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 Tracking 1259 U.S. listed China Stocks and Counting...
 Tracking 3138 U.S. Stocks and Counting...

Limit Risk While You Invest in ChinaHybrids (U.S. Listed Chinese Stocks)

Tuesday, November 2, 2010, 12:58 PM ET -

by Maj Soueidan, President GeoInvesting

Over the last several weeks, we have witnessed a massive bounce across the ChinaHybridTM space. At current prices, many investors are betting that the probability of higher prices is greater than a further disintegration of P/E multiples past levels of what most investors would already consider to be insane. A healthy market and a massive short squeeze have helped ignite a very powerful move.

For now, the market has shelved the fraud case that shorts have attempted to paint across the entire space.

The word "fraud" is loosely thrown around. However, it is important to make a distinction between fraud and inexperienced/inefficient management teams that lead to financial statement problems. As far as I see it, we have a few possibilities that we can consider.

  1. Company is a total fraud, done intentionally to raise money.
  2. Company is just smaller than SEC filings portray, done intentionally to raise money.
  3. Problems with SEC filings from weak internal controls leading to:
    1. Aggressive accounting.
    2. Improper accounting of non-cash items.
    3. Questionable related party transactions or off the book transactions.
  4. Basic understanding of why differences between SEC filings and SAIC/SAT filings exist.
    1. "Commonly accepted" tax avoidance schemes
    2. Differences in accounting standards.
    3. Deliberate inaccurate SEC filings representation (Fraud)

The shorts are attempting to prove that 1, 2 and 4c are rampant in the space. However, thus far, the majority of substantiated problems have dealt with pending accounting issues and related party transactions that may be addressable. Except for insinuations, the shorts have not been able to prove that any ChinaHybridTM has been a total fraud or much smaller than SEC filings portray...not to say that this won't happen. (Closure has yet to occur on Orient Paper Inc (NYSE AMEX:ONP) China Agritech Inc (NASDAQ:CAGC), China Green Agriculture (NYSE:CGA)China-Biotics (NASDAQ:CHBT) & China Sky One Medical (NASDAQ:CSKI)).

For investors who believe that malicious fraud will not embody the space, they still need to consider the ramifications if China were to crack down on companies that participate in tax avoidance schemes. Most, including myself, have believed that China will not impose tactics to jeopardize the business prospect of so many companies.

For this reason, my curiosity was piqued when I came across an 8K filed by Qingdao Footwear Inc (OTC BB:QING), highlighting a tax liability that is "expected to have a material impact on the Company's balance sheets, statements of cash flows and statement of shareholders' equity."

"As a result, the Company's previously filed financial statements cannot be relied upon for the years ended December 31, 2008 and 2009 and the periods ended March 31 and June 30, 2010. Specifically, the Registrant determined that its taxes payable were understated by $11,369,569 due to the fact that the Company may have liability for VAT and income taxes from prior years."

http://geoinvesting.com/companies/qing_qingdao_footwear_inc/research/investor_alert/0026650

I believe this may be the result of auditors becoming more diligent, a good thing, but something to keep on the back burner as we near year end audits.

The Purification Process has been Set in Motion

Although painful at first, the events that transpired over the past several months were necessary to jump start a cleansing process and repair the space. Investors were in a react now and ask questions later mode.

Ironically, recent events have led investors and investment banks to perform deeper due diligence, resulting in aggressive funds flow across the board, a short-term dagger thrust into the portfolios of many pessimists.

Companies are starting to respond by hiring top auditors to perform audits and improve internal control systems.

More importantly, many firms, like China Mediaexpress Holdin (NASDAQ:CCME) and Deer Consumer Products (NASDAQ:DEER) have begun to speak with their wallets by enacting share buyback programs, maybe proving that they actually do have cash on the balance sheet!!! In addition, many have become more vocal regarding goals to maximize shareholder value by holding off on dilutive equity raises and issuing EPS guidance as opposed to just net income guidance. We are currently involved with potential RTO companies and advising them to make sure their ducks are in a row before they become public.

China North East Holdings (NYSE AMEX:NEP) is an example of how investor confidence can be restored once accounting issues are dealt with. The stock has recovered most of the dramatic losses it had sustained from this event.

Short-Term Corrective Bump or Sustained Momentum?

The short assault is likely far from over. Thus far, my findings are inconclusive, but indicates that unscrupulous behavior may be present in many ChinaHybridTM companies. Will the broad-brush allegations that swept across the space begin to only punish the deserving firms? Time will tell, but hopefully the bar to prove foul play is being raised.

Conservative investors should continue to perform extensive due diligence on the space, concentrating on companies with top auditors that have addressed financial transparency problems and have sufficient internal controls. Having a good handle on fund raising goals is also imperative.

Look for companies that have held up in the recent correction and have begun to perk up; for example, Lj Intl (NASDAQ:JADE). This could be a sign of investor confidence. This is also a time when tracking new highs is a great indicator of investors placing their vote on the companies they believe are real.

The riskier investor could consider companies that are in the midst of strengthening corporate governance, like Renhuang Pharmaceuticals (NYSE AMEX:CBP).

Although I have been very cautious for some time, maybe dumb luck will help my suggestion that ChinaHybrids could be rediscovered as we inch closer to 2011 come true. Since prices are so cheap, I choose to wait for sentiment to improve while I devoted funds to my more timely U.S. selections such as Lgl Group (NYSE AMEX:LGL) and Amtech Systems (NASDAQ:ASYS).

I don't know how long this China move will last, but it appears very powerful. The pendulum has certainly swung 180 degrees as the market selectively ignores negative media bias. There is a lot of money to make between P/Es of 3 and 25 if the market wants to even flirt with bringing a glimmer of efficiency to the space.

For now, I won't fight the tape and will enjoy the ride as long as I can, as P/Es readjust away from failure. I will still be nimble with a strict sell discipline and continue to keep ChinaHybrid exposure at no more than 25% to 30%, supplementing my U.S and China indirect holdings.

I will also continue to compare local Chinese and SEC financial filings to guess where the shorts may attack next. Ignorance is not an option. While knowledge may be my worst enemy, hopefully evolution of the space will be my best friend.

Disclosure: Long CCME, JADE, ASYS, DEER, CBP, ONP calls.  I have begun scaling out of ASYS. I have taken some CCME and JADE off the table.

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