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The flavor of the past few years has been China. The country is on an absolute growth tear, putting up double-digit or near-double-digit GDP growth while developed countries have fallen into an anemic crawl. Investors that had some foresight and jumped on the China train early have scored serious returns -- though the Shanghai Composite is down from its 2007 highs, it has absolutely clobbered the S&P 500 over the past five years.

Problem is that the success has drawn more investors to China and with more investors clamoring over China there have been some inevitable... let's just say less-than-honest-folk that have tried to milk the excitement.

Last week Bloomberg detailed the crusade of Texas short-seller John Bird as he unravels the tales of China Sky One Medical (Nasdaq: CSKI  ) and other small Chinese companies that he doesn't think are on the up-and-up. Many followers of small Chinese stocks are likely also familiar with the story of Rino International, which has been sunk by fraud allegations from upstart short-selling research firm Muddy Waters.

So how do you avoid stumbling into lesser-quality -- if not fraudulent -- Chinese companies? If you're not willing to get your hands dirty in the research process, avoiding investing in individual Chinese small-caps is probably a good way to go.

Past that, investors need to tread particularly carefully when it comes to Chinese companies that have come to the U.S. markets through reverse mergers. This is a quick-and-dirty way to get a U.S. listing that usually involves a company with little-or-no business operations merging with a small company in China. Some of the most popular Chinese small-caps have come to the market this way -- including China North East Petroleum Holdings (NYSE: NEP  ) , SmartHeat (Nasdaq: HEAT  ) , and AgFeed Industries (Nasdaq: FEED  ) .

Some of the companies that the Chinese companies merged into had downright laughable histories. China North East Petroleum, for example, merged into Draco Holding Corp., which, prior to the merger, had a primary operating business called Jump'n Jax, described as "[operating] Draco's business of leasing inflatable balloon bounce houses for parties and outdoor activities in Southern Utah."

I'm not making this up.

When a company goes through the traditional IPO process, they are forced to work closely with an underwriting team from an investment bank and draft reams of forms for the SEC. Companies that go the reverse-merger route don't face anywhere near as much scrutiny.

That doesn't mean that investors have to altogether skip Chinese small-caps -- even the reverse-merger ones -- but rather that they have to be extra careful in their research. For those investors brave enough to venture into the world of small-cap Chinese reverse-merger companies, two things worth looking for are secondary offerings and high-caliber auditors. If a company has done a secondary offering, it may have worked with an investment bank. As banks are not keen on selling their institutional clients terrible product, it's likely that they will have done some diligence to make sure the company is on the up-and-up.

Meanwhile, a well-known auditor is more likely than a small, unknown shop to make sure the books are 100% in order. Big auditors do make mistakes, but the scandals in Chinese small caps so far have mostly been over companies with no-name auditors.

The bottom line when it comes to this mine-ridden investment landscape though is to make sure to do your research.

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.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (13) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 18, 2011, at 3:13 PM, king4life wrote:

    Why not pick the last 5 China IPO's opening stock price and list today's PPS? Who is getting scamed now? How's that China car dealership chain with only one dealership?

    Past Reverse Mergers.

    Your right! Blockbuster was a scam!

    Berkshire Hathaway Inc.

    Blockbuster Entertainment

    Muriel Siebert & Co., Inc.

    Occidental Petroleum Corporation

    Tandy Corporation (Radio Shack)

    The New York Stock Exchange

  • Report this Comment On January 18, 2011, at 3:55 PM, Internole wrote:

    "Some of the companies that the Chinese companies merged into had downright laughable histories."

    What is laughable is that the author doesn't have a clue about reverse mergers and is allowed to post this garbage.

  • Report this Comment On January 19, 2011, at 2:03 AM, Internole wrote:

    Hey Matt,

    Here's the truth about reverse mergers -

    Reverse mergers have zip,nada, zero to do with the previous company's business. In fact, the best reverse merger candidates are the 'Jump'n Jax' variety.

    If you are aware of this: you are nothing more than a charlatan, using the fool to create doubt to those who don't know any better. Shame on you if that's the case.

    If you were not aware, then maybe you shouldn't post here or at least apologize for your misguidance.

    I would expect better from a UPenn grad and the fool.


  • Report this Comment On January 19, 2011, at 9:19 AM, JaysRage wrote:

    This really is a poorly written article that doesn't come close to an understanding of Chinese small caps, reverse mergers, the real dangers and what to do about them. Geez, I was critical of Herb Greenberg and his lack of understanding, but you make Herb Greenberg look like Warren Buffet with this article.

    Reverse mergers are INTENDED to target DEFUNCT businesses that are already listed. That's the whole point.

    Reverse mergers are a good option for very small companies to avoid the excessive fees that are necessary for listing to a major exchange.

    Companies that list as part of a reverse merger are required within a year to file a full statement as the new company. This is true as of 2005. So essentially, they are subject to the same disclosures that an IPO is.

    On top of that, the P/E ratios that these companies are selling for are a fraction of their value because almost everyone is "avoiding investing" in them. That is what makes them a good opportunity. Yes, you will have to get your hands dirty, but you'll certainly do better than you will by copping out and buying YUM or KO like you have previously guided.

    *hint* That's not foreign investing, and it doesn't have hte same advantages, so let's stop pretending that just because a company does some business in China that it is a Chinese investment.

  • Report this Comment On January 19, 2011, at 9:45 AM, stills999 wrote:

    Agreed the posters above ... NEP is a huge bargain, BTW, at a PE of 3 and in the oil business in China!

    Sure, they've had some past accounting problems, but they did the work to fix it! The potential of being a 10 bagger is more than worth this accounting risk.

  • Report this Comment On January 19, 2011, at 12:18 PM, IlluminatInvest wrote:

    I agree about NEP, they've got Ernst & Young as their auditor now, not exactly a no-name.

  • Report this Comment On January 19, 2011, at 4:57 PM, TMFKopp wrote:

    Thanks for the comments all.

    I appreciate the fact that many here disagree with the caution I'm urging when it comes to reverse merger companies, but perhaps that's because you're all highly sophisticated investors that are willing and able to really dig into these companies and figure out what's what. That's great for you because I do believe -- as some of you have pointed out -- that there is opportunity that has been created by the pessimism.

    However, RINO and others have shown that there is real reason for concern and real reason for investors who are *not* willing to do a lot of work to take their chances in this area.

    And for those of you that are hot on the Chinese reverse-merger companies, here's one thing to ponder. If these are such great businesses, why are they going the reverse merger route to access U.S. investors? Why not go the traditional IPO route with an underwriter? Why not grow a bit more before rushing to the public markets? And why list on U.S. markets rather than the Chinese?

    No doubt some of the companies will have good answers to those questions, but I am quite sure that there are more than a few in the bunch that saw an opportunity to simply tap U.S. investor enthusiasm about China and Chinese companies.


  • Report this Comment On January 19, 2011, at 5:15 PM, EnigmaDude wrote:

    Great article, Matt. You apparently hit a nerve. I have to wonder if some of those Chinese companies have a sense of ironic humor. NEP does a reverse merger with an inflatable balloon company - I can't help but smile thinking about that analogy!

    I was fooled into investing in LPH until I realized that the numbers they were "reporting" might not be realistic. Yes, there is a potential to make some nice returns on Chinese smallcaps, but they do come with a high degree of risk.

  • Report this Comment On January 19, 2011, at 9:00 PM, JaysRage wrote:

    Reverse mergers are far cheaper than IPOs, which just pads the pockets of the investment banks that do the listing. As mentioned, the filings that are necessary after a reverse merger are on par with an IPO without all the additional cost.

    On top of that, a secondary offering of stock is called dilution. It is not a positive event for most companies, but this is particularly true for small Chinese companies.. These offerings aren't always run through investment banks. The buyers aren't always savvy, and it robs previous shareholders of value. Personally, I look unfavorably on diluters. Management that is willing to rob current shareholders to raise cash draws red flags in my book.

    Being listed on a U.S. exchange is a critical milestone of any company that wants to be part of the global community. It is a vetting mechanism for international partners, increasing the visibility and viability of a company. Why should a quality company have to wait until they are larger?

  • Report this Comment On January 20, 2011, at 6:47 PM, TMFKopp wrote:


    "Why should a quality company have to wait until they are larger?"

    Because there are fees and overhead costs associated with being listed in the U.S. It's not in shareholders' interest to have a small company spending money on unnecessary overhead costs rather than investing it in growth.


  • Report this Comment On January 21, 2011, at 8:29 PM, CaSmiles wrote:

    Muddy Waters has been shown to be a shorting scam, using "DD" like a cloak of righteousness to justify their own short position. They were exposed as a company designed to defraud investors; why you didn't catch this I don't know, since it seems to be all over the net. Look through the boards on some of the Chinese smallcaps such as ONP, CCME, LIWA, and you'll see what I mean.

  • Report this Comment On January 24, 2011, at 11:32 PM, tkell31 wrote:

    Wish I had heeded these warnings last year. I think I managed to invest in every crappy reverse merger there was and it cost me...a lot. Funny thing, many were recommended by analysts, got on wall street buy lists, and were all getting pumped up here as well.

    Fortunately I was able to use options, and some legitimate investments to actually make money for the year.

    I've managed to get out of most of them by selling covered calls, with NEP and APWR being the last two I need to divest myself from. I may keep a thousand shares of NEP...I mean they allegedly have a deal in place with PTR to buy the oil they produce, but anything that seems too good to be true usually is.

    Clearly the SEC has failed as a "vetting" mechanism when it comes to these scams.

  • Report this Comment On January 27, 2011, at 9:43 PM, JaysRage wrote:

    Because there are fees and overhead costs associated with being listed in the U.S. It's not in shareholders' interest to have a small company spending money on unnecessary overhead costs rather than investing it in growth.

    No kidding it's expensive.....even more so if they follow the plan that you think they should take. That's why reverse mergers are a good option. Because the excessive investment bank fees aren't part of the picture.

    Telling them to wait and focus on their busines growth is like telling a company that it shouldn't invest in a website because it costs money that it should be using to build it's product. Getting listed IN THE U.S. is a mechanism for growth in itself, because it gives that company exposure to more partnership options than those companies who are "off-the-grid".

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