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Latest China Small-Cap Report Is Puzzling

Absaroka's track record is somewhat mixed. Its recent report on Yongye (YONG) drove the share price down to as low as $3.01. However, shortly thereafter, it was announced that Morgan Stanley Private Equity was investing $50 million in YONG, which drove the price as high as $6.15 just a week later. Quick 100% pops like that are keeping investors playing in this space. And for those who play the options, the gains are significantly larger. Absaroka has followed up with further thoughts regarding MSPE's investment, which I thought were very useful. In particular, they noted that Morgan Stanley was not simply buying $50 million in the open market (only a complete fool with too much money would do that). Instead, Morgan Stanley is getting a very special deal, not available to ordinary folks, which consists of convertible preferred shares that pay in-kind dividends and rank senior to common shareholders. The headline conversion price of $8.80 got many people excited, but, in fact, the structure of the deal means that Morgan Stanley's "in price" could be substantially lower than the current share price of $5.19 if they receive extra shares. It would appear that they are already making money, despite having a conversion price that appears to imply a much higher target price.

Absaroka's report on Shenzhou Mining (SHZ - Get Report) drove the stock down from around $6 to below $3 in just a few days. But a detailed rebuttal from management (along with an irrational misunderstanding of the stock) quickly drove the price back up as high as $6.50 -- above the pre-report price. It is notable that the CFO resigned immediately after the fraud allegations came out, which is always a troubling sign. On SHZ, I don't know if the fraud claims hold up well or not, but I do view it as one of the most irrationally overpriced stocks out there, and I make sure to short it from time to time when I can. As of this writing I have no position.

I also have no position in SPU, but I might consider taking one after I get to see management's detailed response. The fact that I can easily and instantly contradict many of the points in Absaroka's report doesn't mean the analysts haven't uncovered something that could in some way be problematic. As always, the burden of being 100% right is on the shoulders of management. And, as always, if there is even a 10% problem, then a stock can quickly see some combination of a stock halt, a delisting and a sub-$1 share price. So even at $2, there is still plenty of risk.

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