A Short History of Short Attacks, Part Two

China Marine Food Group (CMFO) has come under pressure from short sellers several times throughout 2010. A person posting under the alias "Chinese Company Analyst" on Seeking Alpha repeatedly called the company a fraud: "The main thrust of our argument that CMFO is a fraud is that the Company's SAIC and SEC filings don't match." (June 1, 2010) and "Investors ... should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements." (June 16, 2010).

ZYCPA, China Marine Food's auditor at that time, is a small Hong Kong firm that has several U.S.-listed clients, including NF Energy Savings (NFEC) and China Sun Group (CSGH). The firm had repeatedly been accused of participating in alleged frauds, and whenever that happened the auditor changed its name: from Zhong Yi (Hong Kong), to ZYCPA, and now they use the moniker "HKCMCPA" - the original firm is no longer recognizable. China Marine Food engaged BDO China as its new auditor in October 2010 and is no longer connected with ZYCPA/HKCMCPA.

Another Seeking Alpha author attacking the company was Chimin Sang, when he wrote in June 2010 that CMFO's "business itself is nearly impossible. It has $400 fixed assets, little inventory, zero finished product inventory, but it has a magic ramp-up of sales." None of those attacks had an immediate effect on CMFO's stock price. The stock traded in a relatively narrow range for the remainder of 2010, and closed the year unchanged from the levels of mid-June. However, the performance for 2011 is terrible and CMFO printed new lows this Friday, to close at $2.92, down 45.93% for the year.

Muddy Waters Research, perhaps the most famous of all China short-selling outfits, emerged on June 28, 2010, with its initial "Sell Short" report on Orient Paper (ONP): "We are confident that ONP is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars." The company swiftly responded by stating that it "categorically denies these allegations and has instructed its legal counsel to contact Muddy Waters and explore all legal options against it for publishing and distributing such a report." However, the stock lost some 20% of its value within three days from the release of Muddy Waters' report.

A whole battalion of short sellers jumped on Muddy Waters' bandwagon and published further attacks over the next few weeks. Again we have "Chinese Company Analyst" - whose website is no longer active today - questioning the integrity of Orient Paper's auditors BDO Limited, the Hong Kong member firm of BDO International. He also published another article where he claims to "provide compelling evidence that Orient Paper is falsifying its financial statements." And Chimin Sang, a very vocal China bear who posted negative articles on a growing number of Chinese reverse mergers (FUQI, CCME, CHBT, ZSTN, SCEI), meant to let the world know that he "side[s] with Muddy Waters: ONP has more likely than not committed fraud."

Orient Paper initiated an internal investigation of these fraud allegations, which, according to the company, did not find any evidence for fraud. Drew Bernstein, the head of ONP's audit committee and a partner in the New York-based accounting firm Marcum Bernstein & Pinchuk, concluded that: "When you look at Muddy Waters' allegations in totality, you'd have to say they are false." He said that ONP is "by now perhaps the most vetted company in China."

Muddy Waters hasn't admitted defeat, instead they questioned the validity of the company's internal investigation. And Orient Paper's share price? The stock recovered nicely after the investigation concluded, yet it is now trading at lower levels than any time in 2010, printing new lows last week and sitting on a 44.34% loss for the year.

Sharesleuth picked on Chinese telecom equipment company Telestone Technologies (TSTC) in an article published on August 11, 2010. The article focused on TSTC's growing accounts receivable issue and concluded that "investors who are considering the company because of its sharp increase in sales and earnings and its attractive profit margins might want to know more about the underlying numbers." The article was explicitly "not alleging any wrongdoing by Telestone," but it set the tone for further negative articles this winter.

On January 10, 2011, The Forensic Factor called Telestone "a RINO in sheep's clothing," stating that they are "nearly convinced that Telestone has misrepresented its prospects, size, and business to the investment community." TSTC swiftly rejected all allegations and called the article "an unjustified swipe at a reputable and successful Chinese business." The Forensic Factor remained unimpressed and posted a follow-up two weeks later with the telling title "The Great Wall of Deceit".

TSTC suffered its steepest losses in 2010 already, when the share price was roughly cut in half. Most of these losses can in fact be attributed to the accounts receivable issues, unrelated to any specific short-selling attack. For 2011 the stock is down 29.67%, yet it has recovered almost 50% from its early April low. It is one of the very few Chinese reverse merger stocks that seems to be in an uptrend for the past four weeks. But TSTC is not for the faint of heart, the Trading China Risk Model suggests that this is one of the highest risk stocks in the China small caps universe.

To be continued...

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.

Preparing for the RINO Fall-out

After a series of events with almost comical dimensions, we now have the first case of fraud on the Nasdaq, involving a Chinese small cap company. RINO International (RINO) admitted Friday that it did not enter into two contracts for which it reported revenue during its 2008 and 2009 fiscal years. The stock has been halted by the NASDAQ Stock Market around noon on November 17, and it will remain halted until RINO has fully satisfied NASDAQ's request for additional information. NASDAQ has not specified what kind of information they are looking for, but at this time it seems unlikely that RINO will be allowed to remain listed on the prestigious NASDAQ market. Investors should be prepared to find the stock on the pink sheets in a couple of weeks.

Earlier on Friday, the first official statement in the RINO case came from its auditors, Frazer Frost LLP, in form of a letter issued in an 8-K Filing with the SEC.

In a telephone conversation on November 16, 2010, Mr. Zou Dejun, the Chief Executive Officer of the Company, informed Ms. Susan Woo of our firm, in substance, that as to the six RINO customer contracts discussed in the recent report of Muddy Waters LLC, the Company did not in fact enter into two of the six purported contracts, and a third contract among the six was explainable. When Ms. Woo inquired about the Company's other contracts, Mr. Zou said he was not sure, but there might be problems with 20 - 40% of them. Assuming that these statements were reasonably accurate, it appears that our reports would have been affected if this information had been known to us at the date of our reports, although the effect on the financial statements is currently unknown and cannot be quantified without a thorough investigation. We further note that in a conversation the following day, November 17, 2010, involving Ms. Woo, several directors of the Company, Company counsel, and Mr. Zou, Mr. Zou stated that he was not sure the day before and went back to look into some things, and found that apart from the two problematic contracts, all other contracts are legitimate and can be verified.

The language used in this letter gives those very serious events an almost comical note. The CEO said "he was not sure" and "there might be problems," then "went back to look into some things." And Frazer Frost is "assuming that these statements were reasonably accurate" to conclude that "it appears that" their audited reports were wrong as they might have based their findings on forged invoices.

The very basic conclusion from last week's events is that RINO is not taking their status as an U.S.-listed public company any bit seriously, and that Frazer Frost did a pretty lousy job as an auditor. To fall for forged information of such a magnitude raises the question of what exactly Frazer Frost did attempt to verify, if anything at all. This will likely lead to lasting damage for the reputation and credibility of Frazer Frost and the market has already started to punish other clients of the firm.

In Friday's trading Frazer Frost clients were among the biggest losers. China Valves Technology (CVVT) dropped 15.28% for the day to close at $8.93, snubbing off any upside from a Roth Capital upgrade ($16 price target) before the open. Harbin Electric (HRBN) closed at $16.95, down 10.7%, and the stock finds itself now 30% below the $24 going-private offer it received a couple of weeks ago. Other FF clients affected were Fushi Copperweld (FSIN, down 6.69%), China Fire & Security (CFSG, down 5.86%) and China Medicine (CHME, down 4.20%).

Another stock that is directly affected is Orient Paper (ONP, down 7.00% on Friday). Rino International's fall is the first big success for 2-man (short-selling) research firm Muddy Waters LLP who released a very detailed report about the company on November 10, which led to the reported series of events. Muddy Waters' previous target was Orient Paper, but that company has very determinedly defended itself and its stock price had stabilized recently. With the collapse of RINO the focus might now shift back to ONP and put the stock under renewed selling pressure until the results of the ongoing independent investigation into MW's allegations is presented.

So what will happen next? Will this lead to new or resumed short-selling attacks on a variety of Chinese small caps? Most certainly it will! Short sellers have the whole weekend and beyond to come up with pretty much anything, knowing that whatever they get published will likely have an immediate effect on the stock price, as with the RINO disaster they now have a precedent of Chinese fraud on the Nasdaq. Those companies do already have a hard time defending themselves, even against totally ridiculous allegations. And always keep in mind that not all those attacks will be unfounded, it is very likely that RINO is not the only Chinese company with severe irregularities in its financial statements. But don't make the mistake to interpret this as a "China problem," other than that Chinese companies are just the easiest targets right now.

Will we see a new downtrend for the sector similar to what we all have experienced last summer? That depends on the direction of the general markets in the U.S. and China. It is an undeniable fact that big money is very eager to put their money in (perceived) quality Chinese companies, proven by the China IPO craze of the last three months when most offerings opened for trading some 30-50% above their IPO price. However, if we see the general appetite for risk fading, or the S&P 500 heading for a 10-15% correction, I would expect China small caps to lose value twice as fast. Right now I am still bullish for equities in general, but less so than two or three weeks ago. We should be prepared for both scenarios now.

This RINO situation is serious. Even the biggest bulls will now have a hard time dodging smear attacks on perfectly healthy stocks from China which just happen to have some detail in common with RINO, being it company structure, a sub-par public accounting firm, a weak Board of Directors, or the way they became a public company. It might be that the normal "innocent until proven guilty" is turned upside down for the time being, especially for those companies that do not take their U.S.-listed public company status seriously.

What we should do is looking at business models and trying to understand them. Doing our own in-depth research and see if we can be comfortable with what we find out. Looking at management credibility and perceived credibility. Who is running the company, which investors are backing it? Personally I am no longer willing to risk my money with a $250MM stock that chose to reaffirm Kabani or similar as their auditors, nor am I seeing the point in holding a position in a stock that doesn't even bother to do earnings calls. Talking about big board names here only, for Bulletin Board stocks and companies that are early on their way of maturing he have to set different requirements. However even there, companies that choose not to communicate at all should be treated with extreme caution.

This is not the time to run away from China stocks. Smart money will always look for value, and you have to find out where the value is, what companies you want to invest in, and why exactly you would do that. Re-evaluate your holdings, make adjustments now, and prepare yourself for possible "bargain hunting" with quality stocks that might get beaten down in the RINO aftermath, but don't deserve to be treated in the same way for reasons you have to determine for yourself.

I am making several adjustments to the China Model Portfolio today:

Changda International (CIHD) is currently trading at $0.75, down 76.20% for the year and down 69.76% from its April 5 high at $2.48. The Trading China Tracker Score is 20 (Strong Buy).

Changda has posted strong third quarter numbers last week, however an equity raise is still looming. CIHD has not reached our price target of $1.00 yet, however we are locking in profits here to protect our gains in the light of the RINO situation. We are closing the position here for a gain of 78.57% or $3,927.

Gulf Resources (GFRE) is currently trading at $10.53, down 9.70% for the year and down 12.25% from its April 15 high at $12.00. The Trading China Tracker Score is 13 (Strong Buy).

While I have little doubts about the integrity of Gulf Resources, the stock has been a target before, also mentioned along RINO in the infamous Barron's "Beware..." article. I believe it is prudent to secure profits here as this is one of the stocks that might see a short-selling attack. We are closing the position here for a gain of 61.75% or $3,087.

Renhuang Pharmaceuticals (CBP) is currently trading at $2.41, up 145.91% for the year and down 19.67% from its April 9 high at $3.00. The Trading China Tracker Score is 16 (Strong Buy).

Renhuang is close enough to our price target now, so we can take profits here as well. We are closing the position here for a gain of 67.36% or $3,367.

Wonder Auto Technology (WATG) is currently trading at $8.50, down 27.60% for the year and down 33.44% from its April 9 high at $12.77. The Trading China Tracker Score is 5 (Hold).


Wonder Auto disappointed us with their third quarter report. Account receivables more than doubled for the quarter and the stock still couldn't get above a "Hold" rating on the China Tracker. I would also expect the company to upgrade to a Big4 auditor as soon as possible. We are closing the position here for a loss of 3.30% or $164.

ZST Digital Networks (ZSTN) is currently trading at $7.25, down 17.24% for the year and down 14.51% from its November 8 high at $8.48. The Trading China Tracker Score is 10 (Buy).

We are also selling our ZSTN position here. The only reason is that we are not entirely comfortable with the company's business model, there are open questions about the reported margins and future prospects (GPS) which lead us to believe that ZSTN does not pass our high quality standard for senior exchange stocks at this time. We are closing the position here for a gain of 29.46% or $1,471.

The Myth of Underperforming Reverse Mergers

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.

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
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:

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
Reverse Merger:	2005-02-03	2007-10-23	2007-12-26	2005-12-06	2008-09-03	2006-10-31	2006-12-12	2007-10-29	2007-10-05	2008-02-26
First Quoted Price:	2005-06-14 $6.10	2007-12-13 $4.60	2008-05-02 $26.51	2005-12-19 $25.00	2009-04-24 $2.075	2006-11-22 $5.0625	2007-11-28 $10.00	2008-01-14 $2.04	2008-05-13 $8.25	2009-10-29 $2.50
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.

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
First 10k Day:	2006-01-27 $8.00	2008-07-08 $6.05	2008-08-07 $3.75	2005-12-20 $7.00	2009-04-24 $2.125	2007-01-05 $2.00	2007-12-03 $9.40	2008-05-13 $1.40	2008-10-30 $2.50	2009-10-29 $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%	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.

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
2008-09-10:	$3.16	$6.90	$3.29	$8.32	n/a	$10.22	$2.12	$0.60	n/a	n/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/a	n/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).

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
2009-03-10:	$1.90	$4.00	$3.30	$3.32	n/a	$1.05	$1.46	$0.38	$2.01	n/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/a	107.62%	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).

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
2009-09-10:	$6.44	$6.12	$13.05	$12.49	$6.283	$5.27	$6.50	$3.44	$13.59	n/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.

	CAGC	CBEH	CGA	CHNG	DEER	FEED	GFRE	ONP	RINO	SPU
2008-09-10:	$3.16	$6.90	$3.29	$8.32	n/a	$10.22	$2.12	$0.60	n/a	n/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/a	n/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.

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.

Trading China Weekly Summary - July 5-9, 2010

Trading in Orient Paper (ONP) shares has calmed down considerably after the company issued several press releases to defend itself against fraud allegations from Muddy Waters LLC. Orient Paper reaffirmed their 2010 earnings guidance of $0.98 per fully diluted share which gives the stock a P/E ratio of slightly above 7 at current levels. I want to point out that the stock is not exceptionally cheap here when compared to its peers in the U.S.-listed China space, and that neither of the two analysts that are following the company, Hudson Securities and Roth Capital, has issued a note yet to defend the stock after the big turmoil last week. ONP shares lost 4.7% of their value last week.

3SBio Inc. (SSRX) raised their 2010 full year net revenues guidance by about 3% on Monday, due to the strong first quarter sales performance. The stock is up 8.9% for the week.

On Wednesday, China Green Agriculture (CGA) announced the closing of the Beijing Gufeng Chemical Products acquisition and said that this is expected to contribute EPS of $0.39 for FY 2011. While Rodman & Renshaw called the acquisition "attractive both financially and strategically," Brean Murray points out integration risks and expects "all margins to decrease significantly in FY11." All three analysts that follow the stock give it a neutral rating. CGA shares are up 10.1% for the week.

Several Chinese companies stepped up efforts to increase shareholder value by announcing a share buyback program last week. I believe this is exactly the right signal to the market now as most China small caps have lost at least one third of their value in the last three months. China-Biotics (CHBT) announced a $20 million buyback on Wednesday and China Medicine (CHME) a $2 million program on Friday after the close.

Also on Friday, Longwei Petroleum (LPIH) posted strong numbers for April and May and issued a bullish outlook for their 2011 fiscal year that started this month: "The Company expects continued favorable market and industry conditions to boost revenue growth and profitability in the first half of fiscal 2011." The stock gained 11.44% on Friday and is up 17.9% for the week. It is now trading safely above $2 and if LPIH can hold this mark for another four trading days we can expect the stock to trade on Nyse Amex as early as July 19.

Growth and Shareholder Dilution

In the China Small Caps space we find very many companies that grow net income by 30% and more year-over-year, so we can safely categorize them as 'Growth Stocks' by definition. However, it isn't actually net income growth that matters for valuation, it is EPS growth -- and here the picture can look quite different if we go into detail. Shareholder dilution is a common problem amongst US-listed Chinese stocks and while I do fully understand the need to raise money to fund growth, we have to look if the significant increase of the share count does actually translate into EPS growth for shareholders.

Let's have a look at seven randomly selected names in the China space, seven stocks that cover a variety of industries. All are traded on senior US exchanges.

Net Income Growth

Ticker	Company	Net 2008	Net 2009	Growth	Net 2010*	Growth*
CAGC	China Agritech	8,641,741	15,584,056	80.33%	23,500,000	50.80%
CCME	China MediaExpress	26,367,000	41,711,000	58.19%	73,000,000	75.01%
CELM	China El. Motor	8,015,892	11,497,698	43.44%	18,450,000	60.47%
CNET	ChinaNet Online	2,800,000	8,444,000	201.50%	14,100,000	66.98%
DEER	Deer Consumer Prod.	3,356,784	12,369,062	268.48%	26,000,000	110.20%
ONP	Orient Paper	8,774,415	12,720,208	44.97%	18,000,000	41.51%
YONG	Yongye Int'l	11,191,779	26,205,453	134.15%	43,500,000	66.00%

(2010 Net Income based on the midpoint of official company guidance)

All seven stocks posted stellar numbers for 2009 with net income growth between 43% and 268%. 2010 guidance is also very positive for all seven companies. Now we should have a look at how the share count (fully diluted) has increased from January 2009 until today.

Shares Outstanding / Dilution

Ticker	Company	O/S 2008	O/S 2009	O/S 2010*	Dilution 2010	Dilution*
CAGC	China Agritech	12,349,808	14,228,943	18,909,219	32.89%	53.11%
CCME	China MediaExpress	20,915,000	22,998,138	33,499,826	45.66%	60.17%
CELM	China El. Motor	10,679,260	12,356,530	21,244,743	71.93%	98.93%
CNET	ChinaNet Online	13,790,800	14,825,125	21,059,683	42.05%	52.71%
DEER	Deer Consumer Prod.	16,985,460	23,190,286	33,767,212	45.61%	98.80%
ONP	Orient Paper	10,769,896	12,232,878	18,336,566	49.90%	70.26%
YONG	Yongye Int'l	20,106,433	31,324,830	44,696,427	42.69%	122.30%

(shares outstanding 2010 based on Q1/10 10-Q filing)

Whoops! And the 2010 numbers are based on the May filings, there are still seven months to go for increasing the share count even more. Now let's look at the income numbers again, but this time we'll measure growth on Earnings per Share:

EPS Growth

Ticker	Company	EPS 2008	EPS 2009	Growth	EPS 2010*	Growth*
CAGC	China Agritech	$0.70	$1.10	56.52%	$1.24	13.47%
CCME	China MediaExpress	$1.26	$1.81	43.86%	$2.18	20.15%
CELM	China El. Motor	$0.75	$0.93	23.97%	$0.87	-6.67%
CNET	ChinaNet Online	$0.20	$0.57	180.53%	$0.67	17.55%
DEER	Deer Consumer Prod.	$0.20	$0.53	169.68%	$0.77	44.36%
ONP	Orient Paper	$0.81	$1.04	27.63%	$0.98	-5.60%
YONG	Yongye Int'l	$0.56	$0.84	50.29%	$0.97	16.34%

(2010 Net Income based on the midpoint of official company guidance)

Already looks a little less exciting, doesn't it? Here are the 2010 numbers next to another in one table:

2010 Growth

Ticker	Company	Shares	Net Income	EPS
CAGC	China Agritech	32.89%	50.80%	13.47%
CCME	China MediaExpress	45.66%	75.01%	20.15%
CELM	China El. Motor	71.93%	60.47%	-6.67%
CNET	ChinaNet Online	42.05%	66.98%	17.55%
DEER	Deer Consumer Prod.	45.61%	110.20%	44.36%
ONP	Orient Paper	49.90%	41.51%	-5.60%
YONG	Yongye Int'l	42.69%	66.00%	16.34%

Based on official company guidance and current share count as of May 2010 (assumed there will be no further dilution this year), all seven companies will grow net income by more than 40% but only one of them will be able to grow EPS by more than 40%. Two of the selected companies will likely end the year with negative EPS growth, while the remaining four should post rather unimpressive EPS growth between 13% and 20% for 2010.

For your investment decisions you should always look at projected EPS growth as well. Most companies will not give EPS guidance - instead they project high net income growth only and leave it to the investor to bring those numbers back down to earth. You should always think about possible shareholder dilution when a company doesn't provide EPS guidance, especially in the China Small Caps space.

This post doesn't mean the named companies would not be undervalued here, in fact most of them trade at very low multiples, and with market sentiment for Chinese stocks having lots of room to improve it is more likely that all seven stocks will trade significantly higher later this year, despite all the dilution. But if you need a reason for why the stock prices seem so depressed in selected emerging market names, always look into EPS growth first

China Model Portfolio Changes

Biostar Pharmaceuticals (BSPM.OB) reported good numbers last week and raised revenue and income guidance for FY 2010. However, during the conference call it became clear that the company will do a public offering soon and the share count might increase by 6 million this year. The stock is cheap here but I am lowering my target slightly from $8.20 to $7.80 or roughly 12x expected EPS for 2010. I believe Biostar is a must hold at the current level and Thursday's pullback is unwarranted with an uplisting being expected for the next six weeks.

China Electric Motor (CELM) reported their first quarter as a public company last week. The company delivered good numbers and very nice guidance with net income of $18.5 million (midpoint of guidance) expected to increase by 60% over 2009 numbers. However the share count has risen much faster and higher than I have expected. With 20.7 million shares outstanding as of March 29, that 60% increase in net income would not translate into any EPS growth. That's not what investors want to see. I'm reducing the target for our China Model Portfolio position from $10 to $8 or roughly 9x expected EPS for the current year.

Lotus Pharmaceuticals (LTUS.OB) disappointed investors with a lousy guidance and the stock sold off hard on Thursday. The company expects EBIT to grow by 15-20% this year and while the stock is very cheap here I do believe that this kind of growth does not justify high multiples. I am reducing the price target for our portfolio position from $3.60 to $2.70 or roughly 6x 2010 EPS. I am fully aware that this is a very low multiple but it was back in early 2007 when LTUS has last seen such a price level.

Orient Paper (ONP) was one of the best performing stocks overall in 2009, not just among the China Small Caps. The stock barely missed our target price of $14.50 this winter and unfortunately we lost out on big gains, instead find our portfolio position now in the red. One main reason for the lousy performance this year is the dramatic rise in shares outstanding. The share count rose from 11.3 million at the beginning of 2009 (split adjusted) to now 18.3 million after the recent offering. The offering price of $8.25 could be the floor for the stock and I've decided to keep it in the portfolio for now but reducing the price target from $14.50 to $12.00 based on 12x my projected 2010 EPS of $1.00.

L&L Energy (LLEN) is one of the biggest winners in the small cap China space this year, and the stock is rapidly approaching my price target of $13. It seems overbought at current levels and - with ONP in mind - I have decided to take action and reduce our LLEN position from full to half, raising the price target for the remaining 750 shares from $13 to $15. Selling 750 shares from the China Model Portfolio at Thursday's close of $12.23 for a 98.86% gain or $4,560.

Earnings Previews, Part 3

GC China Turbine (GCHT.OB) has yet to post a profit or any meaningful revenue but there's a chance that at least the latter will be accomplished with Fourth Quarter earnings. The company posted a slew of positive press releases in the past weeks and said it is well on track with their ambitious plan of generating orders for their wind turbines with an estimated value of $1.1 billion from 2010-2015. However, the stock is down 20% for the year and almost 50% from its November high at $3.79. Highly speculative but possibly very rewarding with the next momentum driven rally.

China GrenTech (GRRF) will report Wednesday, March 31, after the close. The stock just turned positive for the year on Friday after the company announced to be the exclusive WLAN provider for the 2010 Shanghai World Expo. GRRF is expected to post a small profit for the Fourth Quarter, if all goes well in the same range as for Q3 ($3 million net income). Year-over-year comparables will look good as GrenTech was not profitable a year ago, but keep in mind that GRRF handily beat estimates in all of the past four quarters.

Huifeng Bio-Pharmaceutical (HFGB.OB) is very thinly traded and completely under the radar. The company is profitable, pre-announced a healthy net income of $2.8-$3.0 million for FY09 (80% to 93% year-over-year growth) and provided net income guidance between $4.5 million to $5.0 million for 2010. HFGB is in the pharmaceutical raw materials business and doesn't carry drug approval and acceptance risks that are common in the pharmaceutical industry. This should allow them to have a pretty good idea of how their business is progressing mid- to long-term.

Hong Kong Highpower (HPJ) is set to report earnings on March 30 before the open. Like most other Chinese battery stocks HPJ is down sharply for the year (-20%) and from its January high (-37%). Still valuation is one of the highest in the group and the company has to post very strong numbers to support the current short-term uptrend. The stock climbed 25% in the past five sessions probably in anticipation of the earnings report. Personally I would avoid the stock, but I have been wrong about HPJ in the past when it caught strong momentum and tripled in price from November until January.

Jade Art Group (JADA.OB) is sitting on one of the largest jade reserves in China but we do not know much about how the business is progressing. What we know is that the company had six sales contracts for raw jade in 2008, valued at $42 million and "did not acquire any new customers or enter into any new contracts with existing customers during the first nine months of 2009." There should be about $11 million revenue left to collect from those contracts or about as much as JADA reported for Q3/2009. The key here is to look out for new sales contracts and possibly new customer wins in the near future.

Lihua International (LIWA) is scheduled to report on March 31 before the start of trading. The company already pre-announced full-year 2009 revenue of $161.5 million and net income of $25.5 million (non-GAAP) representing 118% income growth over 2008. LIWA anticipates 2010 year-over-year growth of approximately 30-35% in gross profit and 35-40% in non-GAAP net income. The good performance of close peer Fushi Copperweld (FSIN) supports Lihua's high growth prospects. However, there are persistent rumours about possible accounting fraud at LIWA and the stock behaved very vulnerable to recent FUQI issues.

Lotus Pharmaceuticals (LTUS.OB) is another one of China's undervalued health care micro caps. The stock is up 12% for the year but at the current price of $1.43 it has given back most gains since the January high at 2 dollars. The Fourth Quarter 2008 has been Lotus' strongest so far and I do expect nothing less from next week's earnings report than a new record in quarterly net income, possibly more than $7 million. If Lotus delivers I call it an instant buy at current levels and it should be able to take out this year's highs pretty quickly.

China North East Petroleum (NEP) is now slightly down for the year after they had to restate several quarters and admitted to having made 'computational errors' and 'incorrect assumptions.' Plain numbers say the stock is undervalued here and should appreciate significantly this year. The company also announced record oil production for 2009 and drilling results exceeding their expectations. Watch out for the company confirming their 2010 guidance in the conference call and words about the possible impact of a revamped Chinese resource tax on FY2010 results.

New Energy Systems (NEWN.OB) is one of my favourite core holdings in the China Small Caps space as the company has improved in all areas: clever acquisitions, vastly improved investor relations and communications, actively pursuing Nasdaq listing in 2010. NEWN recently reaffirmed 2010 EPS guidance of $1.23, which makes the stock the cheapest one in the battery space. Fourth quarter results will be interesting as NEWN repeatedly held on to their low guidance and expectations are therefore pretty low. With a Nasdaq listing the stock should double from here ($7) and consolidated results including acquisitions will display favourably to 2009 numbers in the quarters to come.

NF Energy Saving (NFEC.OB) will file their 10-K next week. Preliminary 2009 results were announced late February with record revenues and EPS of $0.35. The company also said that an additional $3 million in revenue had to be moved to the First Quarter so those numbers should be not too bad either. I would watch out for proper 2010 guidance beyond the current fluffy note that the 'outlook appears favorable.' and some more details about an uplisting to a senior exchange. The market likes NFEC's industry as the performance of recently uplisted peer China Recycling (CREG) shows.

Orient Paper (ONP) reports Q4 and FY09 numbers on Tuesday, March 30, before the open. There shouldn't be many surprises as ONP has already pre-announced 2009 numbers with revenues up 57% to $102.1 million and EPS up 27% to $1.03. The stock is down 8% for the year and down sharply from its January high of $15.15. Orient Paper is targeting at least 45% net income growth for 2010 and as I pointed out in a previous article an expected revaluation of the Chinese currency should add significantly to ONP's bottom line.

Orsus Xelent Technologies (ORS) is a beaten down consumer electronics stock, trading 75% below book value. However, the company is still profitable, earned $0.20 per share for the first nine months of 2009, which compares favourably to the current share price of $0.48. There are many reasons for the depressed stock price: the company has almost no cash on its books, reported weak earnings, reduced margins, and a 53% drop in net income for the Third Quarter 2009, and pre-announced lower than anticipated full year sales in late December. The 2010 outlook in this last press release was cautiously optimistic, though. For the earnings report this week I would look only at liquidity problems, cash flow, and signs for a business turnaround in the second half of 2010. The company has multi-bagger potential if it can turnaround sales but currently it seems more likely that the stock is kicked out of NYSE Amex before any of this materializes.

When the Yuan Strengthens...

There is widespread talk about an upcoming revaluation of the Chinese currency, the Yuan (Renminbi). While certain circles in the U.S. try to make the case for a currently undervaluation of up to 40% it seems inevitable that China will be forced to let their currency appreciate in the 5-10% range this year. So what would this mean for investing in US-listed Chinese Small Caps?

First of all the obvious: all US-listed companies report in US Dollars, including the China based companies. Any Chinese company that is doing their business in local currency will be able to record a foreign exchange gain equivalent to the valuation gain of the Yuan. And that is unrelated to actual business developments. The whole group of US-listed Chinese companies will benefit from a stronger Yuan.

You want to look for companies that do pretty much their entire business in China. Most of the agricultural and food stocks fit into this category. Let me single out Skystar Bio-Pharmaceutical (SKBI) as a good value play right now. Despite its name SKBI isn't your typical healthcare company as it produces micro-organism products, feed additives and veterinary medicine and vaccines for poultry, livestock and aquacultures. They produce and sell all of their products in China and with a P/E ratio of 6 the stock is currently in the bargain bin. Those with a faint heart might want to wait until the company reports earnings which are due by the end of March.

But it doesn't stop here. There is a whole sector that will enjoy a double benefit from a possible Yuan revaluation: Companies who primarily import their raw materials from international markets like Europe or the U.S. (in US Dollars) and sell their manufactured goods primarily on the domestic market (in Yuan).

Take Orient Paper (ONP), a producer or paper and packaging related products. The company uses recycled waste paper as its primary raw material which it buys from a variety of suppliers. Those suppliers will likely source a good part of their waste paper from the U.S. and Europe as China is just the number one destination for our recyclable materials. Orient Papers sells their finished good entirely on the domestic market so all of their revenues are recorded in Yuan. The stock is currently cheap after a massive sell-off last Friday which was likely triggered by reports the company had dropped out of an investor's conference (a report that has been labeled as a misunderstanding by the company). If you want to reduce risk you might want to wait until the dust settles and ONP reclaims the $9 support level.

But there is one group of companies that will have a disadvantage from a stronger Yuan. All of those that fit into the stereotypical category of Chinese manufacturer with cheap labour and resourced that exports its products to Europe and the North America. Think of all of those neatly cheap products at Wal-Mart, clothes and IKEA furniture, and also all of the contract manufacturers. Their cost of sales will rise with a stronger domestic currency and it is not very likely that Wal-Mart, IKEA and co. will be willing to pay more for the goods. It will depend on the size and scalability of the manufacturer if they can adjust to a stronger Yuan, but overall it should put strong pressure on their margins.

I would strictly avoid investing in any small cap or micro cap company with a business model that entirely relies on exporting cheap products to the international markets. A company that is too small to deal with a possible 10% rise in raw materials and labour cost will struggle to survive, and that is probably the main reason why the Chinese government is trying so hard to defend its undervalued currency as "fairly valued."

One example would be China Linen Textile Industry (CTLXF), a Chinese manufacturer of linen products for the textile industry. As the company stated in their last annual report, "consumers for linen textile products are currently mainly in foreign markets outside of China." CTLXF's customers include well known brands as Boss, Marks & Spencer, H&M and Zara and in its latest presentation the company identified China, Italy, USA, Brazil, Belgium, Spain and Greece as its top customers' markets.

It seems likely that China Linen's competitiveness would be harmed by a stronger Yuan, and while we don't know how well the company might be prepared for such a development it should be noted that they do already have a warning in their annual report: "should the Renminbi appreciate against the U.S. dollar at that time, our financial position, the business of the company, and the price of our common stock may be harmed."

Those three stocks portrayed are just examples from their respective groups, I could have picked several others that fit into the same categories. Bottom line is: it might be wise to be at least partially exposed to the US-listed China Small Caps sector when the actual news of a Yuan revaluation hits the markets.