Reverse-merger Stocks:
A Game of Risk and Reward

Reverse-takeover stocks—especially those happening with Chinese stocks—are quite high risk, but they can also have great rewards. Chinese stocks continue to struggle given the stalling in the Chinese economy.

Yet this does not mean we should all run way from Chinese stocks. There are numerous strong Chinese companies with a worldwide presence. For instance, to take advantage of the country’s massive cell phone market of over 800 million users, I like China Mobile Limited (NYE/CHL).

For some added risk and reward, you can look at some of the small-cap Chinese stocks, but be careful if they were formed via reverse mergers due to the surfacing of numerous cases of fraud. Chinese reverse-merger stock Sino-Forest Corp. (SNOFF.PK) was found to have recorded millions of dollars of revenues from another Chinese company. The problem was that the other company had no business at all in operation.

The flow of reverse mergers has declined significantly, especially those from China. According to the Public Company Accounting Oversight Board (PCAOB), about 159 companies from the China region listed on U.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% from the same quarter last year), according to the “Reverse Merger Report.” To be clear, the drop 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. In mid-August, the index was down 50% since December 2010, compared to the S&P Index decline of 6.3% during the same period. The other indices, TCM and TCO, are down roughly 47% and 73%, respectively. In terms of valuations, CHINARTO is trading at a Price-to-Earnings (PE) of 4.9X and a Price-to-Book (PB) of 0.6X, which are 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-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-takeover 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 U.S. Securities and Exchange Commission (SEC) announcement irrespective of the strength and growth prospects, solid financial performance and clean reputation of the management of the individual business. This gives an opportunity to investors to be selective and to invest in such firms and earn higher returns.

The key is to buy small amounts and diversify with more conservative investments.