With China Small-Caps, It's Shorts vs. Auditors

NEW YORK (TheStreet) -- I have some very good news. The problem of Chinese stock fraud is over. You'll be delighted to learn that Chinese companies whose accounting has come into question have found a solution to whatever may ail them. All you have to do is believe in the infallibility of Big Four auditors!

Yep, I'll bet you guessed there was a catch.

Oh, sure, we know that the Securities and Exchange Commission is probing stock fraud by Chinese companies, and that short-sellers have been targeting these stocks, citing their supposedly shady accounting. So that's why I was so impressed by a statement that sallied forth recently from a Chinese company that has attracted attention from short sellers, China MediaExpress Holdings. The company's stock plummeted because of concerns about its accounting. Concerns that are utter rubbish, I might add, if you believe the CEO.

Responding to allegations that the company is a "fraud and reported revenue is exaggerated by tens of millions of dollars," China Media's CEO Zheng Cheng said in a letter to shareholders: "The company is strong and doing well. Its revenues and cash position have been audited by reputable and well-known auditors who have confirmed both." Emphasis added.

See? Case closed. The shorts are wrong, as a "reputable and well-known auditor" -- Deloitte Touche Tohmatsu -- says they are so. So what we have here is a kind of Chinese stock market version of the Good Housekeeping Seal of Approval, or maybe one of those Underwriters Laboratories tags you sometimes see on appliance cords. As Cheng humbly points out, "Back out of the cash, you get a P/E ratio of little over 3. I bet Warren Buffett would love it when he saw this kind of metrics in his youth. Now he has matured and does not deal with small cap anymore."

What an opportunity! For the shorts, perhaps. As hedge fund manager John Hempton pointed out in his blog, short sellers (which include Hempton) do not feel that the company is, as its financial statements contend, "frighteningly profitable." The shorts contend that this company, which puts TV screens on buses in China, is "too good to be true." As Hempton puts it, "The shorts claim they have found one of the most brazen frauds in the history of capitalism." If indeed this company proves not to be kosher, the word "brazen" would seem warranted by the aforementioned shareholder letter. (H/T to Herb Greenberg for alerting me to this splendid example of investor relations.)

So we have a real acid test under way here. Which of them, Deloitte or the shorts, will turn out to have egg on their faces? Is this company a dazzling profit-maker or a fraud that will deep-six Deloitte's reputation?

If the worst-case scenario comes to pass, it won't be for lack of waving red flags. Many of these Chinese small-cap companies came into being through reverse mergers, which also was the path to the public markets for many a penny stock shell-company frauds in bygone days. The Public Company Accounting Oversight Board issued an alert last summer, pointing out that "some U.S.-based firms issuing audit reports based on work performed by others outside the United States are not properly applying PCAOB standards." Instead, they rely on the work of overseas auditors. The PCAOB specifically mentioned Chinese companies in its alert.

Deloitte is far too reputable to do that. Or is it? Will this fine, upstanding company turn out to be as much of a sad sack as Frazer Frost, the auditor of the Chinese accounting fraud poster child RINO International ( RINO)? Or it will be more on the order of Orient Paper ( ONP), another Chinese reverse merger whose shares tanked on fraud allegations, but which was cleared in an internal probe aided by none other than Deloitte & Touche?

It doesn't help that these stocks are prone to extreme volatility abetted by online gabbing, as has been experienced by other small-cap Chinese stocks such as Universal Travel Group ( UTA), Fuqi International ( FUQI) and China North East Petroleum Holdings ( NEP - Get Report). So even if their financials are as rock solid as the Magna Carta, their share prices are still going to be subjected to spasms.

In the final analysis, it doesn't matter what the auditors of these companies happen to be, whether they are high-priced companies in shiny office buildings in New York or no-name firms in Sheepshead Bay. They can be audited by all of the Big Four in tandem, or they can be audited by the hapless Frazer Frost, a list of whose clients was helpfully posted on Zero Hedge. The supposed prestige of the major firms isn't worth very much, not at a time when Big Four firms miss no opportunity to prove their uselessness, as I pointed out in this space in September.

I wonder if Mr. Cheng is aware of the fact that shortly before Christmas, then-New York Attorney General Andrew Cuomo sued the accounting giant Ernst & Young for assisting Lehman Brothers in its book-cooking scheme? This kind of thing has become so routine, and the Big Four firms' reputations are so frequently besmirched, that it only received modest attention.

The bottom line is that Chinese small-caps are ridiculously risky, and would be even if there weren't such a stench surrounding their accounting. Buying their stocks is an exercise in ignorance. Confucius said, "Ignorance is the night of the mind, but a night without moon and star."

I'd take Confucius (and a good international index fund) over Deloitte any day.