A Unique Approach to Investing in Chinese Companies

by: The GeoTeam

With ChinaHybrids under fire, investors may be asking themselves what other investment options they have if exposure to Asia is part of an overall portfolio strategy. As far as China goes, we have generally published profiles of Reverse Take Overs (RTO) and American Depositary Receipts/Shares (ADR/ADS), such as SouFun Holdings Adr (NYSE:SFUN), that have gone public on a major U.S. exchange; but there are two more ways an investor can approach China.

1. Consider Level 1 ADRs

Three types of ADR programs exist. An American Depositary Receipt (ADR) represents ownership in the shares of a non-U.S. company that trades in U.S. financial markets.

Some major differences between the three levels of ADR programs have to do with where shares will trade in the U.S. financial market, registration requirements, reporting requirements and the ability to raise capital in the United States. Level 2 and 3 ADR companies have to register with the SEC, file annual reports [Form 20F] and adhere to U.S. GAAP standards or International Financial Reporting Standards [IFRS]. These firms will be able to trade on a major U.S. exchange. However, only level 3 ADRs are permitted to raise capital via the equity market. Some may also have dual listings on their domestic exchanges.

Level 1 ADRs are the lowest of the three and cannot raise equity capital in the U.S. These shares trade on the pink sheets with little volume. However, what’s nice about some of these stocks is that they represent some rather substantial companies with impressive growth stories. Since shares also trade in China, they should get the benefit of positive market moves even if China Hybrids under perform. We would also expect these firms to obtain higher multiples that are customary with local Chinese exchanges. An added bonus is that short selling Pink Sheet stocks is prohibited.

Challenges do exist with Level 1 ADRs. First, the pink sheet market is generally illiquid and Level 1 ADR price movements will depend on the price of its difficult-to-monitor domestically listed stock. Second, these companies tend to be Blue Chip companies with many shares and with growth rates not as exciting as the China Hybrid space. Third, Information may be hard to come by, possibly leading to untimely or costly decisions.

A further complication is the fact that level 1 ADRs do not have to report financials to the SEC. However, they are required to publish annual reports on their websites in accordance with its domestic standards. We will slowly begin to devote more time to research the tremendous amount of Level 1 ADRs contained in our internal database. Although we have monitored these ADRs for about 7 years, we have not committed substantial funds. Level 1 ADRs represent the bulk of U.S. ADR listings and contain companies from various international markets.

Here are a few charts of some well performing Level 1 ADRs over the last year, trading near 52 week highs. Please note that we have not performed any research on the following companies.

China Res Enterprises ADR (OTCPK:CRHKY)
Air China Ltd (OTCPK:AICAF)
Boc Hong Kong Sp ADR (OTCPK:BHKLY)
Jardine Matheson ADR (OTCPK:JMHLY)

2. Invest in U.S. Companies That Have Ties to Asia.

We have increasingly added U.S. stocks to our internal database that have or will have direct or indirect business ties to Asia. In this way, you can be greater assured that proper disclosures are adhered to and that the companies may actually trade at premium multiples indicative of US stocks.

Ballantyne Of Omaha (NYSEMKT:BTN), a manufacturer and distributor of commercial motion picture equipment, is a firm that has been aggressively penetrating China and has seen its shares more than double in recent months. Coal producer Alpha Natural Resources (ANR) is benefiting from strong Asian coal demand. Some technology stocks we own that have or plan to have exposure to Asia are AXT (NASDAQ:AXTI), Nanometrics (NASDAQ:NANO), Amtech Systems (NASDAQ:ASYS), Advanced Energy Ind Inc (AEIS), LGL Group (NYSEMKT:LGL). Please note that some of these stocks, particularly LGL, have recently had significant price moves. LGL also filed a shelf yesterday morning, allowing it to offer stock in the future. This could put pressure on its shares. We have begun or will be scaling out of these companies as they approach our internal price targets or as market conditions warrant. AEIS shares have been in a steady decline. It, along with several other technology related companies, was recently downgraded by BOFA Merrill (NYSE:BAC). We do not currently own BTN or ANR.

As the ChinaHybrid reverse merger market has slowed down, the IPO pipeline for Chinese companies remains healthy. We have identified at least six companies set to go public in the U.S.

Country Style Cooking Restaurant Chain

Global Education & Technology Group Limited

Sunity Online Entertainment Limited

Tibet Pharmaceuticals, Inc

ChinaCache International Holdings Ltd

Jintai Mining

Disclosure: Long NANO, ASYS, AXTI, LGL, AEIS at time of article