In the case of RINO International, the short report was amazingly accurate, and the stock was delisted within 20 days of its publication. It is unfortunate for those who lost money, but the fact of the matter is that the short-seller is not to blame for the fraud. RINO is.
In other short cases, the short-sellers may turn out to be right, or it may turn out that they're just trying to cash in on heightened fear by producing false or flimsy reports.
Either way, there is a significant positive effect from these reports. Every Chinese small-cap company I speak with is now very focused on preventing itself from being the subject of the next short-seller report. They're increasing transparency, upgrading their auditors and focusing on details where they had previously been notably negligent (including outdated or inaccurate Web sites, inaccurate domestic filings and a lack of responsiveness to investors).
So, as much as they seem to revile the China small-cap space, the short-sellers are actually doing it quite a service by forcing legitimate companies to make needed improvements. Valuations seem to have hit bottom in the fourth quarter of 2010, and now investors are betting on the stocks which they think will implement corporate governance improvements while also showing strong financial performance.
The chart above shows that most of the stocks' performance is clustered around the middle, either slightly up or slightly down. I strongly suspect that by the end of 2011 the data will look much different.
There will be a number of star performers that were trading far too cheaply at the beginning of 2011 but will have delivered strong financial results and upgraded their corporate governance.
There will also undoubtedly be a number of additional disaster stocks that tumbled significantly, even if they had low valuations to begin with. In short, I expect that 2011 will be a very volatile year for China small-caps, but one that still has the potential deliver positive results. As the data above shows, media coverage is proving to be an inaccurate barometer for actual stock performance.
At the time of publication, Pearson had no holdings of stocks mentioned.
--Written by Rick Pearson in Beijing.
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