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China Stocks: Trading Halts Pinch Investors

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

BEIJING ( TheStreet) -- Shares of China MediaExpress (CCME) in early March were trading in a predictable trading range of $13-$14. I spoke with a number of investors who continually referred to CCME as their "personal ATM machine." When the stock dipped to $13, they would put in a large sum of money, and when it approached $14, they would cash out with a lot more. Each day they would repeat this.

CCME was expected to release earnings Monday, March 15, but it was widely assumed that this would be delayed due to the high level of controversy surrounding the company. As a result, many individuals thought they had plenty of time to continue playing the ATM game, or at the very least, to sell their existing position. It came as a complete surprise to many, myself included, when at just past 10:10 a.m. on March 11 (the last trading day before expected earnings release) trading in the stock was suddenly halted at a price of $11.88. Anyone playing the ATM game or who was still on the fence and long the stock was simply stuck. It has now been almost two months and trading on the stock has not yet resumed, but brokers are marking the stock at $1 for margin purposes. That is a decline of 92% from the last trade.

It seems that just about every week there is a new China small-cap stock that has been halted following allegations of fraud. In addition to CCME, recent examples include Puda Coal (PUDA), China Agritech (CAGC), Universal Travel (UTA), Duoyuan Global Water (DGW), Keyuan Petrochemical (KEYP), China Electric Motor (CELM) and Subaye (SBAY).

I know a number of individuals still stuck holding one or more of these stocks. A few of them still cling to hope that there will be some positive development and the stock may recover. However, most people holding these positions are actually hoping for a decline of only 50% but mentally prepared for a decline of substantially more.

At the risk of stating the obvious, we will definitely see more trading halts and more people will find themselves stuck in limbo holding positions that they are desperate to sell but simply can't.

Many investors were severely burned by CCME yet there still seems to be no shortage of investors who are eager to play the ATM game. The temptation is that it is easy to make small (or sometimes large) gains on a daily basis. But it is important to remember that this only works until the music stops and the stock is halted. Only time will tell, but I am highly confident that all of these halted stocks will see very steep plunges in value once trading resumes.

One good example of the ATM game is Sinoclean Energy (SCEI). In recent months, SCEI traded in the $6-$7 range and often traded as little as 40,000 shares per day. I had thought the stock was simply under-followed and ignored. SCEI was recently slammed by detailed fraud allegations including extensive video footage. The effect was a share-price drop of more than 70%, taking SCEI to a low of $1.91. When the company responded with its rebuttal, investors piled in, driving the share price up by over 100% in 2 days and back to $4 on over 3 million shares in volume. Clearly the stock is not being ignored anymore. The stock has resumed its sell-off and on Thursday closed at $2.59, down 35% from its recent $4 peak just a few days ago.

I visited SCEI a few months ago, toured its facilities, interviewed management and conducted customer tours and interviews. Currently I have no position in the stock.

A second example is Gulf Resources (GFRE). Once again, fraud allegations had driven this stock down to a new low of $2.30. After the predictable bounce and then sell-off following managements rebuttals, the stock now trades in a consistent daily range of roughly $2.85-$3.20, giving some investors the idea that they can simply buy low and sell high each day. Investors are wrongly assuming that the recent lows have somehow established a "floor," and seem to be gauging their risk of loss accordingly.

I believe this is a mistake and that many investors are completely oblivious to the risk of a trading halt, despite the increasing number of precedents. As with CCME, if the trading halt comes, it will come with absolutely no warning and those stuck with large long positions trying to make an easy day-trade could find themselves holding a completely illiquid stock with no "floor" at all. Longs are not the only ones who suffer from a trading halt. Those with excessive short positions will find themselves stuck paying an exorbitant rate (sometimes as much as 100% per year) for stock borrowing, which is subject to increase at the whim of the broker, and there is no way to cover for an indeterminate amount of time.

Both SCEI and GFRE have traded down to nearly the value of the cash last reported on their balance sheets. Many investors also assume that this somehow creates a floor for the share price, thus limiting their risk. However, in the China space, it is not at all uncommon for companies under fire to trade at discounts of more than 30% to their last reported cash balance.

Examples include:

Investors are driven by fear and greed, and now I am seeing a lot of greed as evidenced by the massive volume pouring into previously less-liquid stocks. If the market were rational, one might expect that trading volumes would actually decrease as investors sat on the sidelines waiting for more reliable information. Instead, investors are piling in, looking to hit a home run without considering the very realistic worst-case scenario of a trading halt.

Disclosure: The author has no positions in any of the stocks mentioned The author can be reached for comments at comments@pearsoninvestment.com
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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