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We all hear the same thing over and over about the massive growth and potential of the Chinese market. Many predict the Chinese economy will eclipse that of the United States with the only real argument by almost all being when, not if. I am included in the camp who believes that China at some point will have an economy that is the largest in the world. With that being said, it doesn't appear to be that great of an accomplishment. China currently has the largest population in the world, and while they may become second in terms of population, they "SHOULD" be the number one economy, and the fact that they are not demonstrates how destructive central planning and government regulation is to the overall quality of life. These are lessons that appear to be fully lost on many that reside in Washington.

I am very negative on buying Chinese ADR stocks. Not all stocks, just ADRs. I would be much more comfortable buying class A shares if I could. I continue to believe that investing in Chinese ADRs is a high risk fool's game, and many investors don't know what they are investing in because so few numbers can be trusted in the way investors are accustomed. I would continue to avoid the rush to get in "before it's too late," as these stocks are hard to value with the best money managers, much less with retail investors who are last to know.

It has become common for one or more Chinese stocks each week to implode from allegations of accounting fraud. L&L Energy, Inc. (NASDAQ:LLEN), for example, is a stock I would short (my broker does not have shares to lend, preventing me from shorting, but I may start selling call options). There was recently an article in SA about accounting issues which sent the price of the stock lower. Why the events of what is going on don't spill over completely to all Chinese stocks is beyond my ability to understand, less one factor: investors' unreasonable belief that "their stock" will be different, that XYZ is the auditor, that they are underwater and want to at least break even, that the market is growing so fast and so strong that a few accounting issues are nothing to worry about in the long run. While my list may seem like more than "one thing," it all comes from "denial of the environment" investors are really in and a focus on the environment they wish they were in. It is not just the company numbers and the 10-Ks that can't be trusted, but how can any government numbers be trusted when so many important numbers are "state secrets" or filled with ambiguity due to poor data sourcing/reporting? The simple answer is you can't, or at least in my opinion, shouldn't be trusted. Unlike in North America, financial frauds may be punished with death sentences, and often are in China. That does sound reassuring to investors until you see all the sentences are due to frauds that have Chinese victims. I have yet to read or know about any Chinese person receiving a death sentence for defrauding a foreigner. Lawsuits happen all the time in the U.S. for corporate officers' misdeeds, whether perceived or actual. How about lawsuits in China to capture some of the money from the officers? Sorry, but there simply is not a civil court system like that in North America. Many of the "judges" are political appointees of the party and you can bet from lessons learned by companies that have tried to enforce IP rights and other civil issues that there is a very clear home field advantage.

Time after time, we see it is the short seller who is at the forefront of discovering fraud and other problems with companies. It does make perfect sense if you believe in the free market and are not blinded by the idea that a regulator is going to work as hard at finding fraud as someone who makes a living at it. The fact remains as I understand it that the SEC is virtually powerless to go after Chinese nationals that are committing fraud upon investors in the United States exchanges. It is not hard then to imagine that there are people who are willing to commit accounting fraud when the risk of failure, rightly or wrongly perceived, to be at or near zero. Given the situation, one has to wonder why the situation is not materially much worse than understood, and maybe it is.

It would appear that the marketplace is what I consider "wising up," but still way overvalued in light of the massively large event risk that I believe exists.

Recently we saw what can happen to portfolios with Longtop Financial Technologies (NYSE:LFT). This is a stock that I actually did trade, not long before the halt. Strangely enough, I was taking the fade by going long during extreme price moves. It's a completely different mindset when you buy a stock with the understanding that the company is likely worth less than my son's homework assignment and yet you can buy it in a quick trade while making money because someone else is there ready to buy it from you. If/when LFT does resume trading, which may likely be on the pink sheets, I would submit that an investor appears to be likely to be best off selling the shares the opening day, and if there is any strength in the stock absent material changes in the financial situation, that would likely be the ideal time to get out and redeploy the capital into another company with greater promise. Don't hold your breath on this one though.

It doesn't take a very long and hard look to see how Renren Inc. (NYSE:RENN) has done since its IPO not long ago. To say it has been disappointing so far for those that rushed to be first on their block to own RENN is probably a pretty safe statement. Some call RENN "the Chinese Facebook," as is being done with so many other companies in what appears to be a pretty effective but without substantive marketing ploy. I will likely repeat this point as so many other Chinese companies have been marketed this way but being the "the Chinese anything" by definition appears to limit your marketplace. When the market is really only China, an investor should be asking the simple question of why the company has not been able to break out into other marketplaces. Does RENN have much of a market share beyond the middle kingdom to justify its $10 billion market cap? While in pure numbers China may be the largest marketplace of internet users, not all internet users are the same. There is a massive disposable income disparity between the average North American internet users versus those surfing away on the other side of the planet. According to earnings.com, RENN will now report earnings on June 20th, 2011. Regardless of when the report comes out, who cares? Can you trust the numbers? If you believe you can and you do happen to be wrong, what can you do about it? The trade almost becomes binary in the ability to lose the entire amount at risk and if you actually use margin, even more. What about RENN would make an informed investor want to commit capital to a company that is basically limited to one market that does not have to fear sanctions if they don't play by the rules? You cannot become "a little bit pregnant" and when tough times come, as they do with all companies, you want to believe that the likelihood of the documents you are reading over are true in the sense that they at least meet the minimum requirements by law. I rate RENN an easy stock to avoid and/or short. Why would I rate RENN a sell? Here are several reasons that stand out to me:

  • Taking a look at Reuters and Edgar, the two information sources that I rely on the most for information, gives me a giant goose egg in terms of useable information.
  • Yahoo Finance provides something more, but it's not good for increasing my desire to buy RENN. PE is negative, no dividend, and no key stats.
  • IPOs are tough enough as it is. You always have that looming hold end period coming along, and its generally safe to assume the market will sell off shares out of worry the insiders will dump shares.
  • The trailing PE ratio demonstrates that the company is losing money. If RENN does report significant improvement in their financials, we should be able to trust the numbers but can we? We don't know if the numbers are real, but we do know that the U.S. Justice Department and the SEC is virtually powerless to do anything if the company is committing fraud. They could ask the Chinese government for extradition, but anyone who has done business in China knows that the local political leaders have their pictures up in the offices of every major company.
  • Yes, I know that some will say China will rule the world in about three weeks and that the market is growing and that RENN is undervalued due to the perceived headline risk that investors are discounting, but why take the chance? There are plenty of companies around the world that have proven track records where management feels the heat of regulators and not just auditors.

Next we have Sina Corp. (NASDAQ:SINA) and I pick this one because it is the last Chinese stock that I wrote about with some detail. At the time, I called it a short (Here) and this was mid-April while the price was over $140 per share. I believed Google (NASDAQ:GOOG) offered a much better value for investors than SINA, and I still maintain that GOOG is a buy. SINA more or less bounced off of the 60 day moving average but I am not impressed with that technical bounce. With the price currently near $120, it is not as attractive to short as it was above $140, but I will be watching for another short. Either way, I would not be long this stock without owning puts for protection and doing so would erase what I would consider to be reasonable expectation for appreciation.

Many of the same reasons cited with RENN apply in my opinion with SINA. In the case of SINA, I am much more comfortable shorting it above $140 than I am shorting RENN. This is simply because of the massive run SINA has had and the fact that RENN is so new that clarity is that much more diminished. As I write this, SINA has been moving up and currently trades about $127. Regardless, this one should be avoided with any type of long trade other than a technical day trade.

China Danddang (NYSE:DANG) is another recent IPO that went to the U.S. markets because the NYSE doesn't actually require a history of profits in order to be listed. In order to be listed in China, a company must show three years of profit before a listing on a Chinese exchange will be accepted. I don't actually agree that the Chinese rule is a good one but it is worth pointing out what events at least in part guided the DANG listing here. DANG is an online retail shopping site that sells items like books, music, videos/movies and other low margin products - low enough that although DANG may be making a profit, the margins appear to be in the low single digits. As with American websites that sell these types of goods, it is ultra competitive and a look at the chart today for DANG says it all. With DANG trading under $19 a share, investors have clearly voted this one down at this time. Will DANG be able to gain market share and at the same time gain margins for a reasonable PE and return for shareholders? No one knows for sure, but why try to swim upstream half a mile from Niagara Falls? You are only likely to at best get worn out staying in place if you do well, and go take a giant crash down if things don't work out. The bottom line is to avoid going long DANG and look to short on strength. If you want to get into this space, Amazon (NASDAQ:AMZN) provides a great vehicle to do so and you will even be able to sleep at night. I would be looking to sell DANG call options and buy AMZN puts.

Mecox Lane (NASDAQ:MCOX) an online seller for clothes and accessories in China started trading after its IPO last year. It is a very thinly traded company. About a week ago, Roth Capital lowered the price target from $8.50 to $6. As of the writing, MCOX is trading below $3.50 with all the trend lines trending lower. Yahoo Finance is reporting that the PE ratio for trailing 12 months over 100. Interestingly, shorts have not really grabbed onto this stock. Short interest is rather low, suggesting that the smart money does not consider this one to be a viable long-term short. My experience tells me that it is the lack of liquidity that most likely is holding the shorts back, rather than company value. For small retail traders, there appears to be enough liquidity that this one could be shorted on strength as well. I generally prefer to become short in a stock as a result of selling call options. As the liquidity in this stock suggests, the option liquidity is practically nonexistent. That leaves options out as a viable vehicle to become short MCOX.

Soufun Holdings Ltd. (NYSE:SFUN) is a $1.72 billion market cap company. SouFun Holdings Limited (SouFun) operates the real estate Internet portal and home furnishing and improvement website in China. As of September 17, 2010, SouFun maintained 63 offices. The services offered by the company include marketing services, listing services, and other services and products. SouFun offers marketing services on its Website, mainly through advertisements, to real estate developers in the marketing phase of new property developments, as well as to real estate agencies and other home furnishing and improvement vendors. The annual growth rate of revenue is 0%. The last fiscal year had accounts receivable to sales percentage of 0.1701% compared to the same period a year earlier of 0.1166%. The 2009 income statement needed to be restated. With the Chinese government seemingly raising the bar on a weekly basis to invest in real estate, it would appear that this one may be a very viable short candidate. After recently reporting good earnings, the stock has rebounded, although it is highly volatile. I would consider shorting after multi-day strength with the intention of covering during dips.

Youku.com Inc (NYSE:YOKU) is a $5+ billion market cap company. Youku.com Inc. is an Internet television company in People's Republic of China. Its Internet television platform enables consumers to search, view, and share video content quickly and easily across multiple devices. As of September 30, 2010, its video content library contained more than 2,200 movie titles, 1,250 television serial drama titles, and over 231,000 hours of other professionally produced content, including 194 variety shows. The company had approximately 203 million monthly visitors from homes and offices in September 2010 and approximately 61 million monthly visitors from Internet cafes in August 2010. It derives substantially all of its revenues from online advertising services.

YOKU has falling revenue year-over-year of $22.5 million for 2010 vs. $4.84 million for 2009. YOKU bottom line has falling earnings year-over-year of $-26.7 million for 2010 vs. $-29.97 million for 2009, and falling EBIT year-over-year of $-25.67 million for 2010 vs. $-29.75 million for 2009. Lower revenue along with a drop in earnings is often one of the last signs to get out of the way of a falling stock price. Absent a turn in the top line results in step with the bottom line, and it will be difficult to realize an oversized gain.

YOKU has been one of my favorite stocks to short. It really doesn't get much better than this one, at least when it's screaming higher, it doesn't get better. I have already written about this one here . I think investors should keep this one on the radar on the chance that it might get pumped up again. During the last run-up in price, investors became overly excited by the prospect of a division of YOKU signing up huge amounts of customers. What possibly could be better for an Internet company than signing up more users? Well for one thing, being able to monetize the customers would be very beneficial. What appeared to be ignored as a minor detail sent the share price over $65. Even more amazingly, this was done recently while headline after headline of stock frauds coming out of China were hitting the wire. The price has since fallen back into the $45 range. The 90 day moving average is $45.80, and a very aggressive short seller could use that technical indicator as a resistance point to get short. More conservatively, I will be using the $60-$65 price range as my reentry area to get short again. My method for shorting will be to look for out of the money call options as before.

China Agritech Inc (OTCPK:CAGC) is a $62.3 million market cap company. China Agritech, Inc. (China Agritech) is a holding company. Through its subsidiaries, the company manufactures and sells organic liquid compound fertilizers, organic granular compound fertilizers, and related agricultural products in the People's Republic of China. Its direct and indirect subsidiaries include Anhui Agritech Development Co. Ltd. (Anhui Agritech), Agritech Fertilizer Limited (Beijing Agritech), China Tailong Holdings Company Limited (Tailong), Pacific Dragon Fertilizer Co. Ltd. (Pacific Dragon) and Xinjiang Agritech Agriculture Resources Co., Ltd (Xinjiang Agritech). The Company's main products include spray, water-flush, dip and granular fertilizer products, and other customized, crop-specific fertilizers that are tailored to its customers' specific requirements. Its liquid fertilizer products can be applied on a widespread basis via spraying by machine or aircraft. On May 15, 2009, Tailong acquired the remaining 10% interest in Pacific Dragon.

Most notable from an investor's point of view is the suffering that investors endured for about two months as a result of the exchange halting the stock in the middle of March. Trading resumed a few days ago and CAGC currently trades for approximately half the price at the time of the halt. A lot of mud was slung at management with accusations of fraud, fiduciary mishaps, and illegal activity, leaving many to wonder if the stock would trade again. For those who wish to try to ride this newly moved to over-the-counter trading stock all the way to or near zero, I would recommend proceeding with caution. Just as news of fraud and other improprieties sent the stock into the abyss, positive news articles, even if incorrect, could send the stock price soaring to double or triple the current price. I don't believe the odds favor that happening from a risk versus reward point of view as justification to buy the stock, but certainly as a consideration with shorting. As the title of this article suggests, there is a great lack of transparency, which probably signals that it is just best to stay away from this one at this time, or to conservatively short into extreme strength.

>>Part II

Disclosure: I may short naked calls in any of the stocks in part I or II of the article at any time.

Source: The Great Transparency Wall of China Part I