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Chinese reverse mergers fail investors

Chinese reverse mergers fail investors

July 2011 (Chinavestor) June 2011 ended on a high note for stock investors globally after fears of a Greek debt default eased. The Dow Jones Industrial Average (INDEXDJX:.DJI) surged 648 points in the last five days of June, sending the index 1.1% higher for the month. The index is up 8.7% year-to-date (YTD), a sweet position compared to Chinese investors.

The China ADR Index (CAI) measuring the performance of Chinese ADRs listed in the U.S., compiled by Chinavestor, rose 0.6% in June or 5.7% YTD. Both indices far outperform the Hang Seng Index (INDEXHANGSENG:.HSI) and the Shanghai Composite Index (SHA:000001) YTD.

There has been a major shift in forces driving equity markets. We were focusing on inflation and monetary tightening in China, a factor that kept Chinese equities at bay for all of 2011. But that is about to change as signs of a global economic slowdown emerge. Revised data suggests that U.S. economic growth slowed to 1.9% in the first quarter of the year following consumer spending to the lowest level in May. There hasn’t been any major improvement in the jobs market, putting prospects of a speedy recovery into serious question.

But what’s been bad for the U.S. was good news for China, where investors worrying about monetary tightening got a serious break. With chances of additional fiscal tightening getting slim, Chinese investors have started to embrace stocks again. Renewed interest in equities in China is expected to continue, giving boost to the Shanghai Composite Index (SHA:000001) and its trailing ETF, the Morgan Stanley China A Share Fund (NYSE:CAF).

But for U.S. based investors interested in Chinese stocks the theme for the month was RISK. Many of these investors have started to feel like those Trojans in Homer’s Iliad who said “I’m afraid of Greeks even if they come bringing gifts”. The reputation of Chinese listings in U.S. stock exchanges has fallen to lows never seen before. The reason for such a dive in confidence is due to an increasing number of Chinese companies that got voluntarily or involuntarily delisted from major U.S. exchanges such as the NYSE or the NASDAQ. The U.S. exchanges themselves have started a probe into practices that helped numerous Chinese companies get listings on the world’s most prestigious exchanges. Most of the inquiry is in those companies that got listed via so called reverse mergers.

A reverse merger is a process when a Chinese company buys an existing listing, called shell, and uses it as a launching vehicle to get listed on the exchange. Most of these shells came to existence during the dotcom boom in 2000 but never went into actual trading due to the bust. After their regulatory approval was completed, all they needed was just a third company to buy them. And here came the Chinese… The problem with reverse mergers is that companies using this shortcut never went through a thorough process of listing like an IPO. So the question of the quality of author is more paramount than ever!

We touched upon the importance of this fact in numerous previous Newsletters, as late as May 2011. We said that “we consider anything trading under $250 million market cap dangerous” in reference to the April Newsletter. In that prior issue we told investors to keep an eye on the auditor for Chinese companies under $250 million market cap because they usually can’t afford a big four auditor.

Unless you followed our advice, you might have become a victim of ongoing Chinese delisting. We just saw China Biotics, formerly (NASADAQ:CHBT), voluntarily delisting from the NASDAQ: earlier the month. Or how about Jiangbo Pharmaceuticals (NASDAQ:JGBO), a Chinese company that stopped trading and is under investor investigation, just like Longtop Financial (NYSE:LFT), Terra Nostra (NASDAQ:TNRO) or China Media Express (NASDAQ:CCME).

We are not here to say that all Chinese listings are bad. Far from it. It would be a huge mistake to throw the baby out with the bathwater. To avoid such lemons, we think investors should pay attention to the following four simple measures:

  1. Listing via IPO or Reverse Merger
  2. Top Four Auditor
  3. Market Cap
  4. Sufficient Trading Volume

We consider the following group of stocks the safest: those that went public via an IPO, have a top four auditor with a market cap over $250 million and have a daily volume of 100,000 shares or more. These stocks are found on the previous page—except for Chinese airliners whose home market is Hong Kong rendering their ADR volume to a minimum. Nevertheless these companies are considered safe and have been the basis of our Conservative Portfolio.

The second group of stocks are those that even though they were IPOd, they have small market caps and lower volume. These are risky and not recommended by Chinavestor.

The third group are stocks that IPOd, according to data from the NASDAQ website, but have market caps under $100 million and low volume. These are not recommended for investment by Chinavestor! The list of these stocks is right below.

Another set of relatively safe stocks are those that have market caps of over $250 million and have sufficient trading volume. While these companies got listed via other than IPO, like Shanda Interactive (NASDAQ:SNDA) spun off its online game unit Shanda Games (NASDAQ:GAME) in 2009, these companies have real businesses and are considered less risky. These companies are listed on the top table on the page. These are those companies that have appeared in the Growth portfolio from time to time.

Considering that there are two groups of stocks that we consider “investment grade” - the first table of this Newsletter and this one right above, the total number of viable Chinese stocks is down to 51 out of over 180 listings!

Another trap investors should avoid are stocks that have too much “reported” cash on hand, exceeding market capitalization of the entire company! This is the idea of Ian Bezek, an occasional contributor to SeekingAplha, who provided the following table for guidance.

And finally, the following two pages contain those names whose market cap is under the $250 million threshold and didn't go through IPO’s rigorous process. Most of them have low volume and are under pressure going forward. These I don’t recommend even for risky investors.

Blaze Fabry

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