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Dangers of False Confidence in China Stocks

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) -- Many investors have come to the conclusion that China small-caps are trading in one direction lately -- down. They haven't kept an eye on China Biotics (CHBT).

Over the past year, and subsequent to the filing of its last 10K, CHBT has been the target of a number of short-seller reports and fraud allegations. Shares of CHBT bottomed out at $7.22 on April 15.

As of Wednesday's close, the shares were trading at $11.78, up 63% in less than a month. The shares rose nearly 20% just this week following the posting of two 13G filings by Wellington Management (10.2% stake) and Value Capital Holdings (8.1% stake).

Since there was no other news, I am assuming the filings drove up the stock this week, as investors took extreme confidence from large stakes by institutional investors. These stakes look big on the surface, but in fact represent an infinitesimally small portion of their overall holdings. In addition, the institutions buy in at very favorable prices, then watch the share price automatically rise when their holdings are disclosed.

Take Wellington, for example. From its Web site, Wellington manages $663 billion in assets. Its $20 million investment in CHBT represents 0.00003% of its total assets. Granted, no one wants to lose $20 million, but even if CHBT went to zero, Wellington would not even notice.

Retail investors have the shoe on the other foot. They buy in after the institutions, paying a higher price and allocating a tremendously greater portion of their capital to concentrated positions. The assumption that institutional investors have an informational advantage and perform superior due diligence is not necessarily something that should be relied upon blindly. There are a number of recent examples.

In 2009, Carlyle Group announced that it had invested $15 million in China Agritech (CAGC), a 16.5% stake. The share price was below $10, but within weeks it rose to $30. Carlyle's price was around $5 (split adjusted) and included a large number of free warrants, lowering their effective "in price" even further. In short, Carlyle got a sweet deal while retail investors simply bid the stock up by triple. Fast forward a year, and CAGC is now halted, having last traded at $6.88, and it has "dismissed" its auditor, KPMG.

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