How 2012 Is Looking for Reverse Mergers

Will 2012 Be Another Tough Year for Reverse Mergers?In 2011, the European debt crisis was the major economic event and had a significant negative effect on the financial market performance in Europe, the U.S., and China.

Other important developments like the continued political unrest in the Middle East, the Fukushima disaster, and a rating downgrade of the U.S. also added pressure on the markets. During the second half of 2011, the U.S. dollar represented a safe-haven play, while precious metals and most of the equity markets continued to decline.

During the year, the greenback appreciated 3.2% against the euro, as the market participants anticipated a break-up of the eurozone. Gold declined over 15% from its peak after COMEX increased the initial margin requirements in September.

The MSCI World Index was down 7.6% and the S&P 500 ended the year just above breakeven. The worst performing emerging markets for the year were India (down 24.6%) and China (down 21.7%).

Although the emerging economies enjoyed high growth rates in 2011, there was a decline in growth from 2010. The risk of inflation was the major problem that the emerging countries faced in 2011. China suffered from the tightening of its monetary policy and from the deceleration of the global trade.

On a positive note, I feel this year could be much better for equity investors, as central banks are likely to stimulate economies with printed money, which has the side effect of increasing demand for assets such as shares. And, as the stock dividend yields trade above bond yields, it is also likely to attract the interest towards investment in shares.

Regarding reverse mergers, during 2011, U.S. capital markets witnessed a series of irregularities related to many reverse merger companies from China, as there were allegations of fraud and financial misstatement. These irregularities forced the Securities and Exchange Commission (SEC) to pursue evasive actions and it published a cautioning report for investors in these China stocks, NASDAQ’s proposal of new listing requirements for reverse merger stocks and Moody’s Red-Flags report on China-based companies placed immense pressure on this asset category and resulted in significant loss of shareholder value.

Anecdotal evidence suggests an estimated loss of $34.0 billion in market capitalization related to these allegations of misrepresentation from China companies. Such depressing events have negatively affected the deal activity in the reverse merger space, as only 166 reverse mergers were closed during 2011, well down from 258 in 2010.

Considering the current false reputation relating to China reverse merger companies, it’ll be a big challenge for other Chinese firms to raise capital during 2012. Market participants anticipate a bleak outlook for this asset class during 2012 and expect new reverse merger companies to remain at 10-year lows and the merger activity well below the five-year average of 225 deals a year. Reverse merger stocks from China will remain dry.

The weakness of the reverse merger stocks is evident from the poor performance of the Bloomberg Chinese Reverse Mergers Index (CHINARTO Index), which is a market capitalization weighted index that tracks China-based companies that trade on U.S. exchanges following reverse mergers. During 2011, the index fell by 61.7%, compared to flat closing for the S&P 500 during the same period. In terms of valuations, CHINARTO is trading at a price-to-earnings (P/E) ratio of 4.11X and a price-to-books (P/B) ratio of 0.45X, compared to S&P 500’s P/E of 13.45X and P/B of 2.1X.

As I look forward into 2012, I believe the first half of 2012 might be dry for the reverse merger stocks, especially those from China, but the second half might bring along some positive surprises to boost the investments in these stocks. Despite the current turbulent market environment, there are some positive signs that have emerged and can act as a catalyst to trade selected reverse merger stocks.

You should be clear on the fact that the magnitude of profits from investing in reverse merger stocks is likely to be less when compared to the boom years in 2008 and 2009.

Small-caps have started the year on a bullish note and I feel it could be a strong year should the U.S. economy continue to strengthen. You can read my thoughts in Small-cap Stocks—Drop Them or Keep Them in 2012?