China Stocks Rise Despite Controversy

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING ( TheStreet) -- You'd think China small-cap stocks would have cratered in the wake of news that the Securities and Exchange Commission is probing alleged China stock fraud, intense media criticism of China stocks and increased short-selling attacks.

Think again.

As shown below, U.S.-listed China small-caps have actually risen over the past month despite all these headwinds.

That doesn't mean investors should think everything's OK with these stocks and that they can blithely hop back into them. China small-caps are obviously a much riskier sector in which to invest now, and investors need to use a very high level of due diligence in this space.
Shanghai

Back in December I wrote that the news of fraud was already priced into the China small-cap space. Some people asked with incredulity, "How do you price in fraud?"

What I meant was that valuations across the board had already declined significantly due to fear of fraud. Even companies that have minimal risk of fraud had traded down in the second half of 2010 because of widespread investor concerns about inadvertently holding the next RINO International ( RINO).

My article followed news reports that detailed the SEC's probe into China reverse mergers -- a technique through which the majority of China small-cap stocks came to trade in the U.S.

Since then, the media's focus on fraud in China reverse mergers has only intensified, and now China fraud stories pop up every single day. At the same time, short-sellers have upped their attacks on these stocks. During the first two weeks of 2011, we have seen short-sellers issue reports on China Valves Technology ( CVVT), China Green Agriculture ( CGA) and Telestone Technologies ( TSTC).

A casual observer who doesn't trade China stocks would probably assume that this sector is under massive fire and that valuations are getting hit even harder.

Anecdotally, I have been observed many individual China small-caps rise significantly over the past month. However, to be more comprehensive, I ran a stock screen of all the U.S.- listed China small-caps in my database that were between $50 million and $1 billion in market cap. As of Friday's close, this screen produced 210 stocks. As it turns out, over the past month (four full trading weeks from Friday, Dec. 17 to Friday, Jan. 14), China small-caps as a whole have risen by 6.1%.

The table below is a bar chart showing the performance of these 210 stocks. The number above each bar is the number of stocks in each performance range. The number below each bar show the percentage gain or loss for each range.

As can be seen, there are some outliers at the top, with five stocks having risen by more than 50%. If we exclude all of those outliers at the top, the performance of the remaining 205 stocks is still a positive 4.5%. This is certainly not what would be expected given the high-profile media coverage of Chinese small-cap stock fraud.

Obviously, everyone's first question will be who were the best performers, so I include that data here.

As an aside, it pains me greatly to point out that Subaye ( SBAY) was a stock I recently wrote about as one I wanted to "take a closer look at" but did not own. China Gengsheng Minerals ( CHGS), China Shen Zhou Mining & Resources ( SHZ) and Qiao Xing Universal Resources ( XING) have all (rightly or wrongly) ridden up on hype over rare earths lately, and it would surprise me greatly if they hold at these levels.

As can be seen from the bar chart, the majority (56%) of U.S.-listed China small-caps have risen by up to 25%, while about only 34% have declined.

It is very notable that despite the recent short-seller reports, there are no significant outliers toward the left end (negative territory) of the chart. This was somewhat surprising to me. However, a closer look at the recent performance of these stocks following the short reports demonstrates that the reports are becoming somewhat less effective upon their initial release.

The impact of the short reports so far has been as follows:

This is in sharp contrast to what happened to stocks such as RINO International and China Education Alliance ( CEU) that were targeted with reports in the fourth quarter of last year. RINO and CEU quickly dropped as much as 60% upon release of the reports.

I am by no means suggesting that the declines in the stocks in the table above are over. With RINO.PK and CEU the declines were so fast and steep that the short-sellers could simply cover their positions and move on without any further fight. Given that the declines of the stocks in the table have been smaller, I am assuming that the short-sellers will continue to produce further information and outspoken opinions on these stocks in an attempt to pressure them further. Meanwhile the companies are all actively fighting back, so it will be interesting to watch.

In the case of RINO International, the short report was amazingly accurate, and the stock was delisted within 20 days of its publication. It is unfortunate for those who lost money, but the fact of the matter is that the short-seller is not to blame for the fraud. RINO is.

In other short cases, the short-sellers may turn out to be right, or it may turn out that they're just trying to cash in on heightened fear by producing false or flimsy reports.

Either way, there is a significant positive effect from these reports. Every Chinese small-cap company I speak with is now very focused on preventing itself from being the subject of the next short-seller report. They're increasing transparency, upgrading their auditors and focusing on details where they had previously been notably negligent (including outdated or inaccurate Web sites, inaccurate domestic filings and a lack of responsiveness to investors).

So, as much as they seem to revile the China small-cap space, the short-sellers are actually doing it quite a service by forcing legitimate companies to make needed improvements. Valuations seem to have hit bottom in the fourth quarter of 2010, and now investors are betting on the stocks which they think will implement corporate governance improvements while also showing strong financial performance.

The chart above shows that most of the stocks' performance is clustered around the middle, either slightly up or slightly down. I strongly suspect that by the end of 2011 the data will look much different.

There will be a number of star performers that were trading far too cheaply at the beginning of 2011 but will have delivered strong financial results and upgraded their corporate governance.

There will also undoubtedly be a number of additional disaster stocks that tumbled significantly, even if they had low valuations to begin with. In short, I expect that 2011 will be a very volatile year for China small-caps, but one that still has the potential deliver positive results. As the data above shows, media coverage is proving to be an inaccurate barometer for actual stock performance.

At the time of publication, Pearson had no holdings of stocks mentioned.

--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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