Terrible News for Chinese Small-Cap Investors

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.

Surprised?
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.