A Checklist for Safe Investing in Chinese Stocks

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 |  Includes: CAGC, CAST, CBEH, CILE, CISG, CTRP, DGWIY, DYP, HMIN, HOGS, HQCL, JASO, LDK, LFT, RINO, SDTH, TSL, TSTC
by: Michael Slattery

Are you exposed to a China stock that is about to be delisted, halted or investigated? Here are 10 checks and points to safety.

Is your Chinese exchange traded stock about to get a pink sheet listing? When it comes to Chinese companies, Jim Cramer’s advice may be well advised: “STOP TRADING!” It is also what the AMEX, Nasdaq and NYSE have declared for some Chinese issues.

On April 4th Duoyuan Printing (NYSE:DYP), a firm previously represented by the accounting firm of Deloitte Touche and trading on the NYSE, was delisted. During March madness, four more Chinese stocks had their trading halted or were delisted: NIVS IntelliMedia Technology Group Inc. (AMEX: NIV); China Intelligent Lighting & Electronics Inc. (AMEX: CIL); FUQI International (NASDAQ: FUQI) and Shengda Tech, Inc. (NASDAQ: SDTH). This adds to a long list of companies currently either delisted, or halted while investigations, request for information from the exchanges’ and/or lawsuits are ongoing. They include but are not limited to: OTC:RINO, OTCPK:CAGC, OTC:SDTH, SBAT, OTCPK:CBEH, NEOC and OTCPK:CCME.

Significant discrepancies between the reported income and actual income have been one cause, inaccurate reporting of cash reserves has been another. The fabrication of contracts to falsely increase receivables has been a third. This is just a sampling of the shenanigans going on in some of these companies. Some of these companies will recover, others will just disappear. Some have moved their trading to the pink sheets. OTC pink sheets is the speculative trading marketplace that has no financial standards or reporting requirements. The kindest thing that can be said about the list of companies above is the management was inept. Many were engaged in conspiracies to commit fraud.

Amazing opportunities exists in reputable Chinese companies with great technologies and expanding markets. Unfortunately they are being tainted by the these highly visible problems. Even minor discrepancies and contradictions between what a company states and what it actually does in this environment can be utilized by the shorts to paint legitimate companies with a very negative brush destroying huge amounts of investor equity in breathtakingly short periods of time.

Secondary offerings when the accounting claims would indicate no real need for one has also been a red flag waved by some of these companies and the shorts have pounced upon those occurrences. We all know markets don’t like uncertainties or information voids and with each new scandalous announcement everyone’s suspicions grow and so does the ease with which the shorts can chase everyone to the exits.

In the current market climate every Chinese company trading on a US exchange and especially those that materialized on the scene as a result of a reverse merger must be willing to go the extra mile to prove conclusively that they are not part of the fraud that is plaguing many legitimate stocks in this sector. Reverse merger now has a negative connotation in and of itself, but this method of accessing the US equities markets was often the best and only resort for many of them. I highly recommend reading A Line in the Sand for a good background education on the reverse merger sector.

The goal of this article is to develop an efficient method to determine whether a Chinese company is "probably" legitimate. Probably is as close as we can get. It’s a difficult proposition made more difficult by two regulatory agencies that really bear no resemblance to one another: SAIC, the Chinese registration authority, and the SEC, the governing body here in the US regulating the accountability of US publicly traded equities to their shareholders. SAT is the Chinese tax-reporting authority, but no publicly released information is available from that agency. I only mention SAT because that is where the only reported income figures that would reconcile their SEC filings would exist.

Language differences, business practices and conventions as well as differences in the Chinese market place coupled with cultural differences all create barriers that impede our ability to make a reasonable determination of the accuracy of Chinese companies reporting in their annual or quarterly reports to the SEC.

One enterprising individual came up with an innovative fact checking solution – go there! It was an eye opening and apparently nose clearing exercise that is detailed here on a company recently delisted, CCME. It is well worth reading as it underscores many of the issues we are examining.

This is not a review of the companies’ financials or their underlying technical strengths or weaknesses. We are primarily looking for benchmarks of credibility, accountability and professionalism as indications of business ethics.

This test came about as an attempt to answer those questions for several of my Chinese holdings. I asked myself: What were the warning signs that fraudulent companies had in common? The opposite of that approach was to ask: What do the strong and so far reputable Chinese companies have in common? From this research I put together a list of quick facts that can easily be researched over the internet and gave or subtracted points for each researched element. Here is what I found, together with a scoring system that will at least give you a little perspective on the likelihood that your money is at a minimum safe.

Keep in mind that there are no 100% effective ways to accomplish an honesty test and less legal recourse against Chinese companies in US courts of law if they do commit fraud. Do your own due diligence, diversify and put in stops to protect your portfolio from sudden catastrophic news. Remember that you are asleep while China does business and that news we are reading the next morning is already 6-12 - and sometimes 24 - hours old and could have already decimated your stock’s share price.

There has been an attempt here to keep this simple but effective with no more than 15 to 30 minutes to develop the information you need to score your stock. It should give you some indication on how reputable a company may be and also pretty good idea of the company's risk to us and our portfolios for exposure to fraud, or even the likelihood of accusations of accounting impropriety hurting our investment.

Scores of 20 or above are great. Scores above 10 are good and should provide you with a small measure of comfort that an accusation of fraud will at least be unlikely, but not impossible. If the company receives a score under 5, you should pass on owning the stock. Between 5 and 9 you need to keep a keen eye on this investment and watch the short interest closely. In most instance, links are provided where you can answer the question posed about your specific stock. If you are going to invest a lot of money in a Chinese stock, I recommend that you also invest a lot of time in researching it.

The following checks on your stock are listed in order of their importance to making the best decision regarding your chosen research target. At the end of this article I have provided a 1 page worksheet that you can used to score your own stocks. An excel worksheet comparing 20 companies equally weighted for strong and weak companies is also available for download.

Here are the questions you should be asking and why.

Add all points from each check item listed below and divide by 10 to arrive at your total score.

1) Does your company have a major accounting firm? This is more important than usual for Chinese companies today because of the current rash of fraud. This is not an absolute guarantee as three companies were audited by top tier companies: China MediaExpress Holdings, Inc. (OTCPK:CCME) trading on NASDAQ and Duoyuan Printing (DYP) trading on NYSE both utilized Deloitte Touche Tohmatsu. China Agritech Inc. (OTCPK:CAGC) had previously engaged the Chinese division of Ernst & Young. All were halted because of irregularities found during audits by their accounting firms, but well after accusations of fraud where widely disseminated on the net.

Given the embarrassment and hits to their reputation, all major accounting firms for the near term will be snapping on their latex gloves and examining places these companies never envisioned any accounting firm going. Inquisitional attitudes and Chinese pride may not bode well for these future relationships, but it’s long over due. Here is a list of many of the Chinese traded stocks and their auditors, from Trading China. You can also find many on this PDF document PCAOB audit clients.

  • Give your company +3 points if they have a major auditoring firm, +2 if it’s a middle tier firm and +1 if it’s a U.S. firm.

2) Does the company have institutional investors? This is something that I look for in all of my investments as it usually means someone smarter than me, with much better contacts and informational resources, has wrung this company out and decided it was safe with a high likelihood of continued and increasing profits. It’s also a fair assumption that they have a lot more equity at stake than I do. Keep in mind that China MediaExpress Holdings, Inc. (OTCPK:CCME) had a major investor; Hank Greenberg invested $30 million of his groups C.V Starr & Co. Inc. money into this company as recently as January of 2010. As of today, he is suing China Media Express, its auditor, Deloitte Touche Tohmatsu, its CEO, Zheng Cheng and CFO, Jacky Lam.

If you go to Financial Visualizations or FinViz and enter the ticker symbol of your stock, you will find a wealth of information including “Inst Own” which will provide you with a percentage of all outstanding shares owned by institutions. "Inst Own," is found in a table under the stocks historical price chart. For a list of specific Institutions who own shares in a company, try Yahoo Finance. You must enter the ticker symbol in the box provided and then in the column of links down the left hand side of the page click on “Major Holders” to view the details of each company or individual.

  • Give your company 2 points if any instutional investors holds a position in it. Give it 3 if there are multiple participants or the percentage owned is greater than 10%. Give it 4 point if the percentage is greater than 20% or if institutional participation has consistently grown over the last 3 consecutive months.

3) Does the company have contracts with U.S. corporations, multinational corporations or corporations outside of China? There are, I am sure, innumerable good and reputable companies in China with no contracts outside of China. But those that are doing business with companies in the U.S. provide a small measure of assurance because those contracts and the income they provided can be confirmed. A U.S. firm utilizing a Chinese company’s products also provides some indication of the quality of the goods and services being provided. The more contracts outside of China, the better I feel.

  • Give your stock 3 points for U.S. contracts, 2 points for any with multinational companies and 1 for any contract within any company in an industrialized country outside of China. Add the points for all contracts identified in whatever category they occur, giving your stock up to a maximum of 6 points.

The best place to find this information is on the company's websites as these associations and contracts are usually a point of pride. SEC fillings are the next best place to look using SEC-EDGAR-filings.

4) Short interest increasing. To say that all of the groups and individuals focused on shorting stocks in this sector are communicating their intentions to each other would sound somewhat paranoid. There is, however, an observed increase in the percentage of shares shorted and the stocks that have found themselves being investigated, creating a direct relationship between short interest and the likelihood of a stock’s trading being halted. Several good places exist to check short interest including NASDAQ or FinViz; another good site is Trading China. Remember that dramatic short-term increases can be a harbinger of negative news.

  • Your investment is safer if it’s under 3% add 3 points; if it’s over 5%, subtract -2 points; over 10% subtract -3 points; and over 20% subtract -4 points.

5) Insider selling must be weighed against insider buying. Look to see which way the predominate trades are going and adjust your sentiment accordingly. Obviously large numbers of high share count sells with few or no buys is a big negative flag. Reuters' website provides a great deal of valuable information. By clicking on the “PEOPLE” tab you can see who is buying and selling their respective companies shares. Some of the “sells” are programed automatically and are established to eliminate any appearance of insider trading. Some of these sells are also tax related, making this evaluation a little more complicated.

  • If there are significantely more buys than sells, give your stock 3 points. If it appears to be about balanced, give your stock 2 points and if there are many more “sells” than “buys” subtract -3 points.

6) Independent rating groups such as MSN’s StockScouter Ratings compares the fundamental and technical qualities of each stock, providing you with a free and quick conformation of your China stock pick. StockScouter assigns an expected six-month return to each stock based on this statistical profile and balances that return against expected volatility. SockScouter ratings were chosen because they are doing what this exercise is attempting: Determining the expected volatility or risk against potential returns. A score of 10 is best obtainable, but don’t expect any small cap Chinese stocks to return a 10.

7) Social ratings of stocks provides you with a broad and often in-depth knowledge of an equity that many hours of due diligence would not provide. This is because it brings the "wisdom of crowds" to bear on your stock pick. The Motley Fool CAPS system is rated from 5 to 1 with 5 being the best.

  • 1 to 5 based on the Motley Fool CAPS score

8) STARMINE – Starmine Ratings for “Analyst Earnings Estimate Accuracy” are available free on Yahoo Finance and are described as follows:

When you’re researching stocks and other securities to add to your portfolios, one of the most important factors to consider is how well financial analysts who study specific securities expect them to perform in the near future and beyond. But some analysts’ estimates of stock performance are consistently more accurate than others. For that reason, it’s crucial to find one or more analysts with high accuracy ratings who specialize in the industry or company in which you plan to invest.

What’s important here are the analysts who are familiar with this equity and have a track record of accurately predicting their future earnings . This adds a level of research creditability that we as individuals would be hard pressed to recreate. Go to Yahoo Finance and enter your stock’s symbol. On the column of links on the left hand side is a link to look up your “Star Analysts” ratings.

  • Four or five stars with more than 3 analyst give your stock 4 points; four or five stars with a single analyst give your stock 3 points; three or two stars give your stock 2 points; give your stock 1 point for 1 star.

9) A great website and responsive PR. A professional well executed website with detailed information in English and contacts links with individuals that will actually respond are very important. Use Google translate to see if they are telling the same story in Chinese and English. Send an email to both the CFO (who often speaks English) and the public relations contact or PR firm. Ask them anything pertinent about their company. The real test here is whether you get a prompt and professional response.

9A. Website:

  • For a great website give the company 3 points; fair to good website gets1 point; and a bad website or one with no english translations subtract 3 points.

9B. Responiveness?

  • Add 3 points for a 24 hour turnaround to your questions. No response after 72 hours subtracts 3. If they respond anytime AFTER 24 AND BEFORE 72 give them 1 point. Remember to keep in mind the 12 hour time zone change and weekends. If it’s Chinese New Year, all bets are off. It's best to send another email after it’s over.

10) Does the company give good conference calls? I have heard great financials reported during bad conference calls and watched the stock go down while I was still on the call and continue down immediately after the call. The market sees this and assumes that there must have been something negative reported in the earnings during the conference call because the stock price is falling and that's all it takes for the price to continue down for days and days after releasing good news. This is simply because the appearance of professionalism was missing and it undermined the investors' confidence. I can’t tell you how many train wrecks I have listened to because the management did not anticipate the most obvious of questions and came to the call prepared to respond to those issues.

The second issue for me is someone with enough command of the English language that they can both understand the questions and respond to them without putting the conference call on mute/hold while the management huddles to try and come up with a response. I would much prefer to listen to a person who speaks good English translate questions and answers to their Chinese colleges as opposed to convoluted broken English with rapid burst of Chinese interspersed into them. These companies have come to the U.S. equities markets and that’s the playing field they choose. If they want to effectively communicate with the individuals who are their investors, many of them need to try harder in this area. P.S. Please purchase some decent speakerphones or invest in a good conference call audio system. You may be able to find archived recording of conference calls of the stock that interest you. Check the company's website and Google.

  • The rating here is not unlike our system with the website. It should be well executed with good audio quality, responsive and professional. Give them 3 points if you could follow along without any problems and you felt they were responsive to the questions asked at the end of the call. If the answer is no to either of these questions, then subtract -3.

A real world example.

Telestone Technologies Corp. (TSTC), was chosen for this article not because it is the perfect Chinese stock, but precisely because it has been embroiled in the same fraud acquisitions that have taken down many other stocks in this sector. The goal here is to take a difficult test case and see if we can make the determination whether or not the company is a safe investment.

Telestone has been an amazing growth story since becoming a US traded stock on NASDAQ in 2006. It has performed well for many years with revenue increasing for 2010 over 2009 by 83.2%. to $131.7 million. The company developed an innovative technology, the Wireless Fiber-Optic Distribution System (WFDS), which produces a unified access network and can carry all types of network signals over one wireless fiver-optic distribution system. This allows simultaneous distribution of high speed IP internet, CATV video, 2G, 3G and 4G forward compatibility, Wi-Fi, wireless signal coverage inside and outside of buildings, information applications system based on video, audio and data all combined within one system. WFDS is the company's most cost effective and profitable product and is expected to account for more than 40% of 2011 revenues.

Telestone's problems began with a coordinated attack on its accounting integrity by two groups, Zero Hedge and The Forensic Factor (TFF). The article, entitled “Telestone Technologies - A "RINO" in sheep's clothing", was published simultaneously in early January of this year on multiple websites. The allusion to RINO references the most notorious cases of fraud in the Chinese stock sector. The article contained many suggestions of suspicious improprieties and presented itself as an in depth investigation. Here is the opening paragrapth.

One name that has sidestepped the microscope until now is Telestone Technologies (NASDAQ: TSTC). However, after a deep dive into Telestone, The Forensic Factor ("TFF") has concluded that Telestone is possibly the most egregious target of the entire vilified Chinese reverse merger universe. TFF believes indisputable, as well as circumstantial, evidence exists that supports our request to the NASDAQ to halt trading in TSTC immediately to ensure investors are not acting with incomplete and/or inaccurate information.

Many other sites involved in shorting stocks picked up this article and copied the entire text, immediately creating an intense buzz on all stock message boards. Indeed, The Forensic Factor disclosed that they had taken a short position in the shares of TSTC and Zero Hedge disclosed that they had coordinated the posting of this report with TFF. Within days, three law firms, Robbins Umeda LLP, the Law Offices of Howard G. Smith and The Rosen Law Firm, all know for representing shareholders in fraudulent stock accounting practices, immediately issued press releases to try and attract potential clients of this alleged fraud.

As of today, four months later, none of the law firms are recruiting or pursuing lawsuits against Telestone. NASDAQ never even responded to TFF’s request for a trading halt, if indeed they even submitted such a request. Still, the response of the market in this climate of fear was destructive as TSTC’s share price was reduced by more than 25% (red arrows above and below the candle on chart below) and slid from its close before the report of $10.26 to $7.62 the day after. Volume during this dive was greater than 10 times the average daily volume at 6.9 million shares traded on January 11th the day after the TFF’s report release. TSTC’s share price has never recovered and is currently trading, as of this writing, at $5.35 a share, representing a 50.% decline.

click to enlarge images

TSTC Chart 4/14/2011Click to enlarge

So is TSTC a great value investment with amazing year over year growth, or is it a time bomb waiting to destroy future investors? Let;s see how this company scores on our checklist.

Worksheet checklist:

1) Does you company have a major accounting firm? (AUDITORS)

Give your company 3 points if they have a major auditoring firm and 2 if it’s a middle tier firm.

+ 3

The TSTC auditor, Mazars CPA, is in the top ten auditing firms in the world when ranked by revenue. They have 13,000 employees worldwide and over a 1000 employees working in the China/Asia and Hong Kong Offices.

2) Does the company have Institutional Investors? (FinViz & Major Holders)

Give your company 2 points if any instutional investors holds a position in it. Give it 3 if there are multiple participants or the percentage owned is greater than 10%. Give it 4 point if the percentage is greater than 20% or if Instutional participation has consistiantely grown over the last 3 consecutive months.

+3

TSTC institutional ownership is 12.46%

3) Does the company have contracts with U.S. corporations, multinational corporations or corporations outside of China? (SEC-EDGAR-Fillings)

Give your stock 3 points for US contracts and 2 points for any with multinational companies and 1 for any contract within any company in an industrialized country outside of China. Add all contracts in whatever category they occur up to a maximum of 6 points.

+3

TSTC contracts with US corporation Quell Industries.

4) Short Interest increasing? (Use NASDAQ , FinViz or Trading China)

Your investment is safer if it’s under 3% - add 3 points; if it’s over 5%, subtract 2 points; over 10% subtract 3 points; and over 20%, subtract 4 points.

-4

Short float is 23.80% of all outstanding shares.

5) Insider selling must be weighed against insider buying (PEOPLE)

If there are significantely more buys than sells, give your stock 3 points. If it appears to be about balanced, give your stock 2 points. If there are many more “sells” than “buys”, subtract 3 points.

+2

No insider trades

6) Independent rating groups such as StockScouter Ratings

If your StockScouter Ratings is 10, give your stock 3 points; if it’s 9 give it 2 points; and if it above 5 give it 1 POINT.

3

Receives a score of 3 on the StockScouter Ratings site.

7) Social ratings of stocks (MF-CAPS)

Give your stock 3 point if CAPS rates it a 5 and 2 point if it rates it a 4 and 1 point if it rates it a 3.

2

Two of five stars on Motley Fool CAPS

8) STARMINE (Starmine Ratings for Analyst Earnings Estimate Accuracy)

Four or five stars give your stock 3 points; three, two or one stars give your stock 2 points; no stars, no points.

0

No Starmine Ratings available for TSTC

9 (NYSE:A) Website and (NYSE:B) Responsive PR.

Great website 3 points; fair to good website 1 point; and a bad website or one with no English translations, subtract 3 points.

+3

Excellent

Add 3 points for a 24 hour turnaround to your questions. No response after 72 hours, subtracts 3. If they respond anytime AFTER 24 AND BEFORE 72 give them 1 point. Remember to keep in mind the 12 hour time zone change and weekends. If it’s Chinese New Year, all bets are off. best to send another email after it’s over.

+3

I have always gotten a response in a reasonable amount of time.

10) Do they give good conference calls?

This is not unlike the website. It should be well executed with good audio quality, responsive and professional. Give them 3 points if you could follow along without any problems and you felt they were responsive to the questions asked at the end of the call. If the answer is no to either of these questions, subtract 3.

-3

Terrible conference calls.

Comparisons and conclusions.

A comparison sample of 10 Chinese companies that have been halted, delisted or investigated were compiled and compared against 10 Chinese companies that analysts felt were strong investments. These companies were all cited in an article on The Street entitled “10 China Stocks With Upside: Analysts.” This comparison of strong vs. weak enables us to establish a range of scores that enable interpretation of candidate stocks.

A graph of the relative performance of each stock is superimposed over its own data in the excel spreadsheet below. Statistical significance was an impossibility and because of the delistings many data points for those companies were unavailable (DNA). Additionally, the test emails to these halted companies universally went unanswered and are labeled (RFI), or request for information. Unfortunately, making financial decisions with incomplete information is a common situation in researching and trading Chinese stocks.

Small XLS China Dragons spreadsheetClick to enlarge

The average score for the "strong recommendation," stocks from the “upside analysis” Street.com article was 18.6, while the average score of the delisted and halted stocks was 5.96. There are no guarantees in this world and absolutely none in the stock market; however, when using this research on our test stock, Telestone, with a total average score of 15, appears as a safe investment. With an incredible forward PE of 1.91, TSTC also has tremendous upside potential.

Additional information on Telestone Technologies can be found here and its fourth-quarter, full year-end report is here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: My contact information is available on my profile page. If anyone would like a copy of the excel file I will be glad to share it. This article is intended to provide you with a process for determining a company’s credibility, accountability and professionalism and all but ignores fundamental and technical analysis. A complete investing picture is not produced with the process described herein. Nothing in this article should be construed as a recommendation to buy or sell any security.