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 -- In China's small-cap space, the short-attack phenomenon is relatively new, so it is hard to know what the long-term effects will be on individually attacked stocks or on the space as a whole. China MediaExpress ( CCME) is the latest company to be on the receiving end of a series of short-seller attacks. The stock continues to trade with significant volatility on high volume, meaning that there is still a sizable amount of disagreement between the longs and the shorts.
- Problem No. 1: The burden of proof lies with CCME and not with the short-sellers. Short-sellers deliberately exaggerate their claims and often use dubious evidence to incite maximum panic on the day of the report's release. However, in the case of CCME, even if 90% of the information is wrong, that would still make CCME a 10% fraud, resulting in a stock price that could potentially trade near cash value, which is around $7 a share. The shorts only need to be 10% correct, whereas CCME needs to be 100% correct on all details. CCME is in the media and advertising business, and its operations are spread over a wide area, making it a very difficult company to accurately audit for any auditor, Big 4 or otherwise. And as a result of the short attacks, the company will now be under the microscope by auditors, investors, law firms and research analysts.
- Problem No. 2: Long-term damage to the company's business prospects has already been done. CCME is a media company, and the media industry is notoriously sensitive to any type of bad press or negative imagery. One claim by the shorts is that a Baidu search for CCME (in Chinese) yields very few results. That is no longer the case. Now, a Baidu search results in numerous stories of a company potentially committing a massive fraud. In the image-sensitive advertising business, this has the clear potential to scare off tier one customers. As in the case of ONP, even if the company is ultimately validated, the smear itself can result in permanent damage to the business and the share price.
- Problem No. 3 Deloitte is only the auditor until it is not. Deloitte is a top-quality, Big 4 auditor, but the reality is that in a complicated and fairly opaque business like advertising, a standard audit does not necessarily confirm every minute detail of every piece of revenue and expenses. A standard audit is not a forensic audit. Deloitte also was the auditor for Duoyuan Printing (DYP) until just before the 2010 10-K was filed when Deloitte was suddenly "dismissed." The shares are now down by 70% and trade at a 30% discount to last reported cash on the balance sheet. I am by no means criticizing Deloitte. The fact is that during the course of 2010, certain things "changed" at DYP that prevented Deloitte from signing off on the numbers. Just because Deloitte has signed off on CCME's numbers in the past does not preclude the possibility that "things have changed" for CCME during 2010, which on paper was very much a standout year. Problem No. 4 : CCME's response to date has been very weak, and after an initial pop, the share price has continued to fall. Investors overall are clearly not fully satisfied yet. Unlike ONP, CCME has not had a conference call to address concerns and has released only a fairly brief statement stating that SEC financials should be relied upon and a few other clarifications on its advertising of Apple products via a local distributor. The company also contradicted several factual errors in the short-sellers' reports. Investors are all still waiting for a point-by- point rebuttal as well as concrete proof of client relationships, revenue and cash. However, it is looking like we may need to wait until the release of the 10-K in March to get full information. The risk for those who are selling options or trading on margin is that many holders will not want to bear the risk of holding until after the 10-K is released, and as a result, the share price could see a substantial dip even before it hopefully recovers.