How to Invest in Chinese Reverse Mergers- Part II

by: Ryuto A. Kawai

A. The Case for Investing in Chinese ADRs:

In my previous article, I showed that both outlier gains and outlier losses could be expected in the Chinese reverse merger space. Though my analysis only covered the 10 stocks mentioned in the original Barron’s article, it would not be a hard task to show how this extrapolates into the Chinese RTO or Chinese SPAC ADR space as a whole. In this current article, I want to detail the rationale for investing in this space, as well as lay out a general strategy for doing so successfully.

China's GDP is growing at an estimated ~9%/year give or take a few percent. In contrast to this stellar performance, the Shanghai Composite is down approximately -50% if you examine the last 3-years. I believe that these opposing trends- between fundamental reality and the stock market- present a unique opportunity to make money on the Chinese growth story. There is no question that accounting issues at FUQI or NEP have weighed down the entire reverse-merger Chinese ADR space, and perhaps even the broader Chinese ADR space. This makes the reverse merger space potentially more undervalued and attractive, if-- and this is the big if-- one can avoid the explosive losers.

Below is a spectrum of perceived risk for the long Chinese equity play. It is not meant to be comprehensive or perfect, but is only intended as a general mapping of perceived risk in the Chinese equity space.

click to enlarge

Table 1: Risk-spectrum for longs in Chinese equities.

I bring this general risk-spectrum up because it is clear, from just the sheer number of analysts, commentators, investment managers on TV, newsletters, the blogosphere, and on other investment publications touting the strategy, that the lower risk play of say, buying Caterpillar (NYSE:CAT), GE (NYSE:GE) or McDonald's (NYSE:MCD) to gain exposure in China is a very popular. It is also an increasingly crowded play. The perceived lower risk nature, and perceived high return of such a ‘sure bet’ is ensuring the fair or over-valuation of such investments.

As risk tolerance picks up moving forward, and as investors venture out of the most crowded China plays, I believe the IPO-entry stocks and Big-4 audited stocks will rise, along with reverse merger/SPAC and non-Big-4 audited stocks. The potential upside is clear if you take a few stocks in this space, in each category, and examine the general level of discount these stocks broadly share. Whether a fair or excessive discount is priced in for earnings or accounting quality clearly depends upon the company in question.There is generally a lack of differentiation amongst individual companies that makes picking out winners in this space potentially lucrative.

Upside potential is also evidenced by high short interest. On the short-selling side, the double digit percentage short interest, even in many big-4 audited reverse merger stocks, indicates that the short China play outside of some big-4 audited reverse mergers, IPO-entry stocks, and multi-national Western firms is currently very crowded. Consider this fuel for a potential long winner.

By now, the case for Chinese IPO-entry and non-IPO-entry ADRs longs, at least for the diligent and risk-tolerant, should be very clear. The keys to success, in my opinion, is in knowing and capitalizing on the different drivers between outlier gains and outlier losses. As the debates on SeekingAlpha, in investing forums, blogs, comments, and within the community of investors in this specialized field indicate, there seem to me to be too much of a back and forth about whether or not a company is a fraud. While I do not mean to diminish the importance of this topic, I believe both shorts and longs would do well in considering what is outside this usually unanswerable question.

The following Venn diagram of potential problems may be of use.
Venn Diagram

Many people cite a lack of proof of whether or not a company is a fraud- and undervaluation- as reasons to be long. But there are other potential problems. Below are some examples to highlight the distinctions indicated in the Venn diagram.

-Example of an inexperienced but not unethical company: The company is legitimate but was wooed by overzealous financiers that dumped them, unprepared onto public exchanges. These companies may have too little experience in U.S. accounting norms, and in internal control. Filing delays, restatements, CFO turnover, auditor changes, uplisting and downlisting are all observed to cause a massive decline in stock price.

-Example of a company that has short-magnet details, or ‘red-flags’, but is not necessarily unethical or fraudulent: A company has a main ‘red-flag’ detail that the initial reverse merger deal was put together or promoted by the relative of another unsavory deal-maker, with known ties to felons. The company does not have ties with the relative any more, nor does the relative have a history of failures or crimes. Shorts may nonetheless string this information together with other details, such as difficulty in reconciling certain numbers, or a non-big-4 auditors short report that strikes fear, causing shares to plummet.

B. Pre-Conditions and Triggers for Outlier Losses:

Below is a list of pre-conditions or triggers that are commonly observed in Chinese non-IPO-entry ADRs prior to, or coincident with massive drawdowns or single-day losses:

  1. Late filings, significant earnings restatements, accounting irregularities.

  2. A downgrade of auditor, from a top-quality auditor to a lower-quality auditor.

  3. High management turnover, or a sudden and unexpected resignation.

  4. High auditor turnover, or a sudden and unexpected resignation.

  5. A poor-history auditor or auditor that exhibits consistent deficiencies in PCAOB reports (not all auditors register or report to PCAOB).

  6. No report on internal control and/or no auditor attestation as to internal control.

  7. Material weakness (more serious) or deficiencies in internal control.

  8. Large manual insider sales.

  9. A string of positive PR reports followed by dilutative equity raises.

  10. Excessive or flagrantly vague and exaggerated marketing words.

  11. High or cutting-technology claimed, but patents lacking.

  12. Patent qualities low—out of design, utility, and invention, design patents are considered least stringent. (Note: USPTO and EPO patents are generally held in high regards to SIPO patents.)

  13. Previous or current company affiliation with poor-history, fraudulent, or con-affiliated promoters, financiers, or investors. (Read the SEC filings, and investigate the history of those involved with the company).

  14. Exaggerated or falsified management credentials. (Check with the institutions claimed if possible.)

  15. Management’s past history of affiliation with problematic or dishonest companies. (Find management’s Chinese-character names, and search the name in combination with other search words).

  16. Frequent use of excessively complex financial structures and transactions. (Go through the SEC filings and understand the purpose or end result of complex arrangements).

  17. Payments in related-party transactions that are consistently over fair-market-value.

  18. Hard-to-explain accounting discrepancies such as large cash balances that do not generate interest.

  19. Cash flow that significantly and consistently trails earnings or a ballooning of non-cash current assets.

  20. Uplisting or downlisting and exchange non-compliance notifications, or de-listing notifications.

  21. Short reports that string together details listed in 1-20.

C. Pre-conditions and triggers for outlier gains:

  1. Low valuation combined with high growth.

  2. Extremely high short interest and subsequent short covering.

  3. A complete or near complete lack of trust or quality ‘issues’ listed in B.

  4. Share buyback or dividend announcements.

  5. High FCF growth matching high earnings growth.

  6. Multi-year, audited, earnings figures. (Higher auditor reputation translates to higher risk for shorts).

  7. Uplisting.

  8. A positive conclusion to investigations or developments in that direction.

Here I want to note an observation: That once trust is lost in a company—whether based upon convincing evidence, or upon general uncertainty or issues that may be explained reasonably—stock prices are observed to remain depressed for a minimum of multiple months. Typically, PR events or management statements to clear their name have not been observed to be immediately effective, at least looking back at well-known cases (Bodisen Biotech (NASDAQ:BBC), AgFeed Industries (OTC:FEED), China North East Petroleum (NYSEMKT:NEP), Orient Paper (NYSEMKT:ONP), Fuqi (OTCPK:FUQI), Gulf Resources (GFRE), China-Biotics (OTC:CHBT), China Integrated (OTCPK:CBEH), China Expert Tech (OTC:CXTI), Universal Travel Group (UTA), etc.) In contrast, buybacks seem more effective, as observed in the case of China MediaExpress (OTCPK:CCME), (A share buyback did affect a sharp rebound from a Sept. 16 closing price of $7.83 to $10.63 as of Oct-7.)

D. Acknowledging Assumptions:

In science and engineering, it is frequently the case that modeling a certain phenomena requires the laying out of some general simplifying assumptions. This laying out of assumptions can point out weaknesses and strengths in the model. In investing, whatever level of risk-tolerance we may eventually decide to be comfortable with, it may still prove fruitful to list certain assumptions made. I should note that this exercise should be differentiated from baseless or emotional cynicism and paranoia—or an emotional impulse in seeing only fraud.

Here are some examples:

  1. A company shows investors bank statements to ‘prove’ cash balances. If we place weight on this evidence, the assumption in our mind is that these bank statements are authentic, unedited, and direct from the bank.

  2. A company executive claims to be an ex-Big-4 auditor or manager, or claims certain degrees and designations, and we use this information to upgrade our belief in the quality or ethicality of management. Here there is an assumption that the affiliation is real and that the person did not get fired for impropriety or resign in the face of allegations. With lesser-known designation or Universities, there is an assumption that degrees or designations are not for sale, or simply made up.

  3. There are no insider sales, or sales by large investors, and we use this information to downgrade the possibility of fraud. Here, the underlying assumption is that stock fraud is necessarily or usually pump-and-dump, as evidenced by share sales. Investor poop-and-scoop or short-and-distort are two alternate possibilities. Two other possibilities include funneling equity out of the company through related-party transactions or lavish management expenses hidden from view. Under the right pressures, managers may fudge numbers to meet expectations.

  4. An auditor signs off on earning statements. The balance sheet shows a large cash balance. We use this information to upgrade our trust in the company. Here the assumption is that cash balances are difficult or impossible to falsify. Unless the audit firm is receiving direct, and sealed bank statements, and is not complicit or negligent, the cash balances may still be falsified. Satyam (SAY) is case in point. Granted we cannot expect to have information about complicity, we can gain some information about audit procedures at different firms. As an example, Dou Yuan Printing (NYSE:DYP) dismissed DTT HK, apparently for requesting direct and original bank statements. This gives us a new and stronger assumption, that DTT applies this stringent methodology to other Chinese firms.

  5. A company has a big-4 auditor, and we trust their figures. Here we must note that quarterly figures may be unaudited, while annual reports are generally audited.

E. Possible Strategies:

There is no simple pointer that can be given for successfully investing in this space. I believe people simply have to perform a type of due diligence akin to what a private investigator might perform. You will be surprised at what can turn up if you search the company’s name, the company’s previous name, manager’s names, promoter and investor names, both in English and in Chinese. Contacting competitors and affiliates should also be a part of this type of due-diligence.

Noting outlier losses and gains as common in this space, the correct investment strategy must be to 1.) dilute holdings such as to avoid one bad pick from capitulating the entire portfolio, and 2.) gaining any small edge in terms of reducing the probability of investing in bad/unethical/short-sale-target stocks, even if that means potentially missing out on a good investment.

Point #1 is obvious, and probably applies, not just for Chinese non-IPO-entry stocks, but other speculative high-risk/high-return stocks as well. Strategic point #2 needs some elaboration. The point is that even a perceptibly small decrease in probability of landing on a ‘problem’ stock is usually worth taking. As a long-investor in this space, general thinking must be skewed massively in favor of decreasing the odds of picking a bad company, because the results are very dramatic. Keeping the Venn diagram and outlier loss pre-conditions and drivers list in mind, an investor would do best in filtering out those stocks with even a few ‘red flags’ whether these ‘issues’ or uncertainties indicate fraud or not. In some cases, one ‘red flag’ may be all you get before a large plunge. Given the magnitude of one-day losses seen in this space that have lost trust, it is imperative that the investor take the most conservative approach.

Beyond avoiding companies with even the slightest of 'red flags' I believe that if there are any questions, time and multiple years from a reputable auditor can be taken to reduce the probability of a fraud. Be cautious and patient. However, once in a trade, and there are unexpected signs of trouble, I believe taking the cautious approach of exiting is correct, regardless of the outcome. There is frequently time to exit with a large, but reduced loss, if one acts quickly at the first sign of accounting problems. As an example, when FUQI announced 'issues' with its past earnings statements, I was out with a one-day loss from the previous close of -33%. Although -33% hurt, the holding was a small enough 6% of the portfolio that the loss only impacted my overall portfolio ~2%.

Had I held, the stock would have plummeted and drifted further to a recent price of around ~$6/share, or another -50% loss (recent pop to ~$8 noted). There frequently is time to exit a long position after the first large decline before the much larger, full loss is realized, and this exit should be taken.

F. Summary:

The methodology of deep investigation and assumption-checking is not easy to apply, and the work is significantly tedious. For most, investing in China through H-share companies with a big-4 auditor, or investing in western companies with Chinese exposure such as YUM, CAT, MCD, or BTU may be the only practical ways to invest in this space. However, as the most obvious ways to invest in China, they may also prove to be the most crowded. For the diligent and thorough investor, traditional IPO-entry and non-IPO-entry stocks may be a serious option for larger, more lucrative gains.

Disclosure: No positions in the stocks mentioned.

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