Why Chinese Arbitrage Trades Are Unreliable

Chinese Arbitrage TradesWe all know about the trail of fraud initiated by numerous China-based companies that listed on U.S. exchanges via the speculative reverse merger process. The pipeline of new Chinese stocks is presently closed in North America, as Chinese companies that are subject to intense scrutiny and detailed reporting in the U.S. are staying in China. From 2008 to 2011, 60 China-based stocks listed on U.S. exchanges; but so far this year, there has been one Chinese stock listing, along with the delisting of several Chinese stocks that have been privatized.

The reality is that I do not sense a return to recent years. Speculation of several big China-based e-commerce initial public offerings (IPO) looking to list in the U.S. this year have not come to fruition. Three China-based Internet plays that were looking at listing in the U.S. were: 360buy.com, an online retailer with IPO expected around $4.4 billion; Vancl.com, the largest online clothing retailer in China; and Xiu.com, an online seller of luxury goods. (Read “Luxury Retailers Loving China.”)

The weakness of the China-based reverse merger stocks is evident from the poor performance of the Bloomberg Chinese Reverse Mergers Index (CHINARTO Index), a market capitalization-weighted index that tracks 82 Chinese reverse merger stocks trading on U.S. exchanges. As of Thursday, the index is down over 7.9% year-to-date and 16.0% over the past year.

The point is that the mistrust towards China-based companies is extremely high. The market doesn’t have full confidence in the Chinese reporting process and financial statements.

And given the inability of China-based stocks to gain any traction here, we are seeing more insider takeovers of U.S.-listed Chinese companies.

China-based economy hotel operator 7 Days Group Holdings Limited (NYSE/SVN) received an offer of $12.70 cash per American depositary share from the company’s co-chairmen and others. I don’t feel the proposed $635-million deal to be fair, as it’s only a 20.0% premium above the $10.57 close of Tuesday. The price is too low, given the stock was trading at $17.50 in November 2011.The deal may not go through, as many insider bids of Chinese companies are non-binding, so there’s no penalty if the bid is subsequently dropped. But if you feel the takeover will come through, there is an arbitrage trade with the bid price of $12.70, about 10.2% above the current $11.52.

Here are some other current Chinese arbitrage trades:

Chinese pork producer Zhongpin Inc. (NASDAQ/HOGS) received a $13.50-per-share, all-cash takeover proposal from the company’s Chairman and CEO, Xianfu Zhu, to buy the remaining 82.0% or so of the company’s common shares not owned. The market doesn’t believe the proposal will pan out, as the stock price is 25.0% below the bid price. A special committee of its board of directors has been established to evaluate and consider the offer. The offer price and the fact that it’s an insider bid appear to be stirring up some issues. In my stock analysis, there could be easy money made here of over $3.60 per share, or a quick 25.0%, if the deal pans out and Zhongpin is acquired. Of course, it’s the “if” that is risky.

There are two other Chinese stocks currently with a possible arbitrage opportunity:

— Fushi Copperweld, Inc. (NASDAQ/FSIN), with a share price of, $9.05 and a bid price of $9.50 (4.9% gap); and

— Yucheng Technologies (NASDAQ/YTEC), with a share price of $3.75 and a bid price of $3.90 (4.3% gap).

The key to an arbitrage trade is to understand the facts, including if it’s binding and financing is in place, and who is the buyer. With Chinese stocks, the risk is higher, but the arbitrage profits tend to be greater than with U.S. companies.