Dangers of False Confidence in China Stocks

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

BEIJING ( TheStreet) -- Many investors have come to the conclusion that China small-caps are trading in one direction lately -- down. They haven't kept an eye on China Biotics ( CHBT).

Over the past year, and subsequent to the filing of its last 10K, CHBT has been the target of a number of short-seller reports and fraud allegations. Shares of CHBT bottomed out at $7.22 on April 15.

As of Wednesday's close, the shares were trading at $11.78, up 63% in less than a month. The shares rose nearly 20% just this week following the posting of two 13G filings by Wellington Management (10.2% stake) and Value Capital Holdings (8.1% stake).

Since there was no other news, I am assuming the filings drove up the stock this week, as investors took extreme confidence from large stakes by institutional investors. These stakes look big on the surface, but in fact represent an infinitesimally small portion of their overall holdings. In addition, the institutions buy in at very favorable prices, then watch the share price automatically rise when their holdings are disclosed.

Take Wellington, for example. From its Web site, Wellington manages $663 billion in assets. Its $20 million investment in CHBT represents 0.00003% of its total assets. Granted, no one wants to lose $20 million, but even if CHBT went to zero, Wellington would not even notice.

Retail investors have the shoe on the other foot. They buy in after the institutions, paying a higher price and allocating a tremendously greater portion of their capital to concentrated positions. The assumption that institutional investors have an informational advantage and perform superior due diligence is not necessarily something that should be relied upon blindly. There are a number of recent examples.

In 2009, Carlyle Group announced that it had invested $15 million in China Agritech ( CAGC), a 16.5% stake. The share price was below $10, but within weeks it rose to $30. Carlyle's price was around $5 (split adjusted) and included a large number of free warrants, lowering their effective "in price" even further. In short, Carlyle got a sweet deal while retail investors simply bid the stock up by triple. Fast forward a year, and CAGC is now halted, having last traded at $6.88, and it has "dismissed" its auditor, KPMG.

Carlyle manages $106 billion, with its investment in CAGC representing 0.0001% of its total assets. Separately, Carlyle took at 16.5% stake in Hong Kong-listed China Forestry for $55 million. Its stock is now halted in Hong Kong and auditor KPMG has resigned. In both of these fraud cases, investors who simply followed on the coat tails of Carlyle paid a higher price and certainly allocated a larger portion of their portfolio to these investments.

Another obvious example is Starr Investments' $50 million stake in China MediaExpress ( CCME). Starr is reported to have conducted extensive on-the-ground due diligence for many months prior to making its investment. When the short attacks began on CCME, many investors took confidence from knowing that Starr had thoroughly reviewed the company, had board representation and monitored CCME on an ongoing basis.

As the controversy heated up, Starr reportedly commented that it was "annoyed but not concerned" about the fraud allegations. What many investors didn't focus on was that Starr's investment consisted of convertible preferreds with "liquidation preference," meaning that in the event that the company is wound down, Starr gets all of its money back from CCME before any other shareholders get anything. While many retail investors bid CCME up to as high as $23, Starr's "in price" was around $5 when the effect of warrants is included. CCME is currently halted, auditor Deloitte has resigned and Starr is now suing CCME. Once again, investors who chose to invest or hold simply because of Starr's presence paid a much higher price than Starr and on a relative basis held CCME as a much larger portion of their portfolio.

My objective is not to criticize Wellington, Carlyle or Starr, but rather to point out that these seemingly large investments in small companies are, in fact, just a drop in the bucket for such large firms. When retail investors come in later, they come in at a higher price and with positions that represent a substantial portion of their portfolio, making large losses extremely painful.

Following its 20% run-up this week, CHBT plunged by as much as 20% in a single day on Thursday when a brief report was released by Citron research. http://citronresearch.com/. The stock then recovered most of its losses within hours.

I was as perplexed by the 20% drop as I was by the 63% run-up. A stock under the cloud of fraud shouldn't run up 63% when similar companies are being delisted en masse. But by the same token, all of the fraud allegations have been widely disseminated and are "old news."

But whether the allegations are new or old doesn't have anything to do with whether they are true or false. The only thing that matters is will CHBT pass its upcoming audit for its annual 10K, which unlike most companies, will be released in June, not March?

The month of March saw a wave of delistings and haltings of small-cap China stocks -- so far over 20 companies. The reason that it happened all at once was because most of these companies have a December year-end and are required to file their 10Ks in March. As we have seen numerous times in the past, very little work is performed by auditors on 10Qs. I have not seen an auditor resign or detect fraud in connection with any 10Q filing. But 10K annual filings are a totally different story, and this is where fraud is detected and when auditors resign. Standard audit procedures simply have minimal requirements for 10Qs and substantially greater requirements for 10Ks.

Fraud allegations against CHBT surfaced last year, well after the filing of its last 10K. Since then, auditor BDO has signed off on the subsequent 10Qs without any issue and CHBT has continued to report record results and stellar profitability. However, activist short sellers are directly targeting BDO and demanding a "fair" audit of the company. Materials have been sent directly to BDO and a summary letter which is posted at BDOwatch.com.

As a momentum trade, CHBT has been fantastic for investors over the past month. However, I believe that many investors are taking false comfort from the investments made by Wellington and Value Capital, as well as from the signed-off 10Qs by BDO. The real risk in CHBT is that there is a substantial earnings restatement or auditor resignation which, if it were to happen, would take place in about three weeks. Separately, CHBT trades on a P/E ratio of about 9 times in a space where many RTOs (even those not accused of fraud) are trading on P/Es of roughly 4 to 5 times. As a result, I am short CHBT and plan to stay short until after the 10K is filed.

Please note, I am not encouraging anyone to buy or sell shares of CHBT. All of the allegations have been widely and publicly disseminated, so I won't repeat them here. However, I would strongly encourage anyone interested in the stock to make themselves fully aware of the allegations and make a rational assessment of whether they pose an audit risk, rather than simply taking comfort from a tiny bet placed by some gigantic investors at an unknown price.

Disclosure: The author is short CHBT. The author can be reached for comments 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.

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