Barron's Attack on Chinese Reverse Mergers

Barron's launched a strong attack on Chinese reverse mergers in a feature article this weekend. While the article is extremely biased as it suggests that all reverse mergers are bad investments, and questionable or even fraudulent activities of selected few companies can be safely transfered to the whole group of 200+ Chinese stocks that went public via reverse merger, the underlying sentiment that such stocks bear a higher degree of risk should not be taken lightly and the market will probably react accordingly.

This makes it now even more important for retail investors to proceed with their own due diligence and apply strict quality rules to possible investments. I have made a few suggestions for what to look at in a previous article (Checklist for Quality). If you find a stock with seemingly wonderful fundamentals and a ridiculously low P/E ratio then you might want to dig deeper to find possible reasons for the depressed share price. There are undoubtedly many Chinese stocks out there which got unfairly punished with the whole group and which do really trade at ridiculously low levels here. You want to find those with a level of assurance about reported numbers and credibility of management that makes you comfortable holding your positions through these volatile times. Simply put, if you have reason to question the credibility of a company - your own reason, not something you might just have snapped up from short sellers' inflammatory accusations - then don't get involved. Look for something else then.

Let's have a brief look at those stocks mentioned in the Barron's article this weekend:

China Green Agriculture (CGA) is currently trading at $10.65, down 27.56% for the year and down 36.42% from its March 9 high at $16.75. The Trading China Tracker Score is 3 (Hold).

Fertilizer company China Green has been mentioned for its relationship with questionable promoter Du Qingsong and his involvement in the 2007 reverse merger. Also for having retained Kabani & Co. as the company's auditor, a firm that Barron's singled out as an example of those "that certified the financials of companies that came to grief." While there are no current accusations against CGA in the article and most of the story focuses on 2007/08 events, Barron's mentioned CGA several times throughout the piece and it is very unlikely that the stock will be doing well when trading starts again on Monday.

Unrelated to the article, the stock wasn't doing too well on the Trading China Scorecard. It is relatively expensive compared to its peers and we have already marked the auditor as a negative. Out of four analysts following the stock, three give it a neutral rating. CGA might find itself re-testing the 2010 lows at $8.15 as early as next week.

China Integrated Energy (CBEH) is currently trading at $8.33, up 18.32% for the year and down 32.34% from its April 15 high at $12.31. The Trading China Tracker Score is 7 (Hold).

Bio-diesel maker CBEH is mentioned in the same context as CGA, with Du Qingsong being indirectly involved in the 2007 reverse merger. However, the company has matured since going public, doesn't seem to have any involvement with Du as of today, and the stock has relatively strong analyst backing. All four firms that cover the stock give it a positive rating with an average price target at $11.83. CBEH is not exceptionally cheap here and with Sherb & Co. it doesn't have an auditor which meets the Trading China quality standard for a $360 million company. I would not be too worried here, but there are better deals out there in the China space so no need to aggressively pursue the stock on weakness.

China Natural Gas (CHNG) is currently trading at $5.27, down 52.61% for the year and down 52.66% from its March 10 high at $11.13. The Trading China Tracker Score is 6 (Hold).

Barron's mentioned CHNG for the serious accounting irregularities that surfaced last week and prompted Roth Capital to downgrade the stock to SELL and Rodman & Renshaw to put their rating under review.

"We believe CHNG's Q2 filings indicate worsening corporate governance and internal controls over financial reporting. In its 2Q10 Form 10-Q, the company disclosed additional actions that indicate continued governance and control weaknesses. It entered into a bank loan agreement in the amount of $17.7 million in February 2010 without reporting the bank loans in its consolidated balance sheet as of March31, 2010. In addition, the company acquired four natural gas fueling stations without BoD pre-approval on the final acquisition." (Roth Capital)

The company's auditor is Frazer Frost whose Asian-services partner commented according to Barron's that "every company has some deficiencies in internal controls." While that might be true, even understandable for a newly public company, I believe that risk-sensitive investors should think twice before taking on such an additional risk. I wouldn't touch this stock until all issues are resolved to everyone's satisfaction.

Deer Consumer Products (DEER) is currently trading at $7.79, down 31.13% for the year and down 39.80% from its March 2 high at $12.94. The Trading China Tracker Score is 2 (Hold).

Home appliance maker DEER has been mentioned for its involvement with Benjamin Wey, who Barron's calls "one of the most controversial promoters of Chinese reverse takeovers." The article states that "Wey's Website shows him flying with Deer's management in a private jet on the night before the pricing of a $75 million secondary offering." Again, there are no direct accusations against the company, and just a connection with a very influential Wall Street promoter doesn't make this a bad investment. However, with a forward P/E of 11 the stock is not cheap here, and buying it would be a bet on strong 3rd and 4th quarter results. The company said in their latest press release that it expects "record earnings in the second half" of 2010.

Agfeed Industries (FEED) is currently trading at $2.35, down 53.00% for the year and down 56.73% from its March 9 high at $5.43. The Trading China Tracker Score is -5 (Sell).

Pork producer Agfeed is also mentioned for their business connection with Benjamin Wey. Barron's said that "since our piece describing Wey's work for the hog farmer AgFeed Industries (FEED), the company has missed production targets and its shares have slumped from 15 to below 2.50." What the article fails to mention is that the missed production targets are hardly the fault of Wey or the result of any wrongdoings, but merely the result of a series of natural disasters in China.

"During the second quarter the Company faced an extremely difficult operating environment as a result of a series of severe floods throughout its area of operations. The floods led to significant operating disruptions on the Company's farms and on the transportation infrastructure supporting the operations. The movement of feed and live animals was severely disrupted. These factors led to the loss of over 16,000 live animals." (Source: PR Newswire, 2010-08-10)

All of this led to disastrous quarterly results and severely reduced short term prospects as FEED will have to repair the damaged infrastructure and it will take some time to get the business back to normal. That's why I do not expect the stock to recover soon and the Trading China score is reflecting my investment position very well.

Gulf Resources (GFRE) is currently trading at $8.60, down 26.25% for the year and down 34.38% from its March 8 high at $13.10. The Trading China Tracker Score is 12 (Strong Buy).

GFRE is mentioned in connection with Kit Tsui, who helped with the reverse merger. And Barron's claims that "trouble seems to haunt Tsui's deals." That is certainly true in regards to Orient Paper (ONP), but implying that any type of reverse merger would be automatically a bad deal is very irresponsible journalism. Short sellers will probably find out that next to Tsui, Orient Paper and Gulf Resources also have their auditor, BDO Limited (HK), in common. But that also doesn't make jumping to conclusions right. Cautious investors might want to stay away from GFRE just for the Barron's fallout. However, if you believe the strong numbers GFRE reported for the second quarter, if you believe in the excellent business outlook provided by the company and supported by analysts from Brean Murray, then you might want to buy this stock aggressively on any Barron's induced weakness.

Orient Paper (ONP) is currently trading at $4.34, down 58.59% for the year and down 63.07% from its April 26 high at $11.75. The Trading China Tracker Score is 16 (Strong Buy).

The Orient Paper saga is probably the most talked about event in the U.S.-listed China sector this summer, I don't have to summarize it here again. The Barron's article repeated the attacks on ONP started by Muddy Waters as an example for possible fraud that can be found within the group of Chinese reverse mergers. I still can not judge who is right or wrong here, but it is noticeable that Barron's chose to omit Orient Paper's side in the dispute and printed Muddy Waters accusations uncommented. There seems to be some bias here.

ONP is a prime example of why the Trading China Tracker Score should not be seen as a Buy or Sell recommendation. The ratings (Buy, Hold, Sell) that are posted next to the Score are automatically generated and should be interpreted according to the metrics that are used for calculating the Score only! And those metrics are basically financial data as reported with the SEC. If the data is questionable or subject to restatements then the Score can not reflect that. Additionally future developments can not be accurately reflected by the Score. In ONP's case, even if the company would be able to clear itself from all fraud accusations with an independent investigation, the cost of these initiatives will be significant - approximately a full quarter of earnings - and the future projections should be adjusted accordingly.

RINO International (RINO) is currently trading at $16.03, down 42.03% for the year and down 51.31% from its January 11 high at $32.92. The Trading China Tracker Score is 2 (Hold).

Rino's connection to the Barron's article is limited to the company being a Frazer Frost client and a statement that Rino "has had three auditors and four CFOs in the past four years, while restating its financials twice." Rino still admitted to material weaknesses in internal control over financial reporting in its latest 10-Q, but it has taken several steps to address these issues, including hiring a new Internal Audit Manager last month. Looks to me that Rino is on the right track and all three analysts covering the stock rate it a buy with an average price target more than 100% above current levels. The fact that Rino changed auditors and CFO's several times in the past few years may as well point to the company trying to strengthen their financial reporting, while restatements show that mistakes have been found and corrected.

SkyPeople Fruit Juice (SPU) is currently trading at $4.90, up 18.93% for the year and down 39.51% from its March 5 high at $8.10. The Trading China Tracker Score is 15 (Strong Buy).

SPU has been mentioned in connection with Andrew B. Worden when Barron's aggressively stated that "investors would be well advised to steer clear of stocks like those in the PIPE deals involving Andrew B. Worden's Barron Capital." What should worry investors more than this is last week's secondary offering that was priced at just $5 per share, a huge discount to market and a very shareholder unfriendly price at a time when most responsible companies have postponed their public offerings due to unfavorable market conditions. Management actions like this speak louder than P/E ratios or net income guidance as it doesn't seem that creating shareholder value is very high up on management's agenda.