Beware Chinese companies listed in the US: these firms, which commonly enter public ownership via reverse-mergers, are poor quality and they hide their faults by partnering with auditors and bankers of poor repute. This was the underlying message of an extensive article published by Barron’s on August 28. And the statistics cited appear to confirm as much. Chinese companies that have listed in the US through reverse-mergers – or reverse takeovers (RTOs) – have underperformed the Halter USX China Index by 75% over the last three years.
The article is worth reading for its analysis of certain stocks and explanation of the mechanism – and the usual suspects – that leads to RTOs. But it is not a fair reflection of the market. SinoSage contests that there are many strong Chinese companies to be found on US exchanges – some have got there via RTOs and some haven’t – and that it is wrong to discard the barrel because of a few rotten apples.
There several flaws in the Barron’s analysis that should be noted by investors.
First, inappropriate comparison. There are 349 Chinese RTO stocks trading on US exchanges – 77% on the over-the-counter bulletin board (OTCBB) and 81 that have since successfully transferred to the New York Stock Exchange (NYSE), NASDAQ or the American Stock Exchange (now integrated with NYSE). They range from penny stocks to mid-cap stocks. This sample base is problematic because OTCBB stocks are fundamentally different from those listed on the main boards in terms of scale, risk, trading volume and so on. It’s like comparing apples with oranges – and any conclusions drawn from this are liable to be inaccurate and misleading.
Second, incorrect measurement. Comparing the cumulative return of 349 RTO stocks against the Halter USX China Index is equally confusing. The Halter index is a composite of selected stocks listed on main boards, while most RTO stocks remain on the OTCBB. Companies trading on this exchange are by their very nature more risky and lower quality – in most cases they are at an early stage of their corporate lives – than those on the main boards. The fact that the sample base underperformed Halter by 75% over three years is therefore unsurprising.
Third, unilateral judgment. The very negative view on Chinese RTOs presented in the article is exaggerated and borders on aggressive. While there are inevitably some horror stories from the OTCBB and other boards, they are the exception rather than the rule. There are grounds, however, for saying that some Chinese mid-cap companies in the US could do more in terms of corporate transparency and investor relations.
As for how to draw more solid conclusions about Chinese RTOs, SinoSage looked exclusively into those companies that have graduated from the OTCBB to the main boards. It doesn’t offer a complete picture, but at least index comparisons are more meaningful.
Of all the 81 companies in question, 25 have consistently outperformed the Halter USX China Index and their relevant market indices (NASDAQ Composite or NYSE Composite) since making their main board debuts. Two have outperformed the Halter index only while another two have outperformed their market indices only.
Of the remainder, 37 have underperformed both benchmarks and 15 stocks did not exhibit a clear performance path.
Looking at the Halter USX China Index more closely, of the 33 stocks that have been trading less than three years, 10 have outperformed the index by an average of 46% (ranging from 1% to 131%). Of the 21 stocks that have been trading for three years or more, six have outperformed the index by an average of 66% (ranging from 19% to 136%).
The analysis clearly shows that 30% of all the Chinese RTO stocks listed on main boards have bettered the index and, as such, are worthy of investor consideration. Unfortunately the Barron’s article could easily be interpreted as a recommendation that they are to be dismissed out of hand.