Risk Arbitrage With Chinese Characteristics

by: Afanti Arbitrage

Several Chinese stocks with pending "going private" transactions are on my watch list. As more Chinese companies confirm plans to go private, the high level of uncertainty in this sector may make risk arbitrage opportunities exceptionally profitable for investors willing to rationally investigate each transaction.

Company Price on 8/17/2012 Going Private Price Expected Closing Date Book Value Per Share
China Transinfo Technology (NASDAQ:CTFO) 5.55 5.8 9/30/2012 5.15
Fushi Copperweld (NASDAQ:FSIN) 8.94 9.50 12/31/2012 10.59
Gushan Environmental Energy(NYSE:GU) 1.49 1.62 9/30/2012 2.11
Pansoft Company (NASDAQ:PSOF) 3.97 4.15 9/30/2012 3.91
Yucheng Technologies(NASDAQ:YTEC) 3.65 3.90 12/31/2012 5.17

Sources: Yahoo Finance and SINLetter.com.

Many Chinese stocks, including 3of the 5 stocks on this watch list, trade at a discount to book value, primarily due to widespread negative sentiment surrounding Chinese stocks. Even if analysts adjust these book values down, the valuations are still low. In some cases these low valuations are deserved, but in other cases they reflect investor attitudes towards Chinese companies in general, rather than company specific risk. Most Chinese stocks listed in the US are now priced like they are the next Sino-Forest, even if there is a legitimately successful business, verifiable assets, and shareholder friendly management.

Moreover, in the case of going-private transactions, the arbitrage spreads are exceptionally wide even in cases where the transaction has well documented support from the China Development Bank or large US financial institutions. Of the five stocks listed above, three are on the SINLetter.com list of top 10 deals with the largest spreads. These wide spreads may reflect general distrust of Chinese stocks, rather than transaction-specific risks.

Extra due diligence

Its no secret that investing in Chinese stocks requires extra due diligence. As I go through my watchlist and wait for further developments, I'll be giving extra scrutiny to the following areas:

  1. Management credibility and incentives. Top executives should be deeply involved in actual business operations, and not just figureheads. Management compensation also needs to be tied to performance of the US listed stock.
  2. Verifiability of assets and business activity. If there is a serious problem, the deal may collapse during due diligence. However note that previous reports by prominent short sellers do not automatically mean a going private transaction will not succeed.
  3. Risk from pending shareholder lawsuits. Investors should evaluate the credibility of pending lawsuits, and the potential cost of protracted litigation. Will the lawsuits destroy the deal?
  4. Financing and advisory support for the deal. Speculating on which companies might go private is extremely risky unless the company is already good long term value as a public company. It is far better to wait for confirmed transactions with solid financing. Additionally, for the catalyst to succeed, it helps if the involved institutions have a track record of completing transactions in China. Early announcements need to be verified from sources other than the company itself.

This extra scrutiny can verify if a company is indeed a legitimate entity entering into a rational transaction.

Hedging general China risk

Even the best Chinese stocks carry a unique risk of widespread anti-China contagion. With each new accounting scandal, unrelated stocks plummet. Moreover, a cross-border conflict involving auditing oversight threatens all Chinese stocks.

Investors should look for ways to hedge against a further onslaught of bad news impacting China concept stocks. One option I've looked at is buying put options on PowerShares Golden China Portfolio (NASDAQ:PGJ), an ETF that tracks US listed China concept stocks. This index should collapse in the event of massive China stock delisting scenario. However, currently volume is low in these options, and the ETF itself is at best a crude approximation. In the absence of other adequate hedging options, an investor should keep Chinese opportunities as a small portion of a diversified portfolio, regardless of much independent due diligence they have conducted on a particular company.

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