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Notable Comments On US-Listed Chinese Nanocaps

|Includes: ABAC, AMCO, FTFT, GAI, GURE, Jinpan International Limited (JST), KGJI, SGOC, SORL, XIN, ZX

A commenter I recommend following is MBoller99. He is interested in investing in net-nets. He is not a coward, he dares to invest in the smallest and cheapest net-nets available. Many of these net-nets are very ugly looking US-listed Chinese companies.

See also this article where Bram de Haas discusses MBoller99's best idea for 2016: investing in the smallest and cheapest US-listed Chinese companies. Bram gives a list with a number of these extremely cheap US-listed Chinese companies.

In the comment section MBoller99 is trying to explain how to distinguish the "good" Chinese net-nets from the "bad". I also made 2 comments.

Me:

Great article, I also avoid US listed Chinese net-nets, unless there are strong signs they want to play fair. GAI may be one of these stocks. It's in a management buy-out at $8.85.

Even a few Hong Kong listed net-nets are not safe, such as Real Nutriceutical Group. I have avoided it because there were some red flags and, to me, signs they wouldn't play fair.

While I won't invest in most Chinese companies, I wouldn't generalize. There are many signs that predict a lower or higher fraud risk. So that a company is Chinese shouldn't be a reason to immediately skip it. It is usually just as interesting to do the reading as with other companies. That people generalize makes these companies so cheap but not every Chinese company is cheap for good reasons. And even if it is cheap for a good reason it can still be too cheap.

And finally, I read statistical research claiming that large shareholders who are also managing the company pay out less to the other shareholders. A famous example is Steve Jobs at Apple: no dividend, no repurchases. So investing with a large shareholder/manager is ok as long as the company pays its shareholders.

MBoller99:

My basis for the fraud reducing factors come from a study called "Cheating in China: Corporate Fraud and the Roles of Financial Markets".

http://bit.ly/1Id6DrU

The Study concludes that Fraud is less prevalent in:
- financially developed provinces
- among firms with more block ownership
- companies with long-term bank loans

Based on another study, good signs are also
- exports to U.S. and
- education of management in U.S.

On the other hand, CEO stock ownership is associated with fraudulent activity (see page 40 of the study above). In particular, this was also the case for Chinese listed stocks in Germany. Many of these stocks were frauds and did not survive long (usually less than 3 years).

There are some evidences that U.S. traded Chinese nano caps are undervalued. My strongest argument was that they are traded now for many years and passed many audits. There are some other indications too:

- Chinese Reverse merger stocks are probably not worse compared to U.S. reverse merger stocks, see:

http://bit.ly/1Spvwjs

"Contrary to popular media perception, we find no evidence that CRMs are systematically more problematic than similar firms already trading on the same exchange,"

However, I would avoid all OTC and Grey market stocks anyway, independent of their origin. In addition, I would avoid Chinese stocks which are listed on the stock exchange for less than 5 years.

Further, there was a strong spill over effect of U.S. listed Chinese stocks, indicating an undervaluation:

http://bit.ly/1ls4v5V

"Once the regulators and the public became alarmed by the frequency of alleged-fraud revelations, the stock prices of the offending as well as other companies were hammered. In particular, other CRMs and U.S.-listed Chinese IPOs experienced strong negative spillover effects. "

Finally, my own experience is that also very low valued U.S. stocks can be frauds, e.g. ARCI (tax fraud allegations) or LIQD. So I come to the same conclusion as the article above "To flip an old adage on its head: If something sounds too bad to be true, then maybe it isn't."

Me:

MBoller's summary is what I use. However there can be always exceptions, so I use small positions only.

Other signals for a higher probability on fair play: management buyout in particular if the offer price is high (around NCAV), loss making, more than 5 years since IPO or reverse merger, only independent directors in the 3 committees, large payouts in the past (NASDAQ:GAI), significant insider buying

Exporting companies are less likely to be frauds except if they export standardized or commodity like products. Again there was a horrible exception listed in London.

Other signs for a higher probability on bad intentions: high accruals, high cash pile without significant long term bank loans, independent directors that are not really independent (e.g. having the same family name as the CEO), convertible debt (Southsea Petroleum), dilutions, VIE's (I recommend avoiding all VIE's, even Alibaba and Baidu)

MBoller99:

I did write above "However, I would avoid all OTC and Grey market stocks anyway, independent of their origin."

My reference here is this one:
http://bit.ly/1ISxCnz

"Do Investors Overpay for Stocks with Lottery-Like Payoffs? An Examination of the Returns on OTC Stocks

We study returns on Over-The-Counter stocks and we find these returns are extremely negative on average. The distribution of OTC stock returns is highly positively-skewed: while many of the stocks in our sample become worthless, a few do extremely well."

MBoller99:

I think that the most fraudulent companies were listed in Germany and not U.S. or Hong Kong. I guess that 50 -80% of all listed Chinese companies did have very serious issues. In some cases, cash was stolen by management (Ultrasonic), the financial statements were completely fake (Joyou, Youbisheng), the companies were just delisted without any further information (Tintbright, VanCamel, Fast, Goldrooster), a delisting was done with a ridiculous buy-out price (Haikui, Powerland), financial statements were completely rejected by the auditors (China Speciality Glass), customers of the companies did not exist (Ming le sports) etc.

Even worse, the authorities did not take any actions or legal proceedings. I think that German authorities can just not handle such cases and class actions are not possible. I think the fraudster did just choose the weakest regulations and stock exchange to list their stocks.

So I would be careful to invest in Germany. I think that U.S. or Hong Kong are better stock markets and have better regulations for these kind of stocks.

MBoller99:

These Chinese stocks listed in Germany had something in common: The majority shareholder (>50%) was the CEO/management and the companies were listed for less than 5 years.

MBoller99 (3 months later):

It is often a good idea to buy the cheapest and most ignored stocks, even if these stocks are from China. The performance of the stocks above was as follows in the last 3 months:
JST +39%
SORL -33%
ABAC -10%
KGJI +70%
ZX +46%
AMCO +27%
SGOC +143%
GURE -4%
SPU -20%
XIN +15%

I admit that 3 months is a short time. However, the portfolio of these 10 stocks performed much better (+33% in total in 3 months) than S&P500. It is important to buy a portfolio and not a single stock. I guess the outperformance will continue because these stocks are still extremely cheap.

Conclusion

MBoller99 did a great job explaining the pitfalls of investing in foreign listed Chinese net-nets. Furthermore his update of Bram's list with the returns less than 3 months after the article was published confirms the validity of his idea. 33% in less than 3 months was a great return! And it is even better taking into account that global stock markets went down and domestic stock markets in the PRC went down even more.

Unfortunately the prospect of great statistical returns is not a warranty for immediate investment success. For example in this list I only own Sky People Fruit Juice (SPU) and SORL Auto Parts (NASDAQ:SORL). So we can still be unlucky with great statistical stock bets and that is why using many small positions is important. In the long run however the law of large numbers kicks in. So the chances are very high that you will do great with many small positions in net-nets.

Should you also invest in Chinese net-nets? My take is that it is best to diversify over countries and sectors. So invest some of your money in Chinese net-nets, some in US-listed and Japanese net-nets, some in oil related net-nets and so on. Diversification makes your portfolio less vulnerable to small but high-impact risks.

Want to know more on net-nets? Continue the discussion at Trading Global Deep Value Stocks.

Disclosure: I am/we are long SPU,SORL,DSWL,GAI.

Additional disclosure: Also long about 50 other net-nets and low EV/EBIT stocks with strong balance sheets.