Short-Selling China Stocks Is Game for Pros

BEIJING ( TheStreet) -- When you watch a stock like RINO International ( RINO) or China Education Alliance ( CEU) plummet by 50% to 60% in one or two days, short-selling may look like an attractive game to play.

But in my opinion, the risk vs. reward tradeoff is very unattractive for individual investors.

First, the best you can do is make 100%, and that is only if the stock you short goes to zero. Second, borrowing the stock can be difficult and very expensive. Third, your potential losses are infinite because there is no telling how high a stock can go. Lastly, when shorting, timing is everything. You could have been right about RINO being a fraud and shorted it when it was at $15.00, but the stock still ran to $30.00 and you would have lost 100%. Unless you are a short attack artist who knows the timing of the release of a damaging report about a company, shorting puts you at a distinct disadvantage.

In any event, it seems there is a new short-seller in town going by the name of Kerrisdale Capital. This company recently issued a 28-page report claiming that China Education Alliance is a fraud devoid of students, desks and teachers and that its online Web service (the company's main revenue driver) doesn't even function. China Education Alliance is a NYSE-listed company that was trading at $5.50 before the report's release, giving it a market cap of about $150 million. The short attack caused shares to plummet about 60% to as low as $2.34.

Shares rebounded by as much as 18% on heavy volume Wednesday on no news and closed up 12.2% at $3.03. People keep asking me, "Was that the short cover? Are they gone?" It is difficult to say, but I am guessing the answer is no.

China Education Alliance is scheduled to hold an investor conference call on Tuesday, Dec. 7 to address the report. If the call goes well, shares could rise. But I would expect Kerrisdale to issue a new report rebutting the company's statements on the call and launch a new short attack, driving shares down again.

Keep in mind, too, that the short-sellers' full-time job is to be on the attack, while management has the disadvantage of having a company to run, so they simply can't respond to every attack, every day. In this sense, the short-seller definitely has the upper hand.

Another question people keep asking me is, "Is CEU a fraud?" I don't know, but I am looking into the fraud claims. I have already spoken with the company's chairman and CFO, but so far they are mostly aggregating questions to address on the conference call as opposed to giving specific responses, which is understandable at this point in time. Once I have better information, I will share it here.

People have also asked me about the implications of stock halts, as in the case of RINO International. When a short-seller sells shares, he or she receives the proceeds of the sale into his or her account and then pays interest on that money. Until the short-seller buys back shares and closes the position, he or she continues to pay interest at a rate of as much as 100% per year.

Keep in mind that stock halts can last a long time. In the case of China Northeast Petroleum ( NEP), trading was halted for months. If you are a short-seller paying about 8% per month to borrow shares, those payments can really eat into your return.

As for options, I have confirmed that out-of-the-money options expire worthless if a stock is halted. For example, if you bought $4.00 strike put options on RINO and the stock remained halted at expiration, the options would expire worthless even if the stock subsequently went to zero. RINO's last traded price was $6.07.

I am a long-only investor, but I have been monitoring the stock-borrow situation on Orient Paper ( ONP) closely via several brokers, and it seems to be freeing up from time to time. In fact, people are closing their shorts and then reshorting the stock. In other words, in the absence of further news in the wake of the company's clean investigation report, short-sellers are simply toying with the stock within the $7.00-$7.50 range.

Can they actually make any money this way? The answer is yes. However, short-sellers bear a lot of risk and need to very adept traders. Their strategy is to buy small bits to close out their positions without pushing up the price too much. Then they dump big blocks all at once to spook other investors into selling. As the stock rises during subsequent session, the short-sellers will then close out their positions.

I have noticed that ONP has been trading somewhat erratically over the past few days, and I attribute this to short-sellers gaming the stock. It is particularly noticeable given that the stock jumps significantly at exactly 4 p.m. EST, which is when shorts close their positions for the day, possibly to meet margin calls.

Oddly I actually don't mind the presence of the short-sellers. The drops in price that they create give me the chance to pick up shares on the cheap. Also, their very presence means there will be occasional short squeezes lifting the stock.

I expect the final short squeezes on Orient Paper to occur when Roth Capital reinitiates its coverage of the company. That will create a very, very bad day for the shorts. Orient Paper's closing price Wednesday was $7.27. Short interest has been steadily declining and now stands at only 600,000 shares, down from 800,000 shares previously.

Professional short-sellers can make quite a lot of money by creating fear and panic if they do it systematically, but my recommendation is that unless you want to spend the time and effort to create your very own short-attack report, shorting is best left to the pros.

At the time of publication, Pearson owned shares of Orient Paper.

--Written by Rick Pearson in Beijing.

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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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