There are two kinds of Chinese stocks that trade on US markets - those that are listed through an IPO (initial public offering) and those that are listed through a reverse merger.
The companies that are listed through an IPO have the support of institutions and therefore enjoy great analyst coverage and support from the market. These stocks trade at earnings multiples in the double digits and some of them have reached the lofty heights north of 50 such as China Unicom. A stock with a price to earnings ratio north of 50 is a high flying momentum stock that has double to triple digit growth rates and are coveted by the analysts and the press. US examples would be Apple, Salesforce.com or Vmware. All are high fliers and all are trading at high multiples with Salesforce and Vmware at multiples in the 100's.
As a brief education a stock that trades at a price to earnings ratio of say 100 means that if earnings do not grow that it will take the company 100 years to produce earnings that match the stock price. Obviously the market does not believe that earnings will remain static. The large ratio is due to the market's expectations that earnings will grow at a rapid pace to bring that multiple down to a more reasonable number of say 15. Stocks with multiples like this are prone to big swings and if the company misses an earnings number the stock price typically will get cut in half.
On the other side of the scale are the companies that come to the US markets via way of a reverse merger. A reverse merger is a cheap way to go public. Essentially a company buys a "shell" company (one that has traded on the US market previously but has since ceased to exist) and then slowly works its way from the bulletin board to the big board. These companies come at very cheap multiples to earnings and can be found with exceptionally high growth rates. Some examples are China Education and China Media Express just to name a couple (both of which I hold a long position). Both of these stocks trade at seriously low multiples and, in the case of China Education, trade below cash value. How is this possible?
Well it comes down to trust. Both of these companies have recently been hammered with cyber smear. Cyber smear campaigns can occur at any moment. All they require is for someone to post a negative article about a company that is picked up by the investors and down goes the stock. Now this is where support from a big investment bank is critical. If the support is there, cyber smears are rare. Why? The chance of a cyber smear working on a stock that has a large analyst following is minimal as the smear campaign will garner little attention as investors trust that the Goldman's or Merrill analysts have done their homework and that this is a poor attempt by the shorts to drive a stock lower. Not so with a thinly traded stock. One negative report can drive a stock below cash value (as with China Education), or can cut it in half (as with China Media Express). Attempts by companies to quell investor concerns are normally met with skepticism and give the shorts ample time to exit their position.
To me this is part and parcel of investing in these types of Chinese stocks. As long as there is the inherent distrust in the numbers that are being presented by Chinese companies there will always be an opportunity for a short seller to profit from a random smear campaign. It is not if it will happen but more like when it will happen.
Investors in these stocks can do a number of things to profit from these stock movements. The first is to wait patiently for the smear campaign to happen and then buy once the dust settles. The second is to place protective put options on stocks that you own but this is expensive. The third and far more aggressive way is to sell put options with a strike price at or below the price that you would happily buy the stock. If that price is never met then you pocket the premium. Alternatively when the smear happens you then own the stock at the lower price. There are obviously a multiple of other ways to go, but the point is that there are ways to profit handsomely from these wild swings.
Before you blaze a trail into these bloody waters you had better do your homework. There have been a number of Chinese stocks that have turned out to be nothing more than a hoax, so make sure that the company has a reputable auditor. Furthermore you should make sure that the company exists. Check with reputable analysts and, if you still are unsure but love the stock, get on a plane and go and see for yourself. Finally try to find a company with a management team that protects shareholder value. This is tough as there certainly is a cultural difference. I am still waiting for China Education to eradicate the negative sentiment of the recent smear campaign. Until they prove their cash reserves this stock could languish for a while, but my research shows that the smear campaign is just that, but until the doubts are removed it could be a while for this to recover.
Be patient, do your homework and enjoy the ride!
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