Reverse-merger Listings Decline;
What’s an Investor to Do?

This year is turning out to be a disappointing year for investors in reverse-merger stocks. Why this is happening and what you as an investor should do.During the last few years, investors in the U.S. have been actively investing and making significant returns in reverse-takeover stocks. Although reverse mergers have been in existence for decades, it has become increasingly common for a foreign private company to use this route to become a domestic issuer. It’s easier and cheaper.

In the case of Chinese reverse mergers, this often results in Chinese stocks with almost all of their operations in China, while their securities trade in the U.S.

This year is turning out to be a disappointing year for investors in reverse-merger stocks, as events like the cautious stance of the U.S. Security and Exchange Commission (SEC) for such investors, the NASDAQ’s proposal of new listing requirements for reverse-takeover stocks, and Moody’s Red-Flags report on China-based companies has dampened this speculative area.

According to the Public Company Accounting Oversight Board (PCAOB), about 159 companies from theChinaregion listed onU.S.stock exchanges by engaging in reverse mergers between January 2007 and March 31, 2010. But, as a result of the announcements on Chinese companies being involved in fraud, the activity in reverse mergers has been negatively impacted.

Only 37 reverse mergers were completed during the second quarter of 2011 (down 50% over the same quarter last year), according to the Reverse Merger Report.

To be clear, the decline is not only due to the decline in the activity in Chinese deals, but also the non-China deals. During the first half of this year, only three Chinese Alternative Public Offerings (APOs) were completed, each raising about $4.0 million.

The weakness of the reverse-takeover stocks is also 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. As of August 12, the index is down 50% since December 2010, compared to an S&P Index decline of 6.3% during the same period. Other indices like the TCM and TCO are down roughly 47% and 73%, respectively. In terms of valuations, CHINARTO is trading at a Price to Earnings (P/E) ratio of 4.9X and a Price-to-Book (PB) ratio of 0.6X, which is cheaper than the S&P’s PE of 12.3X and PB of 1.8X. But the risk is extremely high in Chinese reverse mergers.

At this juncture, investors are bearish towards equities, especially reverse-takeover 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-takeover stocks and this didn’t required one to be a “guru” in selecting which ones to short.

The majority of reverse-takeover 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. This gives an opportunity to investors to be selective and invest in such firms, earning higher returns.

The Chinese economy continues to show strong gross domestic product (GDP) growth at near 10%, so it may be an opportune time to accumulate some Chinese stocks selectively.