The Best Kept Secret or Not?
By Maj Soueidan
If you have invested in U.S. listed Chinese stocks (ChinaHybrids) you are probably already aware of their rise and fall from grace. If you are thinking about investing in these stocks for the first time, it’s important that you become familiar with the evolution of the space. GeoInvesting has and will continue to play a big role in bringing awareness to the investment risks and opportunities in ChinaHybrids. I bought my first ChinaHybrid in 2004.
I became interested in these stocks because they offered a way to invest in China without having to deal with the logistical challenges of directly investing in China A share markets. Furthermore, I could read SEC regulatory filings in English that were audited by U.S. firms (occasionally big 4 firms). But a big issue still remained: many of the sexiest China names came public through reverse merger transactions and traded on the over the counter markets (OTC).
Reverse mergers are a back door approach to an Initial Public Offering (IPO). A private company essentially buys a non-operating company trading on the OTC for a few hundred thousand dollars or in exchange for stock of the soon-to-be new company. The OTC is well known to house pump and dumps and purely speculative companies that never succeed. This explained why many of these China based stocks traded at ridiculously low valuations, despite reporting meaningful sales and earnings in SEC filings.
From my perspective, this was a perfect example of inefficient markets. With faith that auditors were doing their job, combined with proper research, it appeared I had a great opportunity to buy stocks on the OTC market with low valuations that would later up-list to a major exchange at higher valuations.
The Good Times
GeoInvesting was launched in 2007 to cover U.S. Micro Cap stocks and help bring awareness to ChinaHybrids. Microcap investors seemed like the perfect match. By 2008, over 500 ChinaHybrids were trading in the U.S. The group had sporadic moments of glory, but not usually on a sustained basis. But then came the Great Recession of 2008, a gift in disguise and perfect storm for ChinaHybrids. China was the first nation to implement policies to combat the global recession. Thus, investors started taking notice of ChinaHybrids that were still growing sales and earnings while the rest of world was suffering. They became the one pocket of hope for many investors.
In 2009 everyone found these stocks and we began writing about them at GeoInvesting. We were “loved” by many investors. China stocks were doubling, tripling and quadrupling one after the other. I began writing about China companies I met at conferences that I routinely attended, usually hosted by well-known investment banks and research houses like Roth Capital, RedChip securities and now defunct Rodman & Renshaw.
Eventually, my business partner, Dan David, began attending conferences with me. Management teams would use these conferences to raise billions of dollars of “growth capital” from institutions and everyday investors.
From Sheik to Geek: The Bubble Bursts
By the end of 2009, we started the process of building an on the ground China team, partly because cracks started appearing in a few stocks we were following. Stories started sounding too good to be true and the market failed to assign high multiples to seemingly high growth, low risk companies. The market was illogically inefficient.
In 2010, we had our on the ground team in place and in the summer of 2010 we gave them a list of 50 companies to start visiting. Within two weeks we received a call with a message we were not hoping to hear.
“Sell them all. The China based frauds and deception is much worse than you anticipated. You can’t trust the SEC flings audited by U.S. Big Ten accounting firms,” our investigators told us.
We immediately issued a note to GeoInvesting members regarding ChinaHybrid stocks, stating that this space was basically not investable for the time being.
Shortly thereafter, the bubble began to burst. ChinaHybrids were tanking, getting halted and delisted amid bearish articles calling out the widespread China based frauds and deception.
Investors, even savvy ones, lost billions.
GeoInvesting’s Role In Cleaning Up The China Based Frauds
Initially, we attempted to work with investor relations firms and investment banks to clean the space up. They soon balked on us. We would later learn that the majority of the reverse mergers that these firms were conducting business with were earning them large fees, so we surmised that they just decided to hide behind disclosures and earn fees for as long as they could before the space totally blew up.
We set on a crusade to write hard hitting due diligence pieces, calling out management teams and protecting investors from fraud. Our work outing deceptive Chinese management teams speaks for itself: we are one of the only organizations that got management teams to admit their deceit and subsequently be jailed. Because of our work 12 ChinaHybrids were either halted and/or delisted.
Our Work Is Not Over
While the ChinaHyrbid space is safer than it was in the past, China based fraud and deceit are still prevalent, even in those companies that went public via IPOs. We will continue to do our work in cleaning up the space, while at the same time searching for investable ideas. We have also broadened our portfolio protection activities to out pump and dump scams and other areas where we see potential for deceit.
It’s important for investors not to forgot that we are also very active in the U.S. microcap space and long-investors by blood. We offer investors a unique opportunity to have access to bullish ideas, while offering portfolio protection and having the knowledge and team to continue outing frauds, both in China and in the U.S.
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