When it comes to Chinese small caps, I have to hand it to many of the short sellers -- they've done some really fine work.
Sure, that doesn't extend to every single Internet writer who's ever said anything critical of a Chinese small cap. But I think that if the bulls are honest with themselves, even they have to give a tip o' the hat to some of the work shorts have done. These intrepid bears have tracked down Chinese regulatory filings to compare them to U.S. filings, performed channel and customer checks, and done long-term surveillance on factories to assess activity levels.
And in a scary number of cases, the in-depth diligence that they've done has uncovered some ugly truths about many Chinese companies trading on U.S. exchanges. But for many U.S.-based individual investors, I think there's a simpler, more glaring factor that should scare them off many of these companies, without the need for a plane ticket to Asia or Mandarin lessons.
I'm referring to the way most of these companies hit the public markets in the first place: through reverse mergers.
For the love of an IPO
When a company does an IPO, investment bankers and a team of corporate lawyers meet with management, examine the company's numbers, visit offices and manufacturing facilities, and often spend weeks going back and forth with the Securities and Exchange Commission to get the filing paperwork for the offering just right.
Why do the bankers do all of this? Because at the end of it all, the salespeople at the investment bank will call up their money management clients -- mutual funds, hedge funds, etc. -- and say, "We've got this IPO that I think you should buy shares of." Logically, if a bank consistently sells what turn out to be junk shares to their clients, eventually those clients will respond with a "thanks but no thanks," or just opt to let the banks' calls go to voice mail.
A reverse merger, or RTO, sidesteps all of the IPO hoopla. Instead, an operating company lets itself be "bought" by a public shell company -- that is, a publicly listed company with no real operations -- and voila! A previously private company now has a public listing with no fuss and no muss.
Unfortunately for investors, the latter scenario involves far less diligence and oversight. As a result, RTO transactions are a favorite for fraudsters.
Start with suspicion
Certainly, there are plenty of counterexamples available. Consider the recent blow-up at Longtop Financial
And if we think of some of what the banks sold during the days of the dot-com and housing bubbles, it's clear that it's not unheard of for big investment banks to sell junk to their clients.
If I can draw a comparison to horse racing, though, I'd say that not every horse that runs in a high-level race is a fantastic horse -- and some may turn out to be utter duds. However, when a horse is running a $3,200 claiming race -- which means that someone can swoop in and buy the horse for the low dollar amount -- on a Tuesday at Fairmount Park, you have to start with the assumption that there's probably something wrong with the nag.
In some cases, companies simply have no choice but to hit the markets via RTO. Take American Apparel
In American Apparel's case, the company had gotten itself in over its head stocking up on inventory and building out its retail stores. It had taken on a lot of debt, and it needed cash badly. The company's financials were ugly, and I have a feeling that many institutional money managers would have balked at the deal after sitting down with CEO Dov Charney (which is a typical part of the IPO process).
In short, American Apparel needed capital and had relatively limited options for getting it.
But in many cases, it's unclear to me why some of these Chinese companies found it necessary to go the RTO route, or even hit the public markets at all. Take China Automotive Systems
So why go the RTO route? Why not jump on U.S. investors' euphoria over China's growth and do a full IPO? Or better still, why not remain a growing, profitable private company until, down the road, you can do a larger and potentially more lucrative IPO?
Cases like China-Biotics
Lighting-rod stock Yongye International
No smoking gun
If you take a look around, I guarantee that you will find precious few successful, high-quality publicly listed companies -- Chinese or otherwise -- that have come to the markets via a reverse merger. Finding this out when digging into a company should put your BS-detector on high alert through the rest of your research.
This doesn't prove anything about these companies. But I'll put it this way: Last night I pulled a package of asparagus out of my fridge that had been there for a week, and it smelled funny. Perhaps after rinsing and cooking, it would have been fine, but I wasn't risking it. The asparagus found its way to the trash, and I ate some just-purchased spinach instead.
In other words, when something doesn't smell right, sometimes you're best off avoiding it and just moving on.
The Motley Fool owns shares of Yongye International. Motley Fool newsletter services have recommended buying 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 Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.