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ETFsRule (99.94)

Wishful Thinking: Navigating the Chinese Small-Cap Sector

Recs

16

April 08, 2011 – Comments (17) | RELATED TICKERS: CNTF , MY , CHRM

Most people know that there have been a lot of problems recently among Chinese reverse-merger companies. I don't want to turn this blog into a debate about the honestly of these companies, but I think everyone can agree that there is a lot of risk surrounding this entire sector.

Still, China is a fast-growing economy and I don't want to avoid it completely. I want to invest in Chinese small-caps while still limiting my risk.

I did this by playing around with the screener at the China Tracker website, to find companies that met several different criteria:

1. Must have gone public through an IPO (not a reverse-merger).

The IPO process requires a comprehensive audit of the company, and I don't know of any Chinese IPO companies that have been accused of fraud. Therefore, this criteria removes a lot of risk from the equation.

2. Must have a top-4 or top-10 auditor.

I only included companies where the auditor had already signed off on an annual report, or in the case of newer companies, had audited them during the IPO process.

3. Good financials.

I didn't have specific criteria here, but I looked mainly at PE, revenue growth, and earnings growth. I only included companies that had "good" financials.

4. Low short interest.

This is another way of limiting our risk. Short interest could be an indicator of fraud or other problems.

5. Not related to the construction industry.

I believe China is in a housing bubble right now, so I don't want anything to do with construction. I used the Forbes housing price indicator to come to this conclusion.

Results:

After looking at all these criteria I came up with 3 Chinese small-caps that stand out from the rest:

CNTF - They sell gaming systems, cell phones, and other high-tech gadgets. Based on their annual report, their products actually look pretty impressive. Most of their sales are in China but they are also starting to sell them in Brazil. Their CEO recently purchased a lot of shares.

MY - A wind energy company. They sell gearboxes to wind turbine manufacturers all around the world. They have also started selling products for the high-speed rail industry.

CHRM - A Chinese media/advertising company. Along with CNTF, this is a good play if you think the Chinese middle class will continue to grow.

Disclosure: long CNTF and MY.

17 Comments – Post Your Own

#1) On April 08, 2011 at 2:11 PM, TMFBabo (100.00) wrote:

I like where you're going with this! +1 rec.

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#2) On April 08, 2011 at 5:28 PM, anticitrade (99.66) wrote:

Really appreciate the screen link.  I have been trying to weed these reverse mergers out of my own system for quite a while.  I will let you know if I find anything worthwhile in this space.

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#3) On April 08, 2011 at 6:51 PM, simplemts (< 20) wrote:

Not a debate, but for you top pro's are there ANY reverse mergers you would trust?  I've been in Orient Paper since the low $4s (where it is again now) who went through an internal audit and has a new line coming up that should double production (Pictures of new line available in presentations).

 Guld Resources also completed an internal review with Deloitte after allegations surfaced.

Any thoughts ONP or GFRE could actually be legitimate, or have "cleaned up" their organization now to the point where it is safe to start buying?

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#4) On April 08, 2011 at 7:57 PM, ETFsRule (99.94) wrote:

Thanks for the comments guys, I appreciate it.

In the case of ONP I think they are probably legitimate based on the audits and appraisals that they have done. They are currently having their 2008 and 2009 results re-audited by BDO, so as long as no problems come up, I think they might be ok.

The problem is, it's still going to be an uphill climb for any of the reverse merger companies to gain investors trust. Don't be surprised if they trade at a PE of 5 for the next couple of years. Short interest is still around 5% of their float, so there could potentially be more reports coming out from the short sellers.

GFRE's short interest is over 15% of their float, which is very high. We'll probably see some negative reports coming out from the short sellers... I personally wouldn't feel very safe holding this stock.

I'd like to mention 1 more stock that has passed all 5 of my screens: SFUN. That's all I know about them at this time.

And I want to mention that I just came across 2 Chinese IPO's that seem to be having problems with possible fraud: NIV and DGW. Although these were IPO's, they didn't meet my other four criteria, so I believe my screening method is still safe.

As is usually the case, DGW's short interest had skyrocketed right before their problems started.

NIV was a little-known stock with lower short interest, but they already had a number of problems that arose on their last 10-K. And based on this form, it looks like they were really a reverse-merger company disguised as an IPO:

"We were originally organized as a “blank check” shell company to investigate and acquire a target company or business seeking the perceived advantages of being a publicly held corporation."

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#5) On April 08, 2011 at 8:04 PM, ETFsRule (99.94) wrote:

Well, SFUN is actually borderline. They're somewhat related to the Chinese housing market and their PE is a little high. I don't recommend them.

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#6) On April 08, 2011 at 8:51 PM, rickdoom (97.96) wrote:

ETFsRule: I think that China Tracker site is mistaken on NIV. That wasn't a "real" IPO either--it was actually a reverse merger orchestrated by WestPark Capital in August, 2008.

See here: http://reversemerger.dealflow.com/wires/article.cfm?title=WestPark-Shell-Completes-Merger-NIVS-Raises-94M&id=ansgnrldcuefzxp

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#7) On April 09, 2011 at 12:08 AM, Valyooo (99.35) wrote:

ETFsRule: What would you say if I called this a "long attack"? Like when you think people exposing frauds are committing "short attacks"?

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#8) On April 09, 2011 at 8:33 AM, ETFsRule (99.94) wrote:

Rick: Good catch. The China Tracker is a great starting point, but it's not always 100% accurate. I usually like to verify their info using the actual SEC filings or other sources.

Valyooo: If I post any false or unsupported information, then feel free to call it a "long attack".

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#9) On April 09, 2011 at 10:32 AM, Valyooo (99.35) wrote:

So then whats up with showing disrespect towards the peoplee posting trutfhul information on the short side?

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#10) On April 09, 2011 at 11:16 AM, ETFsRule (99.94) wrote:

If you're referring to my general statement about "short attacks", that was because there were many cases of short sellers posting false information. And in the case of CCME, there was overwhelming evidence that illegal naked short selling was taking place. I think it's fair to call that a "short attack".

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#11) On April 09, 2011 at 11:42 AM, TMFBabo (100.00) wrote:

I've recently been thinking: if you think China is a fast growing economy, why not invest in mid or large caps? If the economy is growing faster, even the larger companies will also grow faster. 

If you're so focused on small caps that you're going out of your way to only find a small subset, I wonder if you'd be well served also including mid caps and large caps.  I'd be shocked if short sellers tried to target larger companies en masse.

There are also a lot of well-run US companies targeting emerging markets as top growth opportunities in their futures.  Not all of them will succeed, but there are some that have gained footholds and will likely grow from there.

Just some food for thought.  It's entirely possible that you've already scoured all of them and found that the potential returns weren't that great, but I thought I'd check.

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#12) On April 09, 2011 at 11:51 AM, TMFBabo (100.00) wrote:

I'm not personally going to buy Chinese large caps (unless I find one particularly awesome) because I'm worried about construction spending and the real estate in the major cities, but I think one could probably research several large caps in the time it takes to address a short seller's claims one ONE small cap completely.  Both in terms of time and the avoidance of short sellers, I think large caps have the advantage...

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#13) On April 09, 2011 at 3:30 PM, TMFBabo (100.00) wrote:

...in the time it takes to address a short seller's claims one ONE small cap completely

on ONE, not one ONE.  

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#14) On April 10, 2011 at 10:54 AM, ETFsRule (99.94) wrote:

Babo: I haven't come across many Chinese large caps that I like. They have less upside than small caps, and their valuations usually aren't very good.

But I do like the idea of finding international companies with a presence in China. One idea is to buy companies that sell manufacturing or testing equipment to manufacturers of solar cells and semiconductors (ex: VECO).

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#15) On April 10, 2011 at 1:14 PM, Valyooo (99.35) wrote:

Babo: I know it probably isn't your style, but I would suggest buying SINA or BIDU with a trailing stop.  That way if there is in fact a bubble (I am still not convinced there is) you will get stopped out before a collapse.

Also, as more people learn their lesson the hard way about china small caps, their money will flow into SINA and BIDU

People place too much on "value" with these large caps.  obviiously these stocks are not controlled by value, they are controlled by growth.  Look at all the shorts who got killed because they thought nflx, tzoo, bidu, sina, cmg, etc were overvalued.  They dont understand what makes these stocks grow. 

Imagine if google had a market cap of $50 milion 15 years ago.  If the p/e was 50 would it be overvalued, or would you realize it was still cheap in the long run?

Yes, small caps technically have more room to run, but that doesn't mean they WILL expand as fast as the large caps. 

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#16) On April 27, 2011 at 4:55 PM, ETFsRule (99.94) wrote:

Not to toot my own horn or anything, but GFRE is down more than 50% since I made my negative prediction in comment #4 (just 19 days ago). Once again we can see that high short interest is the single best way to predict which Chinese small caps are about to get hammered.

As for my 3 recommendations, I'll post periodic updates on them every 6 months or so.

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#17) On May 05, 2011 at 1:20 PM, ETFsRule (99.94) wrote:

I just came across an interesting site with info on the "hit pieces" (as their authors call them). One dramatic quote was,

"I think a hit piece will have to be creative".

Any thoughts on that, Valyooo?

Anyway, the naked shorts will be forced to cover their positions in YONG tomorrow. Unsurprisingly, we saw a hit piece come out today... and it wouldn't surprise me to see another one published later today, or maybe tomorrow. I wonder how creative they will be?

Short interest in OINK is still low, but it has started to rise over the past few months, and we can see from the comments that the shorts are targetting it. SBAY is also being targetted.

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