China Small Caps: Whom Can You Trust?

What if I told you that you could buy stock in a fast-growing company in one of the world's top growth markets at a price-to-earnings ratio of less than eight? In fact, what if I told you that you could buy loads of stocks that match this description? Sounds too good to be true, right?

It just may be.

Small-cap Chinese stocks, particularly those that have hit the U.S. markets by way of reverse-merger transactions (where an operating business in China buys a public shell company in the U.S.) have faced a storm of Katrina proportions as short-sellers have pummeled them with accusations of fraud. A great many Chinese small caps now trade at multiples that would normally make a value investor drool, but investors in the sector are so starry-eyed from the beating they've taken that they don't even know which way is up.

Liar, liar, pants on fire
A rundown of all of the Chinese companies that have come under fire could fill an entire article. Heck, if we got into the details we could probably fill a book. But to give a taste of what's been racking this sector, here are a few of the better-known instances.

Source: Securities and Exchange Commission filings, Yahoo! Finance, Seekingalpha.com, Citronresearch.com, Muddywatersresearch.com, Variantviewresearch.com, Brontecapital.blogspot.com.

I could go on (and on and on) with more examples, but you get the idea.

It's important to note, however, that these situations are far from cookie-cutter. In the cases of RINO and China MediaExpress, for instance, the evidence available and the tepid response from the management teams make it seem likely that the only news out of the companies is likely to be bad news. With Yongye and Advanced Battery, on the other hand, there has been a much stronger response from the respective management teams and the detractors' evidence hasn't been as damning.

Whom do you trust?
I've had my own concerns with small-cap Chinese companies. To begin with, any company -- Chinese or not -- that comes to the market via a reverse-merger transaction should raise at least a yellow flag for investors. Furthermore, the cash flow dynamics of RINO, Yongye, and China Security & Surveillance (NYSE: CSR) put them all on my short radar last summer.

Earlier this year, I was still skeptical, but I thought that investors who were adamant about tiptoeing through the minefield could protect themselves by looking for certain things -- including a major auditor.

Today, I'm far less convinced about that latter point. China MediaExpress had been audited by Deloitte Touche Tohmatsu while China Agritech (Nasdaq: CAGC) -- which has faced troublesome questions of its own -- dismissed Ernst & Young Hua Ming as its auditor. Over the past weekend, I discussed the issue with a contact that works at a major global investment firm, and he said that they have lost faith in all auditors in China -- big name or not -- and now always send their own people over to audit any company they plan to invest in.

Fight or flight?
Despite my broad skepticism, it also seems to me that it's getting a little too easy for anyone to sell shares of a Chinese stock short, slap together a research-company name with a veneer of professionalism (or not), and send the shorted stock reeling by raising questions about its business.

Are all Chinese small caps fraudulent? Considering that Donald Trump may be a presidential candidate, I guess anything is possible, but I doubt it. So the million-dollar question is how can we figure out which companies aren't going to end up dropping napalm on our portfolios.

And the answer is really pretty simple: Get an accounting degree (if you don't already have one), fly to China, and convince the company to turn over their books to you so that you can review all of the numbers yourself. Visit the company's major operating centers and make sure that everything is as it should be. Finally, load up on a bunch of cool spy technology and revisit the major operating centers when they don't know you're coming and make sure everything is still as it should be.

Laughing? You should be. For most individual investors, the above plan is ridiculous because the cost of the diligence would be nowhere near justified by the likely amount of your investment.

I think there are two potential approaches that could make more sense for individual investors considering Chinese small caps.

1. Don't bother. There are thousands of stocks out there and plenty where there's little, if any, concern that the company is massively fraudulent. I've noted on a number of occasions that large-cap stocks look attractive, and we don't have to wonder whether a company like Intel is actually selling the products it says it is.

2. Create a basket. Going back to my assumption above that not every Chinese small cap is a fraud, an investor could put together a group of low-valued Chinese stocks and put a small investment in each. The advantage of this is that you face less risk from any specific company turning out to be smoke and mirrors, while you can still potentially benefit as the space shakes out and investors revalue the real companies at more reasonable multiples.

If you're considering option two, you'd be well advised to read all that you can on the space so you can fill your basket with the companies that appear least likely to be fraudulent. To do this, just start adding the stocks you're interested in to your watchlist and we'll make sure you get the news and reports you need to keep up to speed. You can add any of the stocks above by clicking the plus sign or you can start a fresh watchlist and add any tickers you want.