Over the last few months, there has been a backlash on small-cap Chinese stocks that has driven the valuation on many of these stocks down to extremely low levels.
The Shanghai Composite Index (SCI) traded at 2,709.95 on May 27, which was its lowest point since September 30, 2010. The SCI is down 15% from its 52-week high and is well below the comparative returns of the key U.S. indices. It was only in April that the SCI was up around 10%, so there has been a 25% swing in the return in two months.
My economic analysis is that despite the impressive GDP growth of just under 10%, China is faced with crippling high inflation at nearly five percent, along with high property prices. The recent Purchasing Managers Index showed some slowing.
Also helping drive the bearish sentiment toward Chinese stocks are the heightened concerns and focus on the safety and factuality of Chinese reverse mergers by the Securities and Exchange Commission (SEC), along with stock exchanges, which have hurt many of the small-cap Chinese stocks that are listed in the U.S.
Reverse mergers occur when a private company that wants to go public finds and shell company that is trading and buys the shell. The private company then transfers its assets into the empty shell, and after minor reporting, the company is public.
The advantage is that it is much easier to take over a shell company than to get listed via the traditional method. The reporting requirements are much less stringent in a reverse merger. This appears to have attracted numerous Chinese companies.
I’m not saying that all of these Chinese reverse mergers should be the subject of investigation, but since this strategy is the easiest method of gaining listing on domestic exchanges, I’m not surprised to hear of the wrongdoings in this area.
There appears to be a witch hunt for these small Chinese companies, many of which are likely legitimate. However, we are seeing short sellers, bloggers, and anyone with access to writing on the Web posting negative reports on small Chinese companies.
As a result, there has been unwarranted selling in many legitimate Chinese stocks, to the point where the valuations are ridiculously attractive.
I have covered many of these stocks based on what I believe were factual results and information. You cannot always differentiate the good information from bad. When a sole short seller attacks a company, you have to take a step back and wonder.
Now, there is a concerted move to develop a special market for reverse-merger stocks in which these stocks would trade prior to listing on the Pink Sheets. And as you apply to trade on a more controlled exchange, the listing requirements concurrently move higher.
Moreover, the U.S. is seeking the requirement to use approved auditors for any new company from China wanting to list here. I actually like the proposal and feel that this will help drive away some of the unscrupulous players from stealing your money.
The way I see it is that investors need to be careful here. There are some suspicious companies, but I feel that the majority of Chinese companies are legitimate—even those that formed via reverse mergers.
The key now is patience for your Chinese stocks, but at the same time, make sure that you have stops and take some profits on some of your big winners.