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More and more, we are seeing written articles, web blogs, message board postings and television segments in which U.S. listed Chinese stocks, especially those that came into being via a reverse merger, are characterized as far more risky and/or frauds.

These characterizations have occurred ad nauseam. Sometimes these characterizations have been made regarding the stock segment as a whole, sometimes they have been made in regard to individual stocks within the segment, and sometimes they have been made in regard to the segment as a whole and an individual stock(s) in conjunction.

In brief, these characterizations are almost entirely false. As with any stock segment, a stock like RINO International (OTC:RINO) is occasionally found. (RINO International appears to have overstated their past revenue since two contracts for which they reported receiving revenue were never finalized.) Despite the very bright spotlight thrown on this stock segment for an extended period, there is not reliable evidence that these stocks are far riskier; in fact, it is becoming clearer and clearer over time that, entirely or almost entirely, the underlying companies are not frauds.

To illustrate, see this quote from the SEC website (here):

…the SEC suspends trading only when it believes the public may be making investment decisions based on false or misleading information. Suspensions give notice to current and potential investors that we have serious concerns about a company. A suspension may prevent potential investors from being victimized by a fraud.

It appears that there were about 236 SEC trading suspensions in 2010, and it appears that very few of these suspensions involved Chinese companies (see the list here). (I was able to find three Chinese companies on this list.)

In fact, since the prices of these stocks have been beaten down to such a ridiculously low level based upon almost-entirely false information, I believe that they represent a fantastic buying opportunity for individual investors. Normally, this kind of buying opportunity is limited to venture capitalists and the like. In this segment, however, individuals have a venture capitalist-like opportunity. Like a venture capitalist, though, you need to do your due diligence to separate the truly great opportunities from the overstated opportunities and the occasional fraud. In this way, it is just like investing in U.S. or Western European based companies, but it has far greater upside potential.

For example, as of February 9, 2011, per MSN Money, the following stocks had a trailing P/E and forward P/E below 10: CTFO, OTCQB:CHBT, OTC:SDTH, BORN, LIWA, HEAT, DQ, CFSG, HEAT, OTCPK:YUII, OTC:CHNG, HRBN, CGA, YONG, OTC:CNGL, GFRE, ONP, OTCPK:ABAT, SUTR, CJJD, DHRM, OTCPK:CELM, DGW, CHOP, CPHI, GPRC, CNIT, SPU, OTC:CVVT, OTCPK:CCME, CADC, OTCPK:CBEH, UTA, OTC:NEWN, CNET, ALN, TSTC and BSPM. The following stocks had a trailing P/E and forward P/E below 5: NEP, OTC:SIHI, AMCF, NIV, ZOOM, CSR, XIN, CIL, NFEC, SKBI, OTCPK:ZSTN, OTCPK:CSKI, and CCCL. (These are only partial lists.) Sometimes, there are a large number of additional future shares that are not accounted for in these P/E ratios; but this is the exception, and not the norm.

Most of these stocks are growth stocks, growing revenues and net income at up to a 100% a year or more pace (e.g., YONG). Some of these stocks have balance sheets with a lot of extra cash and zero debt (e.g., CCME, CHBT, and CEU). They are benefiting from an environment of not only about 10% annual GPS growth, but wherein capitalism is relatively new and there is, subsequently, much more opportunity. Many of them have Big 4 auditors or Top 10 auditors. There are over 70 companies with Big 4 auditors on the list here.

What has been happening is this: Short-sellers know that they can easily make money in this segment by shorting the stocks and, then, often with or via collaborators, they communicate a series of what appear to be lies, exaggerations, and/or misrepresentations that will drag the stock price down. Sometimes these missives hit on what proves to be, in part if not in whole, a true flaw regarding the investment. Usually, though, they hit on nothing or nothing significant. It doesn’t matter much, if at all, to the short seller whether any of these point hit. The stock price still goes down, at least for a while.

A case in point: Based upon Muddy Waters Research’s June 28, 2010 report, in which it stated

We are confident than ONP (Orient Paper) is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars.

The Audit Committee of the Board of Directors of ONP (see here - Audit Committee of the Board of Directors of Orient Paper, Inc. Presents Findings of Independent Investigation and Orient Paper Provides Appraisal and Capacity Check Update) launched and independent investigation, involving Deloitte & Touche, into 12 different matters. To date, 10 of these matters have been shown to be non-issues. The other two matters, involving inventory and raw material purchases, are still being worked. Muddy Waters is 0 for 10. No person or entity that is attempting to be correct goes anywhere near 0 for 10 on something like this.

Is this unethical? Yes, of course it is. Will this continue? Yes. How can it be stopped? Via multiple measures.

(1) The impacted companies are just now starting to speak out well in response to these attacks. This trend must continue and strengthen. Generally, they should not be silent regarding any unfair criticisms that largely affect the stock price, even if the affect on the stock price is temporary. Also, if when a legitimate, significant question is raised that the company has not answered or answered well enough before, they should always answer the question publically. (A criticism can, potentially, be valid.)

(2) The companies should always consider legal action as a potential course of responsive action. They should not consider this based solely upon the possibility of winning an injunction or settlement, or the possibility that the actual or potential time and/or legal costs involved will deter a short-side attacker(s). They should factor in the communication and corporate image aspects as well. It looks bad when a company is unfairly short-side attacked and, maybe, subsequently investigated by law firms and/or sued, and it takes no legal action. It creates the appearance that the company may be guilty, but the short-side attacker may only be mistaken. The companies should factor in the costs associated with a damaged corporate image, e.g., decreased revenue or increased financing costs—whether via a stock offering or loan. This decreased revenue is occurring to CEU now, and a great number of these companies have already gotten a very poor deal on a stock offering per-share price(s).

(3) U.S. regulatory authorities need to address the situation. It is embarrassing that we have done nothing regarding the grave mistreatment of the companies in this stock sector. It is also rather humorous, in the context of all the unfounded or exaggerated claims about how relatively untrustworthy these companies are because they are Chinese. It appears that they can’t trust us, not the other way around.

(4) The more-reputable, and supposedly more-reputable, U.S. news sources should stop covering this story in what appears to be a biased and/or unprofessional manner. Barron’s and CNBC seem unlikely to do this. All of us who are knowledgeable regarding the news realm know that, often, what passes for news may simply be a part of someone’s and/or some institution’s agenda. It is clear that, for the time being at least, some people at these institutions may want to get us to invest in U.S. companies, even though these investments are relatively much less attractive.

In their August 28, 2010 article Beware This Chinese Export, Barron’s used Muddy Waters as if they were a credible source, when they already had sufficient evidence to strongly suspect that they were not. To quote Barron’s (see here):

The Hong Kong-based analysts, whose firm is Muddy Waters Research, said in their report that they visited Orient Paper’s factory in January and found it idle and dilapidated. They calculated that the company’s SEC filings overstated the value of its assets some ten-fold. Revenues were overstated 40-fold…

For just one, to quote ONP from their July 1, 2010 response to Muddy Waters:

Muddy Waters has no apparent history of providing credible independent research or any research for that matter as they state this was their ‘inaugural report’... When this team visited the Company's facility in Baoding, they offered to write a paid-for research report on Orient Paper; but the Company declined their offer.

This is far from the only way in which the Barron’s article was apparently biased and unprofessional. Expectations are higher for places like Bloomberg and The Wall Street Journal; yet Bloomberg recently published an article on Waldo Mushman without doing proper investigation. If they had investigated properly, they would have readily seen that the Mushman, as is standard for short proponents in this stock space, is regularly inaccurate in his criticisms and does not issue retractions.

In fact, they would have found things like this (see here):

The management of China Sky One Medical reminded investors that Waldo Mushman was misleading investors by counterfeiting SAIC documents and posting them on its website and other blogs.

I hereby challenge the U.S. and other business news services to do unbiased, high-quality investigative journalism regarding the point-by-point accuracy and integrity of the short proponents in this space. If and when they do, the results will be shockingly (to many people) unflattering. Am I the only person who has noticed this problem and is issuing this challenge? Certainly not. Here is another instance.

(5) The many well-known and reputable individuals and institutions in this space as long-side investors should be more involved. It may be too difficult or time-consuming for a news service like Bloomberg to go through all of the more-recent major SEC filings, visit locations in China, et cetera, related to a company(s) that has been unfairly criticized. These bigger investors have already strongly vetted these investments. They are a resource via which the many unfair short-side contentions can be more-readily debunked. They should also consider legal action as a potential course of responsive action.

(6) The bigger, more-renowned brokerages, et cetera, should initiate coverage on some of these stocks—and not simply for newer issues for which they may have helped with the financing and/or listing. Some of them are far better investments than the vast majority of stocks that are currently covered.

Source: U.S. Listed Chinese Stocks: Mistreated and Undervalued (Part 1)