"Fuqi went up 15 times in 2009 — 15 times — could you imagine putting 100 grand into that?" says investor and TheStreet.com contributor Rick Pearson. "2009, when I was very very active, was a one way street. Everything was going up. The only mistake you could make was that the stock you put into was up only two times instead of four times."
Then came 2010, a year of reckoning for some of these stocks. Fuqi had to admit its 2009 profits were overstated; the stock opened this morning on Nasdaq at $5.50 and has dropped nearly 4% so far today to 5.35, nowhere in sight of its September 2009 peak of more than $30 a share. Rino International, a manufacturer of water treatment systems and once an investor darling, ended the year delisted from Nasdaq after it was nailed by short sellers for making up contracts.
Investors wondering what to do with China stocks have some new data points since my post last week on the short-selling hype that has begun over hot IPOs like E-Commerce China Dangdang and online video company Youku, neither of which are close to earning the scale of profits that would justify their multi-billion dollar valuations. Dangdang seems to think its valuation is more than justified: In bizarre behavior for a newly listed company's boss, Dangdang CEO Li Guoqing, husband of chairman Peggy Yu, took to China's leading microblog run by Sina to complain that the investment banks that took them public undershot their eventual $2.4 billion valuation by a mile (Dangdang shares surged out of the gate and are trading on NYSE at close to twice the IPO price).
In even more bizarre behavior, a Sina user purporting to work for one of those banks, Morgan Stanley, fired back at Li in coarse language — Morgan Stanley says she is not an employee of the bank, but her tweets did seem to indicate some inside knowledge of Dangdang's pre-IPO machinations. A good account with extensive translated excerpts is at iChinaStock.com, including this inflammatory gem from "Big Morgan Lady" to Li that may raise investor eyebrows: "[Colorful epithet], save your breath until you are profitable! Be careful not to lose your physical mobility if you continue to cook the book." (Bear in mind that Dangdang was long a money-loser and only recently made it into the black, so its soaring valuation is based not on booked profits but on hoped-for profits; then again, that is not the most reassuring of reassurances).
Beyond this headline-grabbing innuendo, there is a more obscure category of China stocks where companies have been booking sizable earnings yet getting an increasing amount of short interest and regulatory scrutiny: reverse-listed companies. Dune Lawrence at Bloomberg has an excellent account of how one dogged investor ultimately profited from his short positions on reverse-listed China companies, including a $1 million gain on the 2010 free-fall of China Sky One Medical, in which he still holds a substantial short position, betting that the company, still valued at $100 million after dropping 3.3% on Friday and another 5.5% so far this morning, will collapse to smithereens.
This category of companies gets listed on the main boards in the U.S. without going through a rigorous IPO, by instead purchasing an inactive but publicly traded shell company, moving up to a board like NYSE or Nasdaq and then selling shares to raise money. Clever promoters, with the help of smaller investment banks and lower-tier auditors, have made a cottage industry out of taking small-cap Chinese companies public this way, raising questions about who, if anybody, is taking a close enough look at the fundamentals of their businesses.
This is an area where the problem of cooked books may be more likely to arise, but there are also a lot of reverse-listed companies that are making investors money. From Bloomberg's report:
Roth Capital Partners, an investment bank in Newport Beach, California, that has been one of the most active in helping Chinese reverse merger companies raise money, recently tried to define the size of the market. It came up with a list of 94 companies with a market capitalization between $50 million and $1 billion that trade an average of at least 50,000 shares daily, with a total stock market value of more than $20 billion. Returns for Chinese reverse merger companies totaled 43 percent for the five years through 2010, even with a slide of 23 percent last year, according to Roth Capital's analysis.
Retail investors on average made money, then, and quite a lot of it, which is why this obscure, difficult to assess subset of stocks proved so tempting, with stocks like jewelry designer Fuqi International jumping by multiples in months that no U.S. company could match.
"Fuqi went up 15 times in 2009 — 15 times — could you imagine putting 100 grand into that?" says investor and TheStreet.com contributor Rick Pearson. "2009, when I was very very active, was a one way street. Everything was going up. The only mistake you could make was that the stock you put into was up only two times instead of four times."
Then came 2010, a year of reckoning for some of these stocks. Fuqi had to admit its 2009 profits were overstated; the stock opened this morning on Nasdaq at $5.50 and has dropped nearly 4% so far today to 5.35, nowhere in sight of its September 2009 peak of more than $30 a share. Rino International, a manufacturer of water treatment systems and once an investor darling, ended the year delisted from Nasdaq after it was nailed by short sellers for making up contracts.
The firm that wrote up Rino, Muddy Waters Research, had less success making charges stick with another target, Orient Paper, which Pearson defended against the company's attack. Nevertheless, Orient Paper's shares took a bruising, and Pearson took a lesson from the experience.
"If you're gonna play these stocks, you've got to watch them every day, you've got to have a quick trigger finger: If there's any mention of fraud, you sell first," Pearson told me. "If you see someone come out and say fraud, take your 15% loss and be grateful for it."
Not a game for the faint of heart on either the long or the short end. When short-sellers are right, they still have to sweat it out, because they may not be proven right in time to see their way to victory. Bloomberg's $1 million man had to make $90,000 in margin calls at one point to keep his bets going. And when short-sellers are wrong and bet against a moneymaking Chinese company in a booming economy, their losses are potentially enormous. Remember: When a Chinese company says that its revenues are growing fast, that may be because it's true.
And what about the hottest long-or-short opportunities out there right now, the multi-billion dollar IPO darlings Dangdang and Youku? I know of investors on both sides of these companies who are equally confident of their bets, and none of them think they are gambling. The naysayers are winning in the latest round of trading, or gainers are taking their profits, with Dangdang down more than 7.5% and Youku down 8.5% at midday today.
Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.
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