By now anyone who invests in China stocks is familiar with the carnage going on with the stock of Rino International ( RINO). On Nov.10, the Hong Kong based research duo (and dedicated short seller) known as Muddy Waters produced a 30-page report on Rino declaring it to be an abject fraud and with a target price of $2.45 vs. its then price of around $15.00.

The stock has now been halted and the share price stands at $6.07, a decline of 60% in seven days. Their auditor, Frazer Frost, came out on Friday and confirmed that there were in fact phony contracts with revenues that didn't exist and other irregularities. I have been following this situation closely and I feel that there are a number of important lessons that can be learned from it.

Readers may remember that Muddy Waters and I have a somewhat strained history following their report on Orient Paper ( ONP) in June 2010. By pure coincidence we had happened to tour the ONP facilities on the same day in January 2010. Where I saw opportunity, they saw fraud. What ensued was an acrimonious online battle of words between the two of us as to whether or not the company was a fraud.

When MW first released their report, ONP stood at $8 and they declared a target price of "less than $1." The stock bottomed at about $4 but recently rebounded to as high as $7.67, almost a double. MW has gained significant credibility due to its extremely accurate and timely call on Rino and now many investors are rethinking their refound confidence in ONP and have been dumping the stock. It now stands at $5.58 -- 28% below its recent high. There is currently an independent investigation under way being conducted by accounting firm Deloitte & Touche and law firm Loeb & Loeb, so the final verdict on ONP will have to wait for the results of this investigation.

There are a number of key lessons that investors can take away from situations like this.

Lesson #1. Shoot first, ask questions later

When a serious and detailed allegation of fraud surfaces, sell. Sell immediately. In the case of both ONP and Rino, the stock "only" fell 15% upon the release of the report. It was only after the report became more widely disseminated and was joined by other vocal online short sellers that the share prices took the 50-60% dive. I have seen this in the case of many other stocks including ( UTA), ( FUQI), ( NEP) and others. Consider the first 15% to be a warning shot and take notice. It may be tough to swallow the loss but it is better than what will come next.

Typically the stock does not fall by 50% on the first day, so be grateful that you have a chance to get out. While it is too late for this advice to be of any use to those who got burned on Rino, I hope it will be a valuable piece of advice going forward because I am sure this is not the last of the short seller attacks.

Lesson #2: Distinguish between a genuine short attack and simple online gossip

On virtually every stock investor board, there are numerous unfounded postings about fraud put up by people trying to cheapen the share price so they can buy in. I see these all the time and don't take them even slightly seriously. The report by Muddy Waters obviously took months to prepare, was very coherent and was 30 pages long and widely disseminated. This is substantially different than a simple baseless fraud claim on an investor chat room.

So to repeat, be very afraid of the professional organized short attack but ignore the random "F" word that is often bandied about in chat rooms. Any serious short seller isn't going to rely on Yahoo! Finance to get his message across.

Lesson #3: Short selling looks profitable but is still a highly dangerous game

The fundamental problem with short selling, in contrast to going long, is that you can only make a profit of 100% whereas your losses are truly unlimited. By contrast, I have made several hundred percent on a number of Chinese stocks and never lost more than 50%. Back in 2009, I almost shorted shares of one of my least favorite companies, China BAK Battery ( CBAK) The company is a perpetual money loser and will inevitably have to continue diluting shareholders if it wants to survive.

I was very close to shorting this stock when a rumor surfaced that CBAK was going to get a contract with Google ( GOOG). The shares jumped 65% in one day. I would have received a margin call and locked in a permanent loss and not even benefited when the stock fell back down. In short, if you're going to short a stock, you had better be very certain that you have momentum on your side and monitor the position literally every minute, including in pre-market and after hours and be ready to close out at the first sign of a short squeeze.

Lesson #4: Put options are not efficient for crisis shorting

The primary advantage of put options is that you pay a fixed amount of money for the option, so that unlike short selling, your loss is limited. However, the key variable is the price that you pay for the options. I have been following Rino put options for the past week and the implied volatility is more than 200%.

What this means is that everyone is piling into the put options, driving up their price. In theory, options should provide substantial leverage, meaning that a 30% drop in the share price would result in a gain of much greater than 30%. But I ran several scenario analyses on Rino puts and found that even if the share price were to drop by 30%, I would make less than 30% -- this is simply due to the option being overpriced. Herein lies the fundamental problem with put options: timing is absolutely everything.

If you know of a terrible company that is not yet in crisis, the put options are probably very cheap and could provide a massive return. But if the crisis doesn't happen quickly enough, the option loses 100% of its value. Once a company enters crisis mode, such as Rino, investors can be comfortable with timing but then the price inevitably gets overbid making the options unattractive.

As a final thought, what happens to a put option which has value but that is "out of the money" and then the stock is halted ? You can't exercise or sell it so does it expire worthless even when you had made a profit ? I have asked five different people and gotten five different answers. In crisis situations, there is a very real possibility of a stock halt and I wouldn't want to learn the answer to this the hard way. (Incidentally, I am scheduled to speak to several other option traders this week and I will let readers know when I find out the ultimate answer.) If you want to play the smart odds, stay away from put options. On average and over time they are a losing trade.

Lesson #5: Buying on the dips can be the homerun of a lifetime or the kiss of death

Prior to the announcement by Rino's auditor I received a number of emails asking if this could be another homerun buy-on-the-dips play. My answer was a categorical no. With Rino, even before the Frazer announcement, the evidence for fraud was too compelling for several reasons.
  • Rumors of Rino fraud have been circulating for more than a year
  • The MW report was pretty much air tight in its accusations
  • The stock lost analyst support and the company didn't respond to analysts
  • The earnings call was cancelled
  • Shockingly, the company made no effort to respond to any of the allegations
  • This stock is only going one way -- down. Any time a stock like this enters crisis mode, the only thing you can be sure of is extreme volatility. Only play the buy on the dips if you feel that you have a very, very good knowledge of the company and that the short attack is without merit and that the company will prevail over time.

    Lesson #6: Cash per share is not a "floor price" for stocks

    With ONP, Muddy Waters provided a share price target of "less than one dollar," but they did not provide any rationale for it. The stock bottomed at $4 made substantial moves up since then. As a result, I think some people question the credibility of the $2.45 share price target. Muddy Waters stated that their target share price for Rino is $2.45 because this is the amount of cash per share on the company's books, so at least now they are providing some methodology.

    Once again I disagree with Muddy Waters, but this time I feel the "floor" value of the company could be even lower than cash per share. Why ? Because I have seen it in numerous post-crisis companies. Once investors don't trust the books of a company, they tend to not believe that the cash is all there.

    I have seen numerous cases where companies trade at a 10-15% discount to their reported cash value. As a result, I think Rino could trade as low as $2 despite having cash of $2.45 per share. Canacord analyst Michael Deng revised his rating to sell but did not set a new share price target. Rodman Analyst Amit Dayal has the stock under review and has not issued a share price target.

    Lesson #6: How to play Rino now

    Before the stock was halted, several people recently asked me if there was still a way to play Rino. For the nerves of steel types, I felt that at above $6 there was still enough downside to short it. For the longs, I told them all they can do is sit back and watch the carnage. There may be a short squeeze bounce at some point but timing that is too uncertain. Unfortunately, the stock is halted and will likely gap down as soon as it is resumed.

    For the truly obsessive short seller, there may be one strategy. When the stock does resume trading, there will likely be a delay until the press release comes out. A really obsessive short seller could start watching the pre-market every day to see if it begins trading and then go full short, but that strategy is not appropriate for most investors. So this one is probably game over for the typical investor.

    There have been a number of high profile frauds and alleged frauds in China stocks this year and the topic has been heavily discussed both online and in print articles such as Barrons. However, in many ways these frauds are like shark attacks or plane crashes; they are very scary and they grab the headlines in a high profile way. But keep in mind that there are more than 500 Chinese stocks that trade in the U.S. (listed and OTC) so even if we see a number of frauds this year, it is still a relatively rare occurrence but one which gets maximum attention.

    Also, keep in mind that if you want to see fraud at its highest level, then you should be looking to the U.S. where frauds such as Enron, WorldCom and Bernie Madoff took place right under our eyes --for much larger sums of money and with supposedly world-class auditors and regulators.

    As a final thought, I would like to offer my condolences to anyone who got taken down by Rino.

    The author currently holds no positions in any of the stocks mentioned.

    The author can be reached 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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