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Terrible News for Chinese Small-Cap Investors

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By now, most investors focused on the world of Chinese small caps have likely heard that China Security & Surveillance (NYSE: CSR  ) has officially accepted the buyout offer from its chairman and CEO Guoshen Tu.

The company has agreed to let Tu take it private -- a transaction that the company said was in the works back in March. Tu will be rolling his 20.9% ownership stake and using financing from China Development Bank to pay current investors $6.50 in cash for their shares.

Put simply, this is terrible news for investors who are bullish on Chinese small caps.

It seems like good news, right? With short sellers absolutely mashing on Chinese small cap stocks, making the sector look like a demented stock-market version of Whack-A-Mole, this seems like a clear victory for the bulls. Don't be small-f fooled.

CS&S's takeout price of $6.50 represents a mere 30% premium on the 90-day volume-weighted average price prior to the initial announcement that the company had received a going-private proposal. The price also is a paltry 6.8 times the company's 2010 earnings per share, and just 5.8 times expected 2011 EPS. If this weren't a battered sector, a valuation like that would be considered out-and-out robbery.

Bigger problem
This dilemma doesn't stop with China Security & Surveillance. Investors brave enough (or crazy enough?) to venture into this sector face the potential of massive losses.

Late last year, RINO International (OTC: RINO.PK) traded near $20. Today, it fetches $1.75 from its ignominious home on the pink sheets. If that's any sign of what will happen to China MediaExpress (Nasdaq: CCME  ) and China Agritech (Nasdaq: CAGC  ) -- both of which have been halted since mid-March -- then those investors can look forward to a further battering. Heck, Yongye International (Nasdaq: YONG  ) which has no smoking gun to speak of, has lost around a third of its value since the beginning of the year.

For investors to have a reasonable case for putting their money at risk here -- even if they're taking a basket approach, as I've suggested -- they need the potential for pretty serious upside to offset the very real risk of crippling downside. If the China Security & Surveillance buyout goes through and becomes a model for the non-fraudulent companies in the sector -- that is, that management or an outside party can step in and buy the entire company for a song -- then a thin investment case for the sector may just disappear completely.

Any investor currently invested in Chinese small caps or considering an investment would be well advised to keep a close eye on what happens with this buyout. You can do that by adding China Security & Surveillance to your watchlist.

Yongye International is a Motley Fool Global Gains recommendation. The Fool owns 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.

Fool contributor Matt Koppenheffer does not have a financial interest in 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 (4) | Recommend This Article (12)

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 April 25, 2011, at 1:16 PM, vonwao wrote:

    The sky is falling! There's no hope... all hope is lost!

    Seems like bearish sentimentfor China small caps is at peaking . That means we must be close to a market bottom.

  • Report this Comment On April 25, 2011, at 4:52 PM, CMFStan8331 wrote:

    It may take a few more of these buyouts for investors to get the idea that all Chinese small-caps aren't playing with Monopoly money, but I suspect they will eventually get clued-in. It is a scary time to own these stocks, but if one sticks to a a diversified basket of companies who have strong balance sheets, significant competitive advantages, respectable accountants and where there have been no credible specific allegations of wrongdoing, you'll be insulated from an occasional meltdown and the occasional private buyout, while gaining the potential for tremendous upside.

  • Report this Comment On April 26, 2011, at 8:01 AM, john795806 wrote:

    A "mere" 30% premium? Hey, if you are a new investor not already holding a stock in that beaten-down sector, it sounds re-assuring to think that you might get that sort of upside, even if you have to wait some months to realize it. And if you don't, seems like the sector is shaking out nicely.

  • Report this Comment On June 01, 2011, at 3:45 AM, GraceAlone wrote:

    I own CSR and would be delighted to sell it for $6.50/share. How do I it?

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