The Myth of Underperforming Reverse Mergers
posted by The Traveller on Sunday, September 12, 2010

Two weeks ago, Barron's magazine printed a feature article titled "Beware This Chinese Export", written by Bill Alpert and Leslie P. Norton. It was labeled as a "study" and subtitled (as you can see in your browser's title bar) "Chinese Reverse-Merger Stocks Lag Key Indexes." The tone of the article was very negative about anything related to U.S.-listed Chinese stocks that went public via reverse mergers. It basically warned investors not to touch any of those when the article closed with this caveat: "the reverse-merger industry gathers in Hawaii this week at a Roth conference—a venue equally favored by China stock touts and by the sector's short sellers. The rest of us should probably stay home."

Barron's explicitly mentioned nine Chinese stocks in their article and I have added a tenth name here (China Agritech CAGC, which has been downgraded last week on concerns over an auditor the company has dropped 2 1/2 years ago), just to get to an even number. As you can see this group of Chinese reverse merger stocks has clearly underperformed the key indexes since the Barron's article was published. In the last two weeks both the Shanghai Composite Index (SSE, +2.0%) and the S&P 500 (SPX, +4.2%) posted gains, while this group retreated on average by a significant 8.56%. It can't be denied that Barron's had some influence in this.

2010-08-27: $16.72$8.33$10.65$5.27$7.79$2.35$8.60$4.34$16.03$4.90
2010-09-10: $12.18$6.71$8.55$6.08$8.12$2.18$7.70$4.42$13.65$4.50
Performance: -27.15%-19.45%-19.72%15.37%4.24%-7.23%-10.46%1.84%-14.85%-8.16%

Now back to the key argument of Alpert and Norton, that Chinese reverse merger stocks lag "key indexes.". I will use the Shanghai Composite as the most watched index in mainland China, and the S&P 500 Index for the U.S. as "key indexes" for this article. But let's also add the Halter USX China Index (HXC), as Barron's refers to this index as their "key index."

A quick look at the Halter FAQ shows that "for a company to be included in The Halter USX China Index, it must be listed on the NYSE or Nasdaq and have an average market capitalization of at least $50 million for the preceding 40 trading days," and if we look at the list of current components, we find out that China Agritech (CAGC), China Integrated Energy (CBEH), China Green Agriculture (CGA), China Natural Gas (CHNG), Deer Consumer Products (DEER), AgFeed Industries (FEED), Gulf Resources (GFRE), Orient Paper (ONP), RINO International (RINO) and also SkyPeople Fruit Juice (SPU) are in fact current components of this index.

Those 10 stocks haven't always been eligible for the Halter Index, though. They usually started out on the OTC/BB a short while after their reverse merger deal, stayed there for a for a few months or even years, did a reverse split and uplisted to Nasdaq or a NYSE exchange shortly after. All 10 names have matured from their rather obscure post-RM stage on the bulletin board. They have successfully listed their stock on a senior U.S. exchange now, which is the final goal of basically all reverse merger deals.

Now Barron's claims that reverse-merger stocks have drastically underperformed the key indexes: "Most reverse-merger stocks have proven to be a poor way to ride China's boom. Today, the market cap of these stocks has shrunk to $20 billion, a 60% drop." The authors have also determined that "the median return among the 30 CCG reverse-merger clients with at least three years of trading history underperformed the Halter index by a whopping 70%, since their mergers."

So... Alpert and Norton use stocks with "at least three years of trading history" and measure their performance "since their mergers." I believe using both those terms is deliberately misleading, it doesn't prove anything and doesn't show the actual performance of those stocks.

First of all, there aren't that many reverse-merger stocks with a trading history of three years or more. If we go back those three years we get to the peak of the stock market bubble in mainland China. The Shanghai Composite climbed 124% from January to October 2007, reached 6124 points on October 16, and dropped 56.5% to reach the current level of 2663 points. Yes, the average return of a domestically listed Chinese blue chip is a negative 50% for this 3-years period.

However, it is not just pure coincidence that the number of reverse mergers exploded at the peak of China's stock market bubble. Five of the ten stocks in our group exercised their reverse merger between October 2007 and February 2008:

Reverse Merger: 2005-02-032007-10-232007-12-262005-12-062008-09-032006-10-312006-12-122007-10-292007-10-052008-02-26
First Quoted Price: 2005-06-14
2010-08-27: $16.72$8.33$10.65$5.27$7.79$2.35$8.60$4.34$16.03$4.90
Performance: 174.10%81.09%-59.83%-78.92%275.42%-53.58%-14.00%130.00%94.30%96.00%

Now what we can't do is evaluate the overall performance of a stock using the date of the reverse merger or the first quoted price as the starting point. The first quote price is meaningless if there is no active trade in the stock. It can take many months until a reverse-merger stock is actively traded, until then there is virtually no one outside of the deal participants or shell share owners involved. The quoted price on the OTC/BB does in no way reflect what the market is willing to pay for the stock, it very often is nothing else than a painted quote on a single trade of 100 shares with many days of no volume at all in between.

A good example is North China Horticulture (IDCX) which completed their reverse merger on July 16 this year. The first quoted price since the merger was $4.50 and the stock is quoted between $5.00 and $7.00 since. However, there have been only four days with actual volume since July 16, and none of those days saw more than 1000 shares changing owners.

The current quote of $5.00 for IDCX is completely meaningless as it would imply a P/E-ratio of 43 based on the last two reported quarters. We don't know when the stock will actively start trading, but I would expect the price per share to settle at a level of around $0.50 - or about one tenth of the current quote - which would imply a reasonable P/E-ratio of 4-5.

If Alpert and Norton use the term "since their mergers" for measuring performance, it is misleading investors, and they know it. A responsible approach to evaluate total performance would be to use the opening price of the first day when a reverse-merger stock traded more than 10,000 shares - or even better, the average price of the first five sessions a stock was actively traded.

First 10k Day: 2006-01-27
2010-08-27: $16.72$8.33$10.65$5.27$7.79$2.35$8.60$4.34$16.03$4.90
Performance: 109.00%37.69%184.00%-24.71%266.59%17.50%-8.51%210.00%541.20%82.16%
Avg. First Week: $8.00$6.14$3.07$7.18$2.211$2.046$9.24$1.312$2.62$2.69
2010-08-27: $16.72$8.33$10.65$5.27$7.79$2.35$8.60$4.34$16.03$4.90
Performance: 109.00%35.67%246.90%-26.60%252.33%14.86%-6.93%230.79%511.83%82.16%

Investors who purchased our group of 10 stocks during the first week of active trading, would have been sitting on an average return of 145.00% on August 27 this year, the day before the Barron's article was published.

2008-09-10: $3.16$6.90$3.29$8.32n/a$10.22$2.12$0.60n/an/a
2010-09-10: $12.18$6.71$8.55$6.08$8.12$2.18$7.70$4.42$13.65$4.50
Performance: 285.44%-2.75%159.88%-26.92%n/a-78.67%263.21%636.67%n/an/a

Investors who purchased our group of 10 stocks two years ago - at the close of September 10, 2008 - would have a gain of 176.69% today. That compares to a 23.83% gain for the Shanghai Composite (SSE), a 9.94% loss for the S&P 500 (SPX) and a 13.68% gain for the Halter Index (HXC).

2009-03-10: $1.90$4.00$3.30$3.32n/a$1.05$1.46$0.38$2.01n/a
2010-09-10: $12.18$6.71$8.55$6.08$8.12$2.18$7.70$4.42$13.65$4.50
Performance: 541.05%67.75%159.09%83.13%n/a107.62%427.40%1063.16%579.10%n/a

Investors who purchased our group of 10 stocks 18 months ago - at the close of March 10, 2009 - would have a gain of 378.54% today. That compares to a 23.38% gain for the Shanghai Composite (SSE), a 54.19% gain for the S&P 500 (SPX) and a 84.21% gain for the Halter Index (HXC).

2009-09-10: $6.44$6.12$13.05$12.49$6.283$5.27$6.50$3.44$13.59n/a
2010-09-10: $12.18$6.71$8.55$6.08$8.12$2.18$7.70$4.42$13.65$4.50
Performance: 89.13%9.64%-34.48%-51.32%29.38%-58.63%18.46%28.49%0.44%n/a

Investors who purchased our group of 10 stocks one year ago - at the close of September 10, 2009 - would have a gain of 3.46% today. That compares to a 8.95% loss for the Shanghai Composite (SSE), a 6.26% gain for the S&P 500 (SPX) and a 4.28% gain for the Halter Index (HXC).

As we can see, our group of 10 reverse-merger stocks has not underperformed the "key indexes" in any of the scenarios, quite the opposite actually. However, many of the Chinese RTO stocks have retreated this year, probably in large parts as a result of negative articles like Alpert and Norton's piece and generally due to concerns over corporate governance, internal controls, earnings quality and management credibility.

This development suggests that many long-term investors who started a position in those reverse-merger stocks have realized profits in the last 12 months and didn't hold on to their shares no matter what, watching their portfolio drop in value every day. Most responsible long-term investors will have protected their holdings with stop-loss marks or will have reacted on market developments. Just for fun, let's have a look at what those investors could have earned if they had sold at the 52-week high.

2008-09-10: $3.16$6.90$3.29$8.32n/a$10.22$2.12$0.60n/an/a
52-week high: $30.75$12.31$18.70$15.62$18.97$6.05$14.94$15.15$35.15$8.10
Performance: 873.10%78.40%468.39%87.74%n/a-40.80%604.72%2425.00%n/an/a

Now what is the bottom line of all this? You should not generalize all Chinese reverse-mergers and throw them all into the same pit. Alpert and Norton followed-up on their article in this weekend's Barron's edition with another misleading claim: "[we measured] the investment performance of every identifiable reverse merger company, then showing how investors would have done if they had picked the typical (i.e., median) performer in the group."

Here is your answer to that: many, if not most reverse mergers fail! Those stocks never make it past their post-merger stage, they never come even close to maturing, to becoming eligible for a senior exchange. And most importantly they never came even close (and probably never will) to catch the attention of a value-oriented investor in Chinese stocks. Those stocks are trading on very low volume on the OTC/BB or Pink Sheets, they are often delinquent in their filings, the price per share is below $1 or even below 1 cent and nothing and absolutely nothing makes them part of the group of serious, profitable Chinese businesses that became public companies via reverse mergers.

No serious investor puts their money in any of the many questionable China-based penny stocks on the OTC/BB or pinks, and most of them went public via reverse mergers. Just like you wouldn't choose any of the OTC-quoted U.S. penny stocks if you seriously intended to invest in technology or mining and metals. That's why the Halter Index has eligibility rules, and that's why investors and research firms do their due diligence, visit the company, talk to customers and competitors and so on...

Look for maturing reverse mergers! They have to be actively traded, should be consistently profitable, and should have a clear path ahead, off the OTC/BB or Pink Sheets onto a senior U.S. exchange. You have to do your own due diligence, there is no way to avoid that for a serious investor in Chinese stocks. If you buy into a newly listed reverse merger stock, you take on many additional risks, including a large number of shares that might flood the market from early investors (hedge funds) who got in at a very low price, or from those parties that managed the reverse merger deal and got a good share of the company in return. Again, as an investor, watch for those RTO stocks that are maturing and have a clear path to Nasdaq or a NYSE exchange.

Alpert and Norton wrote this weekend that "unless one cherry-picks examples, the expected performance of these stocks is lousy." I have cherry-picked those very stocks Alpert and Norton explicitly mentioned as negative examples in their original article, and those have outperformed the key indexes including the Halter Index in every single reasonable scenario. I have picked those ten stocks despite the fact that they are now far off their highs, having dropped in no small part due to Barron's and other publications presuming that "China plus Reverse Merger automatically leads to losses." As any reader or prospective investor can now see, this presumption by the critics is simply not valid.

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At September 12, 2010 9:47 pm , Anonymous Anonymous said...

Please publish this on SeekingAlpha!!!!!

At September 13, 2010 1:27 am , Anonymous Timothy Conway said...

A really excellent article, Rames, filled with cogent points. I second the motion to have you publish this at Seeking Alpha.

At September 13, 2010 1:27 am , Blogger jimidean said...

very good analysis, thank you

At September 13, 2010 2:14 am , Anonymous Anonymous said...

Excellent analysis and a very impressive piece of work. I just wish Barron's were willing to publish your rebuttal !

At September 13, 2010 8:26 am , Anonymous Anonymous said...


At September 13, 2010 11:46 am , Anonymous Anonymous said...

This article has to be circulated and make sure Barrons gets a copy. Seeking Alpha would be a great place too.

At September 13, 2010 4:01 pm , Anonymous Anonymous said...

We should say a big THANK YOU to Barron's for creating a great buying opportunity. These stocks are traded now with a nice low P/E.

At November 19, 2010 5:09 am , Anonymous Anonymous said...

Looks like the earlier comments were all done by the same person - I wonder what motive one would have to do this on RINO - a true POS.


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