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How China Small-Caps Can Come Clean

Stocks in this article: FUQI RINO NEP CSKI CHBT CMFO CEU ONP

The good news going forward is that companies are starting to see the havoc that SAIC filings can wreak upon their company. I am increasingly hearing that going forward, companies will make it a priority to file SAIC filings themselves with attention from senior management and that they will make sure that the filings do indeed reflect the profitability of the business which should therefore also match the SEC filings. What we will see going forward is that historical SAIC filings do not match, but 2010 and onward filings will be largely correct. Also, in my dialogue with Chinese companies, I am strongly suggesting that they make an effort to make their own SAIC and SAT filings public (disclosed on their Web sites). Whether or not this actually happens remains to be seen.

Use of unknown auditors

Many Chinese small-caps began their public existence as tiny micro-cap reverse mergers. They therefore engaged small unknown accounting firms who were cheap and willing to do the work. As the firms grow, it is obviously appropriate to switch to a top 10 auditor, or perhaps even a big four auditor. Large companies who use no-name (or even shady) auditors are a major red flag for me and there have been many times where I avoided a company that had great financials simply due to its choice of auditor.

Again, the good news for 2011 is that this is already starting to change and in this area, Chinese small-caps clearly "get it."

Based on recent discussions with China small-cap companies, I expect to see a wave of auditor upgrades during early 2011; hopefully some will be in time to process 2010 10Ks due out in March or early April. This will greatly enhance investor confidence in the space, and I believe it will help separate the good companies from the bad. Companies who are unwilling to upgrade to a reputable auditor will see their share prices suffer.

Recent examples of auditor upgrades that have recently occurred include:

It should be noted that there are more than 500 Chinese companies that trade in the U.S., and it is simply not feasible for all of them to be using big four auditors. For most of the smaller companies, I am perfectly happy with the selection of a top 10 auditor, including auditors such as BDO or Grant Thornton which have a strong and reputable China practice.

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