Chinese Reverse Mergers: Detecting Fraud Using Short-Seller Sentiment

There has been a lot of concern recently over reports of fraudulent small-cap Chinese stocks listed on American exchanges. The trend involves Chinese companies using reverse mergers to enter an American stock exchange without subjecting their financials to the scrutiny of regulators.

Regulators are having a difficult enough time finding the bad eggs. Investors without the tools or know-how to sniff out the cheats are understandably avoiding many of these Chinese stocks.

One research firm, Muddy Waters LLC, has been at the vanguard of the investigations into these companies. The markets have paid close attention to the reports.

"Toronto-listed Sino-Forest Corp. saw its share price collapse after research by Muddy Waters raised questions over its books, and may have sparked Paulson & Co., run by hedge-fund titan John Paulson, to sell off its holdings in the company ... Sino-Forest's share price dropped by about 80% this month," reports Chris Oliver of MarketWatch.

Muddy Waters' next target: China Yuran Food Group (CYUFF). The stock has plummeted by almost 31% in the two days since Muddy Waters' announcement.

Of course, not all of the reverse merger companies have dubious intentions. In fact, it's probably safe to assume that some of these Chinese small-cap stocks have honest and healthy financials. But how can we spot them?

For this article, we decided to follow short-seller trends. In particular, we looked for stocks that have seen significant short covering in the last month, a sign that sophisticated investors are generally bullish on these stocks.

Short-selling is tricky and costly. An individual or institution must meet several requirements (including background checks) to engage in short-selling. Thus, in general, they are more sophisticated than the average investor.

When short-sellers think the price of a share is going to rise, they "cover" their positions by buying and returning the borrowed stock. This represents a net decrease in short positions on a stock. Short covering therefore amplifies upward movements in stock price and can be considered a bullish indicator.

Do you share the bullish sentiments on these reverse merger Chinese stocks? Or are you planning on playing it safe by avoiding the whole lot of them? (Click here to access free, interactive tools to analyze these ideas)

List sorted by decrease in the number of shares shorted as a percentage of the share float.

1. Cogo Group (Nasdaq: COGO  ) : Diversified Electronics industry with a market cap of $192.80 million. The number of shares shorted decreased to 685.89K in the most recent month from 1.29M in the previous month, which represents 2.98% of the 20.25M share float.

2. ChinaCast Education Corporation (Nasdaq: CAST  ) : Education & Training Services industry with a market cap of $245.42 million. The number of shares shorted decreased to 8.75M in the most recent month from 9.78M in the previous month, which represents 2.96% of the 34.77M share float.

3. Yongye International (Nasdaq: YONG  ) : Agricultural Chemicals industry with a market cap of $253.27 million. The number of shares shorted decreased to 3.88M in the most recent month from 4.93M in the previous month, which represents 2.84% of the 36.92M share float.

4. China Information Technology (Nasdaq: CNIT  ) : Application Software industry with a market cap of $99.39 million. The number of shares shorted decreased to 1.19M in the most recent month from 1.78M in the previous month, which represents 2.70% of the 21.89M share float.

5. China Shen Zhou Mining & Resources (NYSE: SHZ  ) : Industrial Metals & Minerals industry with a market cap of $101.06 million. The number of shares shorted decreased to 2.52M in the most recent month from 2.69M in the previous month, which represents 1.95% of the 8.70M share float.

6. Deer Consumer Products (Nasdaq: DEER  ) : Home Furnishings & Fixtures industry with a market cap of $232.11 million. The number of shares shorted decreased to 2.74M in the most recent month from 3.03M in the previous month, which represents 1.64% of the 17.67M share float

7. Feihe International (NYSE: ADY  ) : Dairy Products industry with a market cap of $149.92 million. The number of shares shorted decreased to 1.60M in the most recent month from 1.78M in the previous month, which represents 1.64% of the 11.00M share float.

8. China Valves Technology (Nasdaq: CVVT  ) : Industrial Equipment & Components industry with a market cap of $108.44 million. The number of shares shorted decreased to 3.56M in the most recent month from 3.74M in the previous month, which represents 0.92% of the 19.58M share float.

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.


Kapitall's Eben Esterhuizen and Andrew Dominguez does not own any of the shares mentioned above. Data sourced from Finviz.

The Motley Fool owns shares of Yongye International. Motley Fool newsletter services have recommended buying shares of Yongye International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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