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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.