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China Stocks Rise Despite Controversy

Stocks in this article: SBAY SHZ CVVT

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) -- You'd think China small-cap stocks would have cratered in the wake of news that the Securities and Exchange Commission is probing alleged China stock fraud, intense media criticism of China stocks and increased short-selling attacks.

Think again.

As shown below, U.S.-listed China small-caps have actually risen over the past month despite all these headwinds.

That doesn't mean investors should think everything's OK with these stocks and that they can blithely hop back into them. China small-caps are obviously a much riskier sector in which to invest now, and investors need to use a very high level of due diligence in this space.


Back in December I wrote that the news of fraud was already priced into the China small-cap space. Some people asked with incredulity, "How do you price in fraud?"

What I meant was that valuations across the board had already declined significantly due to fear of fraud. Even companies that have minimal risk of fraud had traded down in the second half of 2010 because of widespread investor concerns about inadvertently holding the next RINO International (RINO).

My article followed news reports that detailed the SEC's probe into China reverse mergers -- a technique through which the majority of China small-cap stocks came to trade in the U.S.

Since then, the media's focus on fraud in China reverse mergers has only intensified, and now China fraud stories pop up every single day. At the same time, short-sellers have upped their attacks on these stocks. During the first two weeks of 2011, we have seen short-sellers issue reports on China Valves Technology (CVVT), China Green Agriculture (CGA) and Telestone Technologies (TSTC).

A casual observer who doesn't trade China stocks would probably assume that this sector is under massive fire and that valuations are getting hit even harder.

Anecdotally, I have been observed many individual China small-caps rise significantly over the past month. However, to be more comprehensive, I ran a stock screen of all the U.S.- listed China small-caps in my database that were between $50 million and $1 billion in market cap. As of Friday's close, this screen produced 210 stocks. As it turns out, over the past month (four full trading weeks from Friday, Dec. 17 to Friday, Jan. 14), China small-caps as a whole have risen by 6.1%.

The table below is a bar chart showing the performance of these 210 stocks. The number above each bar is the number of stocks in each performance range. The number below each bar show the percentage gain or loss for each range.

As can be seen, there are some outliers at the top, with five stocks having risen by more than 50%. If we exclude all of those outliers at the top, the performance of the remaining 205 stocks is still a positive 4.5%. This is certainly not what would be expected given the high-profile media coverage of Chinese small-cap stock fraud.

Obviously, everyone's first question will be who were the best performers, so I include that data here.

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