China Stock Fraud News Already Priced In

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING (TheStreet) -- It was widely announced Tuesday that the Securities and Exchange Commission was conducting a major crackdown on the practice of "reverse mergers" by Chinese companies due to widespread allegations of accounting misstatements and outright fraud. It was top headline news at TheStreet as well as the Wall Street Journal.

One might assume this type of news would have had a negative impact on the prices of U.S-listed Chinese stocks. However, I decided to run a quick screen to see what the real impact was and the result was a bit surprising. I looked at all U.S.-listed China companies that I track with a market cap of greater than $50 million (266 companies) and found that the overall return for the day was a positive 0.5%. Basically, they were flat on the day.

Why didn't the market react more to this news? Because the market already knew. This year has seen numerous accounting restatements and outright frauds among U.S.-listed Chinese companies and the prices of the entire space have traded down as a result. Therefore, this fraud news is already priced in. But this has been a process that has slowly been evolving over the course of 2010 and the SEC investigation comes as no surprise to many investors who have witnessed numerous individual stocks drop by 40% to 60% in a day due to accounting irregularities or accusations of fraud.

It was just a few years that there were only a handful of Chinese stocks traded in the U.S.. Now there are more than 500 (including the major exchanges, OTCBB and Pink Sheets). And the number is growing substantially every month. The vast majority of these new listings come from reverse mergers, which also are known as reverse takeovers (RTOs) as seen below.

In 2010, Chinese initial public offering, as opposed to RTOs, have garnered much attention for two reasons. First is the sheer number of them, with Chinese IPOs accounting for roughly a quarter of all IPOs completed this year. Second is the performance, with Chinese IPOs being among the year's best aftermarket performers. Examples include:

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