Shorts' Impact on China Stocks Lasting

The following commentary comes from an independent investor as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

BEIJING ( TheStreet ) -- It is not possible to write an article that pleases both long investors and short investors at the same time. Yesterday, however, I found out that it is quite easy to displease both sides at the same time.

I received a substantial amount of email about my last two articles ( here and here), most of it from people who either disagreed with my conclusions or who were unhappy with the overall tone of the articles. Notably, criticism came from both longs and shorts.

Firstly, many people have challenged my notion that short attacks create a lasting overhang on the share price of the affected stock. As a result, I have compiled a table of the recent major short reports and will let readers draw their own conclusions. The list only includes what I consider to be the major reports and not simple blog attacks.

On average, share prices drop about 30%-40% in the first few days following a short attack, and so far (with the exception of Orient Paper ( ONP)) have only recovered mildly. Some have gone on to reach further lows after settling down following the report. Others have seen their share price take a few jumps due to short-covering.

Orient Paper has recovered by around 51% from its bottom but is still down 25% from its pre-short report price level.

I have left China MediaExpress' ( CCME) "recovery" and "loss" columns as "to be determined" because the stock price is still very volatile, and I think it will have a very "digital" outcome when the 10-K is released in March.

Investigating Chinese Reverse Mergers
After the short reports, many of these stocks have received broad online support through various blogs and bulletin board postings, yet the road to recovery faces several challenges.

A primary problem with China small caps is that the investor base is largely dominated by retail investors as opposed to large institutions. Once burned by a stock collapse (whether justified or not), retail investors are more likely to say "never again" and abandon a stock regardless of how its fundamentals change. There are certain groups of China-focused investors (myself included) who continue to play these stocks on the fundamentals, but the fact remains that some outside capital that had previously been attracted is no longer chasing the individual stock in question, which results in a lower share price.

An additional problem is the ubiquitous lawsuits that are filed almost as soon as the short report hits the new wires. Despite the fact that many of these lawsuits have no substantial basis (aside from simply quoting the short-sellers), their lawsuits create two problems. The first is "headline damage," which is simply that new investors who are researching the stock see a dozen or so lawsuits under the company's news headlines and decide to invest elsewhere.

The second is that these lawsuits are in fact time-consuming and expensive for management to defend against. The cost of defending against the lawsuits can create a temporary drag on earnings and can also create a distraction for management, which is trying to execute a business plan but is instead forced to expend time, money and effort in a lawsuit.

The final problem is just simple math. A stock that falls 50% needs to rise 100% to regain its original price, and a rise of 100% takes time and a lot of investor conviction.

Some readers were unhappy that I raised the "John Dillinger Problem" with the short attacks, namely that shorts need to be correct only on 10%-20% of their assumptions whereas the company needs to be 100% correct on everything filed with the SEC.

This issue should come as no surprise to anyone, and it is worth repeating. The burden of proof rests with the company and its auditors to be 100% accurate and nothing less. The strategy of the short-sellers is to call a target company a 90% fraud or an empty shell, using many arguments that are quickly and easily disproved. However, it is still my belief that their real goal is to bring to light fraud in the range of 10%-20%, which is more than adequate for them to achieve their goals.

Lastly, it turns out that short-sellers have feelings too, and I received a number of emails from angry short-sellers who took umbrage at the John Dillinger analogy. After all, Dillinger was a criminal and the short-sellers wanted to express their own view that they are simply "righting the wrongs of the capital markets" (while making a hefty profit at the same time). One short-seller suggested that Robin Hood would have been a better analogy. My only response was that if they wanted to win a popularity contest, then they have probably picked the wrong profession.

In any event, any comments, positive or negative, are always welcome.

Disclosure: The author holds a long position in common stock of CCME and a long position in puts of CCME. 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.

More from Emerging Markets

Wall Street Looks To Extends Gains After Goldman Earnings Beat, China Data

Wall Street Looks To Extends Gains After Goldman Earnings Beat, China Data

China's President Xi Jinping Tells Boao Forum He Supports Opening Markets

China's President Xi Jinping Tells Boao Forum He Supports Opening Markets

U.S. Stock Futures Steady; Asia Stocks Mostly Lower

U.S. Stock Futures Steady; Asia Stocks Mostly Lower

Jim Cramer: There Are Plenty of Shorts in Constellation Brands

Jim Cramer: There Are Plenty of Shorts in Constellation Brands

Renault Shares Hit 10-Year High on Nissan Merger Report

Renault Shares Hit 10-Year High on Nissan Merger Report