Reverse Mergers Facing Issue of Trust

So many fears and concerns out there right now about debt, the economy, and another potential recession. How all of this affects reverse mergers.Global financial markets are facing not only the headwinds from the European sovereign debt crisis, but also fears of another recession in the U.S., despite what everyone is saying.

There are concerns rising over the policymakers’ ability to find a concrete solution to fight such a situation in both the United States and Europe. This has negatively affected the global markets. The interest rates in Europe continue to rise, while the banking stocks continue to fall due to the Greece debt risk and fear of it spreading to other countries and their banking systems. Moody’s just downgraded two main French banks.

President Barack Obama proposed a $447-billion unemployment package, which might raise uncertainty globally as the U.S. Congress debates over the President’s stimulus package. On the other hand, the biggest emerging economy China is facing a downside risk due to reduced exports if the U.S. enters another recession.

All this has significantly increased fear towards investing in risky assets that are facing immense volatility. The strength of the greenback and gold suggests the well-known theme of “flight to safety.” The reality is that the U.S. markets still lead the global markets in terms of year-to-date returns, with European markets being the worst performers.

Investors should closely monitor an expected stream of warnings and commentary from corporations, which could also help to clarify their reaction to the global slowdown and its impact on their balance sheets during the third quarter.

Talking about reverse mergers, 2011 has turned out to be a disappointment for investors in reverse-merger stocks. Events such as the Securities and Exchange Commission’s cautious stance for such investors, the NASDAQ’s proposal of new listing requirements for reverse-merger stocks, and Moody’s Red-Flags report on China based companies have placed immense pressure on this asset category. A large list of accounting fraud accusations along with the questionable practice of reverse takeovers with shell companies have made investors more hesitant towards such Chinese stocks.

The weakness of the reverse-merger stocks is also evident in the poor performance of the Bloomberg Chinese Reverse Mergers Index (CHINARTO Index), which is a market capitalization-weighted index that tracks China-based companies trading on U.S. exchanges following reverse mergers.

As of September 9, the index was down a whopping 53.2% from December 2010, compared to an S&P Index decline of 8.2% during the same period. China Main Index (TCM) and China OTC Index (TCO) were down roughly 57% and 87%, respectively.

In terms of valuations, CHINARTO is trading at a Price-to-Earnings (PE) of 4.8X and a Price-to-Book (PB) of 0.6X, compared to S&P’s PE of 12.6X and PB of 1.9X. The CHINARTO has superior valuation, but with much higher risk.

Since the beginning of this year, the volumes in CHINARTO Index have declined by 20%. This is not a surprise given the inherent risk in Chinese reverse mergers.

Investors remain jittery towards equities, especially reverse-merger stocks due to the enormous volatility in the share prices. The last few months have been a harvest season for the short sellers in the Chinese reverse-merger stocks and this didn’t require one to be a guru in selecting which ones to short. The majority of reverse-merger stocks have taken a hit following the SEC announcement irrespective of the strength and growth prospects of the business, solid financial performance, and clean reputation of the management.

At the end of the day, this provides an opportunity for the investors to be selective and invest in such firms and earn higher returns. Be very careful what stocks you buy.

The key is to make sure you are diversified.