Safety/Risk Model - Quality of Auditor

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

Quality of Auditor (65/100)

All CPA firms have to be registered with the U.S. Public Company Accounting Oversight Board (PCAOB) if they want to audit U.S. public companies, including U.S.-listed Chinese companies:

"Public companies, whether located in the United States or abroad, access U.S. capital markets by complying with certain U.S. legal requirements, including the requirement to periodically file audited financial statements with the U.S. Securities and Exchange Commission. Under the Sarbanes-Oxley Act of 2002, the auditor of those financial statements - whether a U.S. auditor or a non-U.S. auditor - must be registered with the PCAOB, and the PCAOB must regularly inspect the firm to assess its compliance with U.S. law and professional standards in connection with those audits." (PCAOB)

As of January 25, 2011, a total of 111 China-based CPA firms is registered with the PCAOB, 54 from mainland China and 57 from Hong Kong. This number is not likely to increase in the near future as on October 7, 2010, the PCAOB released a new directive, stating that new registration applications from jurisdictions that do not allow PCAOB inspections will no longer be approved:

In light of the length of time that has elapsed without successful resolution of the obstacles, and the continuing inability of the Board to inspect PCAOB-registered firms in some jurisdictions, the Board has re-evaluated its approach to new registration applications from firms in those jurisdictions. The Board has determined that its consideration of new applications from firms in those jurisdictions will no longer be premised on an expectation that those obstacles will be resolved without undue delay to any necessary PCAOB inspection of a firm. (PCAOB)

China has prohibited the PCAOB from inspecting its CPA firms, including the Hong Kong firms if the inspection would include mainland Chinese clients. This includes all Chinese accounting firms, including the Chinese or Hong Kong member firms of the Big 4. But China is not alone with this policy, as most European countries block the PCAOB on similar grounds (national sovereignty, legal matters). Let's have a look at Europe's largest economy, Germany, and the reasoning of the German Institute of Public Auditors (Institut der Wirtschaftsprüfer in Deutschland e.V.) for blocking PCOAB inspections.

...the German legal system differs so significantly from that of the U.S., that implementation in Germany of certain provisions of the Sarbanes-Oxley Act, in particular, numerous aspects of the proposed rules relating to inspection, investigation and adjudications would be legally impossible and implementation of others would place extremely onerous burdens on German public accounting firms.

In Germany the auditing profession is subject to professional confidentiality obligations set forth in the legislation governing the profession and audits of financial statements. This legislations prevents our members from providing the PCAOB, as a third party, access to any or all facts and circumstances with which they are entrusted or of which they become aware during the course of their professional work. The German Penal Code makes undue disclosure by an accountant a criminal offence (§203 Strafgesetzbuch). Furthermore, the contract between a public accountant and the client carries an implied duty of confidentiality. (Source: IDW Letter to PCAOB, August 18, 2003)

As we can see, the U.S. legal environment differs greatly from that in Germany, and certainly even more from the Chinese system. But we can safely assume that oversight, regulation and professional standards for European CPA firms - PCAOB inspected or not - follow more closely the outline of U.S. standards (supporting the objectives of the Sarbanes-Oxley Act), than what we find now in China. Chinese regulators have shown no interest in reports that are not used in China and that have been prepared under US GAAP (Paul Gillis, November 14, 2010). Without independent inspections and with very loose regulations by local authorities, the right choice of auditors is of crucial importance for U.S.-listed Chinese stocks when it comes to credibility and investor confidence. The engagement of an internationally operating CPA firm, with an excellent reputation and a strong presence in China, is a necessity for every foreign-listed Chinese company that has reached a certain level of maturity.

In our safety/risk model, the choice and history of auditors has the highest weight. It is our belief that any U.S.-listed Chinese company with a market capitalization higher than $100 million should be in the process of upgrading their auditor to at least a Top10-ranked firm. With a market capitalization above $200 million, a top ten firm should be used, preferably one of the Big Four. Such an upgrade might double annual audit fees, but the value that is created for the company and its shareholders should be significantly higher. We believe that senior management of every single U.S.-listed company is very well aware of this fact, and stubbornness or refusal to proceed with an auditor upgrade leaves the investor with two damaging questions:

1. Is the company afraid that a tier one auditor would ask too many questions? Revealing unplesant details that better stay hidden? Does see company see a risk that a better auditor might not sign off on the prepared financial statements?

2. Has the company tried to hire a tier one CPA firm, but got rejected as a client? Did the company fail to pass a Big Four's due diligence test? Lack of quality internal controls, inadequate documentation, or insufficient or badly trained personell? Or worse?

The Big Four firms are Deloitte, Ernst & Young, KMPG, and PricewaterhouseCoopers. Their PCAOB-registered Chinese member firms are Deloitte Touche Tohmatsu, Ernst & Young Da Hua, Ernst & Young Hua Ming, KMPG, KPMG Huazhen, and PricewaterhouseCoopers Zhong Tian. All four do additionally have a separate Hong Kong member firm.

For the Top Ten firms you will find a different order of firms from different sources. Additionally to the three firms directly following the Big Four - BDO, Grant Thornton, and Crowe Horwath - we added Baker Tilly, Plante & Moran, and RSM McGladrey to this group. The Chinese member firms are Baker Tilly China, BDO China Guangdong Shu Lun Pan, BDO China Li Xin Da Hua, BDO China Zhonglian Mindu Shu Lun Pan, Crowe Horwath China, Grant Thornton, Grant Thornton Beijing, and RSM China. And in Hong Kong we have Baker Tilly Hong Kong, BDO Limited, Crowe Horwath (HK), Grant Thornton, and RSM Nelson Wheeler.

For all other auditors, that are not included in the Top Ten, we see the biggest risks with two groups of firms:

1. Small and widely unknown Chinese or Hong Kong firms. They are usually not inspected by U.S. or international oversight authorities, and Chinese regulators do not show much interest in their work for non domestically-listed companies. For all we know, they might do a most excellent job as auditors, or they might just sign off on anything their clients present to them. There is no reasonable assurance of the quality of their audit work for an independent international investor, without having insider knowledge about the audit plan and thoroughness of the work and procedures.
2. Small U.S.-based auditors without any, or just a very limited presence in China. Small firms with just a few partners and limited professional staff, often don't even have the resources to do a proper audit in China. They might fly over some people from California for a week, or even solely rely on third-party work peformed by sub-contracted Chinese accountants, then signing off on those reports.

A company's independent auditor is responsible for reconciling U.S. filings with Chinese tax filings. With each U.S. GAAP audit, the auditor must consider the appropriateness of a company's Chinese taxes filed and paid. Severe discrepancies between U.S. GAAP reported income and PRC reported income and tax should be immediately apparent to a good and responsible auditor, particularly those with extensive experience in China. Risks are significantly higher with small and understaffed CPA firms, with either just limited experience in China or limited U.S. GAAP experience (sub-contracted Chinese accountants).

To reflect those risks we use the following scoring in our model:

• 65/65 - Big Four Auditor
• 60/65 - Top 10 Auditor and Market Cap under $200 Million
• 50/65 - Top 10 Auditor and Market Cap $200-500 Million
• 40/65 - Top 10 Auditor and Market Cap over $500 Million
• 35/65 - Top 100 Auditor and Market Cap under $100 Million
• 30/65 - Top 100 Auditor and Market Cap $100-200 Million
• 15/65 - Top 100 Auditor and Market Cap $200-500 Million
• 5/65 - Top 100 Auditor and Market Cap over $500 Million
• 0/65 - Unranked Auditor

Safety/Risk Model - Going Public

(Back to Introduction)

Going Public

(accounts for 10% of the final score)

Market Segment / Exchange (50/100)

The standards for an initial and continued listing vary greatly between the exchanges and respective market segments. Those standards include financial, liquidity and especially also corporate governance requirements. The requirements for the NASDAQ markets can be found here. In our model, a company that meets the highest standards will score full points in this category, a pink sheets quoted stock that is not fully reporting will score zero points.

• 50/50 - NASDAQ Global Select, NASDAQ Global Market, NYSE
• 40/50 - NASDAQ Capital Market
• 30/50 - NYSE Amex
• 10/50 - OTC Bulletin Board quoted
• 0/50 - Pink Sheets

Type of Going Public (50/100)

The three most common ways for a Chinese company to go public in the U.S. is via Initial Public Offering (IPO), a reverse takeover into a public shell company (RTO, Reverse Merger), or via business combination with a SPAC (Special-Purpose Acquisition Company) or blank-check company. For investors, an IPO provides the highest degree of safety as those companies are generally more mature, went through much more thorough due diligence by the involved investment banks and the public with the IPO process, and they start out trading on a senior U.S. exchange with significantly higher liquidity, market support and the backing of well-connected Wall Street firms with a reputation at stake.

While RTO stocks are not inherently bad, the risks for investors are significantly higher here. Reverse Mergers provide a much cheaper and faster path to getting listed than regular, underwritten IPO's, and for an early-stage growth stock from China this is often the only way to get access to the U.S. capital markets. But for determining the risks in a particular RTO deal, we have to dive into several, often blurry details. What is the history of the shell company, is it clean, who are the current players and promoters involved in the shell? Who owns the company post-merger, what is their history? Do U.S. financial advisors involved in the merger now hold a position in the company? Did they install an investor relations firm, law firm, accounting firm?

• 20/20 - regular Initial Public Offering
• 10/20 - SPAC / Blank-Check
• 0/20 - Reverse Merger or Self Filing

While we acknowledge a higher safety profile for IPO stocks, we also see a possible difference in the quality of Initial Public Offerings and their lead underwriters. An offering led by a tier one Wall Street firm with the highest reputation in the market will score higher in our model than IPO's led by relatively small firms that are specialized on small-cap China deals. We have grouped all relevant investment banks into two categories, based on Renaissance Capitals statistics for lead underwriters in 2010. The data going into this ranking is Average Deal Size, Proceeds Raised, and Average IPO Returns.

• 30/30 - Tier One Lead Underwriter (Barclays Capital, BofA Merrill Lynch, Citi, Credit Suisse, Deutsche Bank Securities, Goldman Sachs (Asia) L.L.C., Goldman, Sachs & Co., J.P. Morgan, Morgan Stanley, UBS Investment Bank, Wells Fargo Securities)
• 15/30 - Tier Two Lead Underwriter (Baird, Broadband Capital, Cowen & Company, Global Hunter Securities, Keefe Bruyette Woods, Leerink Swann, Maxim Group LLC, Morgan Joseph, Oppenheimer & Co., Piper Jaffray, Raymond James, Rodman & Renshaw, Roth Capital, Stifel Nicolaus Weisel, Suntrust Robinson Humphrey, Thomas Weisel Partners, William Blair, Wunderlich Securities)
• 0/30 - Unranked Lead Underwriter or none at all (non-IPO stocks)

Dual Listing

U.S. listed China stocks that are also listed on a domestic Chinese exchange (Shanghai, Shenzen, Hong Kong) provide a much higher degree of safety for U.S. investors. Those stocks are usually listed in the United States in the form of American Depository Receipts (ADRs), and only Chinese companies with the best financial integrity and corporate governance can usually achieve such a dual listing. Another form of dual listing we acknowledge in our model is the listing of the main operating subsidiary on a domestic exchange. There are very few examples of such a dual listing as the requirements for an IPO in Shanghai or Shenzen are very high. A company that has recently announced a plan to list their subsidiary on the Shenzen exchange is Wonder Auto Technology (WATG), but we would expect this process to take up to one year - if successful. A clearance through China Securities Regulatory Commission supports the legitimacy of the company and its corporate structure, which leads to a much improved safety profile for the U.S.-listed company. In our model a successful dual listing leads to an UPGRADE of the Safety/Risk Score.

Introducing a Safety/Risk Model for U.S.-listed China Stocks

The idea is to create a basic and objective safety/risk score based on public, verifiable, and comparable information, as a starting point to identify possible problems with U.S.-listed Chinese companies (here STAGE ONE).

The two stages are important because STAGE ONE is objective, based on publicly available information, using the same sources for all U.S.-listed Chinese stocks. Every individual investor can assess risks and safety with a bit of work in less than one hour. STAGE TWO is subjective, based on personal, individual research that can be time-consuming, costly, also requires profound knowledge of the Chinese language and legal system. Most investors will not be able to pull this off on their own, and those who rely on other people's work will have to trust their judgment and believe in their thoroughness.

The general idea behind this model is that a company that fails STAGE ONE is not "investment grade" unless it passes STAGE TWO. A company that passes STAGE ONE can very well turn out to be a fraud in STAGE TWO, however the risks should be contained with a good score in STAGE ONE. The thesis is that for a standard retail investor a STAGE ONE pass should provide reasonable safety. For investors looking to build a large position in a Chinese stock, for high net-worth individuals, institutions etc. a STAGE TWO pass should be a requirement.

I will introduce the Trading China Safety/Risk Model in a series of posts over the next 2-3 weeks, followed by a few sample companies for STAGE ONE of our model. Be warned, there will be a lot of text to read, often rather dry information to digest. This is the basic structure of STAGE ONE:

1. Going Public (accounts for 10% of the final score)
2. Auditors (30%)
   • Quality of Auditors
   • History of Auditors
   • PCAOB Inspection
3. Internal Controls (5%)
4. Chief Financial Officer (7.5%)
5. Board of Directors (7.5%)
6. Ownership (10%)
7. Equity Financings (10%)
8. Stock-Based Compensation for Services (2.5%)
9. Legal Matters (5%)
10. Communications (12.5%)

Another Auditor Blow-Up - Digging through the Chinese RTO Jungle

Davis Accounting Group

As of November 4, 2010, the independent registered public accounting firm of two OTC-quoted Chinese microcaps has ceased to exist. Davis Accounting Group P.C., the current auditor on file for both Jade Art Group (JADA) and BioPharm Asia (BFAR), has to be licensed with the state of Utah to work as a certified public accountant. But a recent filing with the Utah Department of Commerce's Division of Occupational and Professional Licensing reveals that the principal of the firm, Edwin "Ted" Reese Davis Jr., "has engaged in unlawful conduct by continuing to practice as a certified public accountant and otherwise hold himself out to be a CPA after his license had expired on September 30, 2008."

Ted Davis's license has been revoked, and with that the license for his Davis Accounting Group is gone as well. "Respondent's expired license to practice as a CPA FIRM was revoked effective the date of the Order (November 4, 2010). Respondent was also ordered to cease and desist from engaging in any acts or practice which constitute the practice of public accountancy unless Respondent is duly licensed in that regard." (Source: State of Utah Newsletter, December 1, 2010)

Digging deeper into this story reveals that Ted Davis has been arrested in December on suspicion of issuing bad checks and a Montana-issued warrant. We don't have a statement from either JADA or BFAR on this matter, and both companies are still registered with Davis Accounting Group as their auditor. Attempts by Trading China to contact the companies have been unsuccessful so far, but we will keep trying.

In 2009, the Public Company Accounting Oversight Board (PCAOB) issued a report on Davis Accounting Group. According to this report, the firm had a total of one partner (Ted Davis?) and 3 employees, but 13 clients. And the report reads like this: "pervasive failure to plan, perform, and document performance of the audit and inappropriately taking responsibility for the work of another auditor when the other auditor performed substantially all of the audit procedures that served as the basis for the Firm's opinion." So, additionally to Davis signing off audits without a license for more than two years, the PCAOB report suggests that no actual audit work had been done by the firm.

BioPharm and Global Pharm

BioPharm Asia (BFAR) engaged Davis Accounting Group on February 21, 2010, after their previous auditor, Sherb & Co., resigned on February 11, 2010. Sherb had been engaged for just a couple of months (since June 30, 2009), following the dismissal of BFAR's previous auditor, Moore & Associates Chartered. A reason for Sherb's resignation was not given in the filing, but the firm declined to re-issue its report on BFAR's 2008 Financial Statements, and Davis was engaged to perform a re-audit. On May 10, 2010, Davis Accounting Group signed off on both the 2008 and 2009 financial statements (10-K Filing).

There is an interesting connection between Davis, BioPharm Asia, and another recent Chinese reverse merger, Global Pharm Holdings Group (GPHG). Global Pharm, known until September 2010 as Top Flight Gamebirds, Inc., is a Shenzen-based wholesaler and distributor of pharmaceutical-related products. Two of the company's three executives come directly from BioPharm Asia: Chairman, CEO, and sole director Yunlu Yin served as BFAR's CEO until April 2010, while Secretary Dan Li was assistant to President in BioPharm Asia until late 2009. Li was also director of China US Capital Holding Group. The third executive, Chief Financial Officer An Fu, was employed as an auditor at Davis Accounting Group until May 2010.

China US Capital Holding and Subsidiaries

Now this China US Capital Holding Group has several wholly-owned subsidiaries: China US Venture Capital Group Limited, China US Bridge Capital Limited, China Finance Inc., and Giant Fortune Investment Management Limited.

China US Venture seems to have changed its name to "China US Strategy Capital Group", advertising its services as "paving a way to US capital market for excellent Chinese enterprises, enabling them to become international excellent enterprises as soon as possible." Among the clients presented on their website are Home System Group (HSYT), Jade Art Group (JADA), Gulf Resources (GFRE), China Organic Agriculture (CNOA), Universal Travel Group (UTA), and China 3C Group (CHCG). The company is partnering with several U.S. accounting firms, among them two small firms with a strong presence in the Chinese RTO space: Kabani & Co. and Weinberg & Company. Davis Accounting Group is not mentioned as a partner.

China US Bridge says it were dedicated "to strengthening the integration between fast-growing China enterprises and US capital market." As partners they have listed the same accounting firms as China US Venture, and the same reverse merger "cases" are advertised with additionally New Energy Systems (NEWN). US Bridge is also partnering with several investor relations firms, among them well-connected Hawk Associates. AMI Research, a division of Hawk Associates, initiated paid coverage of Jade Art Group (JADA) in June of 2008, and recommended the stock with a $7.49 price target. JADA is currently trading at $0.08. Among AMI Research's 2011 Top Microcap Picks are two Chinese companies: Tri-Tech Holding (TRIT) and China Kangtai Cactus (CKGT). Both are current clients of Hawk Associates.

Giant Fortune again presents the same auditing and investor relations partners as the previous two entities. Three U.S.-listed Chinese companies are presented as "successful cases" on their website: BioPharm Asia (BFAR), Universal Travel Group (UTA), and China 3C Group (CHCG). Giant Fortune's Zuhong Xu still is the largest independent shareholder of BioPharm Asia as of its latest annual report, holding 8.50% of outstanding shares.

Mr. Xu served as Chairman and CEO of the fourth company on our "subsidiary list": China Finance Inc., which was quoted on the Bulletin Boards under CHFI, before it went dark in 2009, became delinquent and subsequently demoted to the pink sheets. As of March 31, 2009, China Finance still held sizable positions in Jade Art Group (JADA, 8.87%) and Gulf Resources (GFRE, 5.46%), additionally small leftover shares in Home Systems Group (HSYT) and China Organic Agriculture (CNOA, 1.30%). Previous holdings of CHFI include Universal Travel Group (UTA, 2008), Orient Paper (ONP, 2008), and the failed RTO stocks China 9D Construction Group (CNAG.PK), Beijing Logistic (BJGL.PK), Guilin Paper (GUPR.PK), and China Ivy School (CIVS.OB).

Doubts about Jade Art Group

Jade Art Group (JADA) engaged Davis Accounting Group on July 13, 2009 after dismissing Chisholm Bierwolf, Nilson & Morrill. Davis has been engaged "for all audit and permissible non-audit services," and the firm signed off on JADA's 2009 financial statements on April 12, 2010. JADA is currently not delinquent with its filings, and the most recent balance sheet shows cash and cash equivalents of $16.27 million or 250% of their current market capitalization. The company went dark again, all attempts to contact anyone there have been unsuccessful for weeks, and the stock price keeps collapsing on extremely high volume. With the recent developments regarding their auditor the market does apparently not believe JADA's financial statements, questions that all that cash even exists. We will see if (and what) they file their 2010 annual report - due by March 31, and who will sign off on the numbers (can't be Davis anymore).

Colatteral Damage?

Both BFAR and JADA have not yet shown any reaction on the developments at Davis Accounting. They will both have to engage a new accounting firm for the 2010 report, and I have my doubts that this can be a quality name. I am also not sure about further legal implications. Will a re-audit be required by the SEC for the fiscal years of 2008 and 2009 when Davis illegally practiced as a CPA firm? If so, then another Chinese firm that had connections with China US Capital Holding and China Finance might be affected:

Orient Paper (ONP) engaged Davis Accounting Group on November 27, 2007, replacing Moore & Associates Chartered (similar to BFAR). Davis signed off on Orient Paper's 2007 results on March 28, 2008, and on the 2008 numbers on March 19, 2009. Davis resigned as ONP's auditor on December 1, 2009 and was replaced by BDO Limited. On November 29, 2010, Orient Paper presented the findings of an independent investigation, assisted by two law firms and Deloitte & Touche Financial Advisory, into several issues which also covered the period when Davis was engaged. ONP said this investigation found no evidence for falsely reported revenue, inventory turnover, and gross profit in previous financial statements.

Best Performing China Stocks 2010

China Shen Zhou Mining (SHZ) -- +1,083.09%

Shen Zhou is basically a fluorite producer in Inner Mongolia with additional copper, lead and zinc resources in that same region and Xinjiang. The stock was bouncing around the $1-level from January to October, before it took off with the big theme of the fourth quarter, "Rare Earth Metals." The company only has a very small exposure to rare earths, if anything at all, and the stock price will likely come down hard when the theme is over and momentum traders exit the sector. Fundamentally, the stock should be fairly valued at around 2-3x book value, which currently stands at $0.86/share.

Yasheng Group (YHGG) -- +321.53%

Yasheng Group is a massive agricultural holding with annual revenues of more than $750 million. Its operations are in the Northwest of China where the company produces field crops, vegetables, fruit, beef and poultry. Early in 2010 the company has decided to take its status as a public company seriously again. It caught up with open SEC filings, became fully reporting again which allowed the stock to be quoted on the OTCQB. The company is heading for a senior exchange listing "in the near future." YHGG's price gains reflect these developments.

China Agri-Business (CHBU) -- +317.07%

Another agricultural play is CHBU, a producer of bactericides and organic fertilizers in Shaanxi. This widely unknown stock exploded in early December, apparently on a newsletter recommendation, but it managed to hold its gains and establish a new trading range. CHBU is not expensive here, trading at around 1.8x book and 6x earnings with explosive growth rates. It might see another pop to the $2-2.50 level this year.

Kingold Jewelry (KGJI) -- +245.76%

A relatively new reverse merger (December 23, 2009) that managed to secure a Nasdaq listing in mid-August. The company is based in Wuhan and designs and manufactures gold jewelry. Despite the large gains for the year, the stock lost 43% of its value since trading on Nasdaq, and I would recommend caution and quality due diligence before taking a position in the stock.

Eastern Environment Solutions (EESC) -- +171.42%

EESC is operating the landfill in the Northeastern megacity of Harbin (pop. 10 million). Since January 2010 the company expanded operations from just waste storage to recycling of especially plastic and PET bottles. This strategy works out well, and in Q3/10 EESC already generated 69% of its revenue from the sale of recovered bottles and bottle caps. The stock is a Trading China Model Portfolio position, and we expect further gains in 2011 as the stock is undiscovered, trading at only 3x trailing earnings.

Asia Pacific Wire & Cable (AWRCF) -- +148.97%

AWRCF makes telecommunication and power cables in China and especially also in South-East Asia (Thailand, Singapore). The stock has always been cheap, even after the roughly 150% gains in 2010 it is still trading at just 0.63x book value. However, this is a low margin business and Asia Pacific's account receivables are currently higher than its total market capitalization.

China Gengsheng Minerals (CHGS) -- +128.88%

Gengsheng doesn't have any exposure to rare earths, yet the stock was bid up in the current rare earths craze. Lesson learned... it doesn't matter to momentum traders if the company's business is deteriorating (negative net income growth of 45% year-over-year), or if the company clarified they are not part of this industry. For as long as this rare earths mania continues, the stock will likely be in play. With TTM earnings of $0.16, fair value for CHGS should be below $2, and this is where the stock will be heading when the momentum is gone. But don't fight the tape, it might as well go all the way to $10 before the inevitable happens.

China Energy Corporation (CHGY) -- +124.39%

The smallest of the U.S.-listed Chinese coal stocks has benefited the most from continued strength in coal prices last year. China Energy is in the final stages of getting approved for a NYSE Amex listing. A 1:3 reverse split has been approved and should become effective this January. With a current P/E-ratio of 4.x the stock is among the cheapest coal stocks and I expect further upside in 2011.

China Yuchai (CYD) -- +118.55%

Yuchai is a major producer of diesel engines and power generators in China. Historically the stock has been trading at very low valuations, even close to the $13.71 of cash/share the company currently holds. But that has changed in the second half of 2010, reasons include the government-ordered power restrictions which catapulted demand for diesel generators to unprecedented levels. The stock is no longer cheap here, but analysts from Piper Jaffray expect further upside in 2011 and raised their price target to $37 last month.

China Model Portfolio

The Trading China Model Portfolio closed the year with a gain of 37.79% since September 24, 2010. We are currently holding more than 26% liquidity, looking for good long-term entries this January. One name that looks very promising is Shengtai Pharmaceutical (SGTID), a leading producer of glucose and cornstarch, raw materials for the pharmaceutical and food & beverage industry. Shengtai promised massive growth for 2011 with net income expected to grow by more than 200% to $10 million. With fully diluted 10.5 million shares, incl. 4.4 million warrants (strike price: $2.60), the stock seems very attractive at current levels below $3. Keep Shengtai on your watch list.

China Redstone Group (CGPI) is currently trading at $4.26, up 21.71% for the year of 2010 and down 8.39% from the November 29 high at $4.65. The Trading China Tracker Score is 15 (Strong Buy).

We are closing our CGPI position for a gain of 39.67% or $1,983. While China Redstone's reported numbers and business outlook appear entirely positive, we have identified several open questions that need to be addressed. Results of our due diligence have been inconclusive so far and we have decided to lock in profits here.

Lotus Pharmaceuticals (LTUSD) is currently trading at $2.59, up 1.17% for the year of 2010 and down 13.09% from the November 10 high at $2.98. The Trading China Tracker Score is 15 (Strong Buy).

A two-for-one reverse split of Lotus Pharmaceuticals' common stock became effective on December 31st. The company announced the reverse split as "an important step toward our goal of a national securities exchange listing." The shares will be trading under the ticker symbol LTUSD for 20 business days. We have adjusted our Lotus position in the China Model Portfolio and changed the target price to $4.50. We are now expecting an uplisting to NYSE Amex in the first half of this year.

Positive 4th Quarter for China Small Caps

Here is an overview of the Fourth Quarter highlights:

Main China Index (NYSE, NYSE Amex or Nasdaq)
- 917.66 (up 12.88% for the Fourth Quarter)
- 27 stocks are up, 13 are down

Top Five

• China Biologic Products (CBPO) +65.89%
• China Yuchai (CYD) +65.65%
• China MediaExpress (CCME) +55.29%
• Ambow Education Holding (AMBO) +39.75%
• Gulf Resources (GFRE) +39.01%

Bottom Five

• RINO International (RINO.PK) -71.04%
• A-Power Energy (APWR) -34.22%
• Funtalk China Holdings (FTLK) -27.23%
• Country Style Cooking Restaurant (CCSC) -19.56%
• China XD Plastics (CXDC) -18.60%

OTC China Index
- 915.59 (down 3.62% for the Fourth Quarter)
- 18 stocks are up, 21 are down, 1 unchanged

Top Five

• U.S. China Mining Group (SGZH.OB) +81.19%
• China Ceramics (CCCL) +44.99%
• Lotus Pharmaceuticals (LTUSD.OB) +36.31%
• Nutrastar International (NUIN.OB) +34.36%
• Far East Energy (FEEC.OB) +29.62%

Bottom Five

• China New Media (CMDI.OB) -58.80%
• Sen Yu International (CSWG.OB) -48.83%
• China Green Material (CAGM.OB) -41.67%
• VLOV, Inc. (VLOV.OB) -41.18%
• China Environmental Protection (CNVP.OB) -35.72%

Quarterly Revision (Fourth Quarter)

Both China indexes are revised at the beginning of each quarter. Stocks that do no longer meet the requirements are being removed. Reasons could be posting a loss in the most recent quarter, uplisting to a higher exchange or just a huge decline in share price. Following is a list of all changes for both indexes.

Trading China Main Index (NYSE, NYSE Amex or Nasdaq)

Additions

• 3SBio Inc. (SSRX)
• BitAuto Holdings (BITA)
• Bona Film Group (BONA)
• China Xiniya Fashion (XNY)
• ChinaCache International (CCIH)
• Cogo Group (COGO)
• Global Education & Technology (GEDU)
• L&L Energy (LLEN)
• Le Gaga Holdings (GAGA)
• Mecox Lane (MCOX)
• Puda Coal (PUDA)
• SinoTech Energy (CTE)
• Xueda Education Group (XUE)

Removals

• A-Power Energy (APWR)
• Ambow Education Holding (AMBO)
• Camelot Information Systems (CIS)
• China Gerui Advanced Materials (CHOP)
• China Information Technology (CNIT)
• China New Borun (BORN)
• China XD Plastics (CXDC)
• China Yuchai (CYD)
• eLong (LONG)
• RINO International (RINO.PK)
• ShengdaTech (SDTH)
• Wonder Auto Technology (WATG)
• Xinyuan Real Estate (XIN)

Trading China OTC Index

Additions

• China Electronics Holdings (CEHD.OB)
• China Shandong Industries (CSNH.OB)
• American Jianye Greentech (AJGH.OB)
• China Carbon Graphite (CHGI.OB)
• One Bio Corp (ONBI.OB)
• Deyu Agriculture (DEYU.OB)
• China Clean Energy (CCGY.OB)

Removals

• BEFUT International (BFTI.OB)
• China Green Material (CAGM.OB)
• China Ceramics (CCCL, uplisted)
• China New Media (CMDI.OB)
• China Environmental Protection (CNVP.OB)
• Eastern Environment Solutions (EESC.OB)
• NF Energy Savings (NFEC, uplisted)