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By Maj Soueidan

Over my investment career, I have never been one to over analyze risk. Let’s face it - dwelling too much on the negative will paralyze your portfolio. Any micro cap stock can have some mud on it, but with U.S. firms I've generally been accustomed to believing the numbers filed with the SEC.

Unfortunately, if you are an investor in the reverse takeover [RTO] ChinaHybrid® space you can not ignore the fact that fear and uncertainty, as opposed to fundamentals, are currently strong motivators of stock performance. This could continue through the 2010 audit season, so it makes sense to understand the red flags commonly identified by short sellers that feed this fear and uncertainty. You need to know what you are investing in and the type of potential risks to your portfolio. You can also profit from this knowledge by:

  • Shorting stocks that you feel may come under attack

  • Bottom fishing for the ones that have been unfairly punished due to guilt by association

  • Feeding on the scraps of the companies that you feel will successfully resolve issues

  • Buying stocks that you believe have successfully addressed issues.

I have included the following check list to help investors understand the risks present in the ChinaHybrid® space as well steps companies should take to establish credibility. The list is a work in progress that will be amended as we move through the ChinaHybrid® purification process.

Red Flags Commonly Used to Insinuate Fraud

A. Financial

  1. SAIC documents do not match SEC.

  2. SAT documents do not match SEC.

  3. Low R&D expense, especially when company has unique technologies. (China New Borun (NYSE:BORN))

  4. Unusually low accounts payable position. (ZST Digital Networks (OTCPK:ZSTN))

  5. High margins compared to competitors.

  6. Allegations of low credit rating when SEC filings look pristine. (China MediaExpress Holdings (OTCPK:CCME))

B. Internal Controls/Corporate Governance

  1. Ineffective internal controls, especially when issue exists for an extended period of time. (Skystar Biopharma (NASDAQ:SKBI)).

  2. High CFO turnover. (China Sky One Medical (OTCPK:CSKI))

  3. Resignation of several members of the board of directors. (BORN)

  4. High auditor turnover, especially if company goes back to old auditor.

C. Ownership Structure Issues

  1. A significant delay in meeting registered capital requirements upon an RTO transaction. This could imply that original players were not comfortable infusing capital into a company. (Weikang Bio-Tech (OTC:WKBT))
  2. Desire to switch ownership structure to a variable interest entity, or VIE, from a foreign invested enterprise, or FIE. (Orient Paper (NYSEMKT:ONP), China Energy (OTC:CHGY)). This could insinuate difficulties in securing capital from original players of the the RTO transaction.

  3. Illegal corporate structure as defined by PRC law. (China Education Alliance (CEU) note)

D. Share transactions

  1. Several equity offerings within a tight time period.

  2. Company raises money when it has excess capacity

  3. IPO that priced well below desired price, yet company does not cancel or delay offering. (BORN)

  4. Company raises money despite adequate cash balance. (Renhuang (NYSEMKT:CBP) note)

  1. Company raises money despite contradictory comments in filings and press releases. (Telestone (NASDAQ:TSTC) note)

  2. Equity offerings at low valuations when balance sheet is healthy and at least 30% EPS growth is expected. RTO stocks in general.

E. Miscellaneous

  1. High land right use. (Lotus Pharma (OTCPK:LTUS))

  2. Company won’t disclose sellers related to certain transactions. (China Green Agriculture (NYSE:CGA))

  3. Company won’t disclose address or names of retail locations, distributors and subsidiaries.

  4. Lies about date of establishment of acquired business.

  5. Negative commentary by media outlets in PRC. (Kingold Jewelry (NASDAQ:KGJI) note)

  1. IPO rejected in the PRC if firm claims to be a leader. (KGJI)

  2. Inadequate Website. (China Education Alliance (CEU) note)

  1. Low executive salary.

I have also also included what I feel are steps companies should consider to establish credibility, as well as my thoughts on clues that an equity raise is on the horizon. You can see more on this here.

Source: 27 Red Flags for Chinese RTO Stock Investors to Look For