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With China Small-Caps, It's Shorts vs. Auditors

NEW YORK ( TheStreet) -- I have some very good news. The problem of Chinese stock fraud is over. You'll be delighted to learn that Chinese companies whose accounting has come into question have found a solution to whatever may ail them. All you have to do is believe in the infallibility of Big Four auditors!

Yep, I'll bet you guessed there was a catch.

Oh, sure, we know that the Securities and Exchange Commission is probing stock fraud by Chinese companies, and that short-sellers have been targeting these stocks, citing their supposedly shady accounting. So that's why I was so impressed by a statement that sallied forth recently from a Chinese company that has attracted attention from short sellers, China MediaExpress Holdings. The company's stock plummeted because of concerns about its accounting. Concerns that are utter rubbish, I might add, if you believe the CEO.

Responding to allegations that the company is a "fraud and reported revenue is exaggerated by tens of millions of dollars," China Media's CEO Zheng Cheng said in a letter to shareholders: "The company is strong and doing well. Its revenues and cash position have been audited by reputable and well-known auditors who have confirmed both." [Emphasis added.]

See? Case closed. The shorts are wrong, as a "reputable and well-known auditor" -- Deloitte Touche Tohmatsu -- says they are so. So what we have here is a kind of Chinese stock market version of the Good Housekeeping Seal of Approval, or maybe one of those Underwriters Laboratories tags you sometimes see on appliance cords. As Cheng humbly points out, "Back out of the cash, you get a P/E ratio of little over 3. I bet Warren Buffett would love it when he saw this kind of metrics in his youth. Now he has matured and does not deal with small cap anymore."

What an opportunity! For the shorts, perhaps. As hedge fund manager John Hempton pointed out in his blog, short sellers (which include Hempton) do not feel that the company is, as its financial statements contend, "frighteningly profitable." The shorts contend that this company, which puts TV screens on buses in China, is "too good to be true." As Hempton puts it, "The shorts claim they have found one of the most brazen frauds in the history of capitalism." If indeed this company proves not to be kosher, the word "brazen" would seem warranted by the aforementioned shareholder letter. (H/T to Herb Greenberg for alerting me to this splendid example of investor relations.)
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