The trials and tribulations of Chinese Micro Cap RTO’s have been widely publicized by CNBC, short sellers, and every other financial publication. Most of the scrutiny has been well founded. In a nutshell, a bunch of Chinese companies (fraudulent and real) went public through means of a reverse merger/reverse takeover (RTO) because it was the easiest, cheapest, and fastest means to an end ie: seeking capital from the US. Reverse mergers as a means of going public has been around for a few decades, and many well known companies have gone public via reverse RTO. In recent months, the RTO market has been decimated due to the wide spread panic surrounding multiple fraudulent China RTO’s. In Q2 2011, the number of reverse mergers completed was down by more than 50% from Q2 2010, and in real terms an amount not seen since 2003.
Just after the low in the markets in April 2009, China micro caps started catching bids in the market place. Most of the companies were trading for 2-3 PE’s, and over the next few months most were up 300-400-500%+. Now most of these Chinese RTOs were growing sales 100% year over year, and even after their stocks were up 500%, most still had a single digit PE’s. Everyone “sort of” knew the risks involved which is why the PE’s were so low in the first place. These low PE’s sort of acted like a built in risk premium for retail and institutions..besides if these were US based companies they would be selling at 50 PE’s. A few months later the first high profile Chinese micro-small cap came public with their accounting irregularity which was like yelling fire in a crowded room. Soon after, investigative shorts went after several others and the whole space was deemed guilty until proven innocent. China RTO’s were specifically targeted by shorts since it made sense a fraudulent company would go public via the quickest and cheapest way possible. So most of these companies went from trading at 2-3 PE in Q1 2009 to 10 PE in Q2-Q4 2010, and have now come back to 2-3 PE today.
Today, any fraction of confidence has left the China RTO’s. The shareholders that are left have a case of “battered wife syndrome”, almost numb to the countless short articles hitting the wires. I think as a whole the pendulum has swung far enough in one direction, and it is about to start coming back the other way. As a whole the longs holding a basket of names are probably right. Either the 2 PE Company they own goes to 0, or as the months and years tick by credibility is slowly seeded back into the investor base and they make multiples from today’s levels. Of fully reporting micro cap stocks, maybe 2-3% are outright frauds and maybe 8-10% of Chinese RTO micro caps are likely frauds. I have no proof to back up these numbers, but it probably isn’t too far off.
It’s currently easy (way too easy) to manipulate and yell fire in a crowded room to make a quick buck. Some of the companies deserve it, but most of them likely do not deserve to be as low as they are. I wait for the day that some financial analyst/reporter will grow some balls and seek out to prove innocent some of these Chinese stocks. Over 90% of the companies are probably real, but they trade like 90% of them aren’t. There is an opportunity here, but who is willing to make the first step. It isn’t me. I hate flying, and I don’t speak Mandarin.