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China Stock Fraud News Already Priced In

Maj Soueidan of Geoinvesting.com recently posted a very useful article -- "27 Red Flags for Chinese RTO Stock Investors to Look For" which I think is a must read for anyone investing in this space. Moreover, for the sake of thoroughness, I think these criteria should be applied to IPOs as well as RTOs. When finding these red flags, the devil is always in the details. So it is very important to read all of the available disclosure including 10-Qs, 10-Ks and 8-Ks. These are the places where the red flags will be found, not simply in the press releases that everyone reads.

As for my own take on the decision-making process, I strongly believe that the most important criteria for investors to be aware of is a company's auditor. I have had many discussions with investors about particular stocks and when I ask who the auditor is the majority of people I have spoken with don't have any idea. Many people will spend countless hours researching a stock but never take the time to research the company's auditor.

A very good Web site which lists Chinese companies and their auditors, along with the auditors PCAOB ranking is Trading China. Obviously, with more than 500 Chinese companies traded in the US, it is not possible for every one of them to use a Big Four auditor. But for companies with a top 10 auditor I tend to feel well-protected, as long as it is a firm with a strong China practice.

It should definitely be noted, however, that the list of 27 red flags is an extremely comprehensive one. If an investor wants to narrow his or her list of investments down to companies with zero red flags, there probably won't be many stocks to choose from. In other words, most companies will have at least one red flag.

Take, for example, China MediaExpress (CCME). This stock lately seems to be everyone's favorite stock pick. It has been recommended to me via tweets, emails, phone calls and in person. Yet it is explicitly named in the red flag list as an example because of its low domestic credit rating. Or take a look at China New Borun (BORN). This company was an IPO, not an RTO, yet it gets two red flags for having notably low research and development expenses as well as for having an offering priced well below its initial desired range. It is noteworthy that on the day the SEC's crackdown hit the news, BORN's stock was up as much as 10% despite these red flags.

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