Latest China Small-Cap Report Is Puzzling

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.

NEW YORK ( TheStreet) -- In early March, when I finally came to the conclusion that China MediaExpress ( CCME) was likely to have accounting problems (before the stock was halted), the first thing I did was sell all of my China small-cap stocks.

It seemed clear to me that if the market lost faith in a company that was audited by Deloitte, backed by Starr Investments and covered by Global Hunter, that less-credible stocks were bound to suffer. As a result, I sold stocks that I liked and I sold stocks that looked too cheap. I keep following a few names where I am tempted to go long, but since everything seems to just keep going down, I have basically sat and waited.

Yesterday, one stock that I liked, SkyPeople Fruit Juice ( SPU), was the subject of a short-sellers report by Absaroka Capital, which drove the share price down by 20%. Given that I visited the company, its distributors and retailers in January, I thought it might be useful if I weighed in with my views.

First, I was puzzled that anyone would bother writing a short report on a $2.50 stock that has little to no stock borrow for shorting. From a stock-price perspective, it seemed to be the equivalent of kicking a three-legged dog, just for the fun of it, and not for profit.

Even before delving into the body of the report, the report summary can be found to contain a number of statements that are easily contradicted. The authors note that they "struggled" to find SPU's products on store shelves. They must not have struggled much because, for me, I simply hopped a cab to Wal-Mart ( WMT) and walked to the juice section where I saw their products displayed on a middle shelf close to international brands such as Dole. After struggling to find Wal-Mart, the authors did manage to find SkyPeople's product, but noted that it was on a bottom shelf, which is typically reserved for slow-moving goods. I easily found individual bottles on a middle shelf at arms reach, and I noted from the authors' photos that the particular products they were filming were cartons of juice in big boxes. It seems logical to put big boxes on lower shelves.

I was surprised that the authors received such detailed feedback from Wal-Mart sales managers regarding product sales because when I asked the same questions, I was told adamantly that Wal-Mart won't release that kind of information to anyone, period. In fact, Wal-Mart employees wouldn't even allow me to photograph inside the store without advance written permission. (But I did sneak a few photos when they weren't looking.)

As for my visit to the factory near Xi'an, the equipment I saw was obviously new and imported from Italy, which is at odds with the authors' view that the equipment was old and out of service. I saw robust production of bottled juices and juice concentrate and a level of inventory that seemed appropriate.

I could continue with quite a few more examples, but I am expecting management to provide a detailed rebuttal sometime soon, so I will leave that to them. As for responsiveness, SPU gets an "A+." When faced with fraud allegations, some companies choose to "go dark" and simply avoid investors by hiding behind an IR firm. This is always a troubling sign and, to me, indicates that worse things are yet to come. I am currently in Shanghai and don't have contact details for SPU management with me, so I simply called the general phone number listed on Google Finance and left a message for the chairman. He called me back within 15 minutes and was happy to answer all of my questions.

If this were 2010 again, I would currently be pouring money into shares of SPU, feeling confidant that I could successfully and effortlessly rebut much of the authors' arguments. However, we now live in the post-CCME world and there is enough skepticism in the market that I am hesitant to jump in. Even though I liked the stock at $4.50 (prior to CCME and the onslaught of China hit pieces), I am hesitant at $2. As I have written in the past, even if I can debunk 90% of the arguments made by the authors, that doesn't provide an ironclad guarantee that there isn't a problem somewhere.

Absaroka's track record is somewhat mixed. Its recent report on Yongye ( YONG) drove the share price down to as low as $3.01. However, shortly thereafter, it was announced that Morgan Stanley Private Equity was investing $50 million in YONG, which drove the price as high as $6.15 just a week later. Quick 100% pops like that are keeping investors playing in this space. And for those who play the options, the gains are significantly larger. Absaroka has followed up with further thoughts regarding MSPE's investment, which I thought were very useful. In particular, they noted that Morgan Stanley was not simply buying $50 million in the open market (only a complete fool with too much money would do that). Instead, Morgan Stanley is getting a very special deal, not available to ordinary folks, which consists of convertible preferred shares that pay in-kind dividends and rank senior to common shareholders. The headline conversion price of $8.80 got many people excited, but, in fact, the structure of the deal means that Morgan Stanley's "in price" could be substantially lower than the current share price of $5.19 if they receive extra shares. It would appear that they are already making money, despite having a conversion price that appears to imply a much higher target price.

Absaroka's report on Shenzhou Mining ( SHZ) drove the stock down from around $6 to below $3 in just a few days. But a detailed rebuttal from management (along with an irrational misunderstanding of the stock) quickly drove the price back up as high as $6.50 -- above the pre-report price. It is notable that the CFO resigned immediately after the fraud allegations came out, which is always a troubling sign. On SHZ, I don't know if the fraud claims hold up well or not, but I do view it as one of the most irrationally overpriced stocks out there, and I make sure to short it from time to time when I can. As of this writing I have no position.

I also have no position in SPU, but I might consider taking one after I get to see management's detailed response. The fact that I can easily and instantly contradict many of the points in Absaroka's report doesn't mean the analysts haven't uncovered something that could in some way be problematic. As always, the burden of being 100% right is on the shoulders of management. And, as always, if there is even a 10% problem, then a stock can quickly see some combination of a stock halt, a delisting and a sub-$1 share price. So even at $2, there is still plenty of risk.

I was puzzled that Absaroka would choose to go after a $2.50 stock with little or no stock borrow, and I am equally puzzled why the firm would use arguments that are so easily refutable. Some of the points raised clearly deserve attention and a detailed response by management, but the easily refuted points dilute the impact of the report. I have already sent the firm an email, and I hope to get a better understanding of our differences of opinion.

Disclosure: The author holds no positions in any of the stocks mentioned. 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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