacy
- Institutional ownership is preferable as it demonstrates they have done research and believe in the company
- Make sure the company is not over diluting through multiple secondary offerings and high stock compensation
- Watch for insider transactions, make sure insiders are not selling very large share amounts. Buying behaviour is preferable as it shows management has a vested interest in their companies performance.
China will eventually come back in favor, for the time being focusing on companies that are the most reputable and that have upcoming catalyst could be the best strategy. Someday the value will be uncovered...
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