China's GDP (gross domestic product) in 2010 was reported to be around 10%. In 2010, China surpassed Japan to become the world's second largest economy. In 2011, China's GDP growth is estimated to remain around or above 10%. With this past and projected rapid economic growth, investors are looking for opportunities in the stocks of Chinese companies.
Presently, the stock valuations of many small Chinese companies look very attractive and the financial fundamentals appear strong. Although many of these companies are not covered by analysts, quite a few of those that are have a buy or a strong buy rating.
While the stock of some of these small Chinese companies looks like a potentially good opportunity to cash-in on China's continued projected growth, prior and recent allegations of fraud, accounting discrepancies, and deceptive financial reporting against certain of these companies, including Orient Paper (ONP), China Sky One Medical (CSKI) and China MediaExpress Holdings (CCME), have caused fear and uncertainty about investing in the Chinese RTO market and quite a bit of volatility in not only the stock of the targeted companies but of other China RTOs.
What exactly is an RTO? An "RTO" is a "reverse takeover" and is also known as or sometimes called a "reverse merger" or a "reverse IPO" and refers to a type of merger that is used by a private company to quickly become publicly traded on one of the stock exchanges without having to go through the expense or financial scrutiny that is normally involved or associated with an IPO (Initial Public Offering).
This is achieved by the private company (in this case a small Chinese company or "X") initially buying enough controlling shares of an already listed and publicly traded company or "Y". The X company's shareholder(s) then trade their shares held in the X company for shares of the Y company and, thereby, the X company then effectively becomes the publicly traded Y company.
The problem with this for investors is, of course, that X becomes the publicly traded Y without having to go through the expensive and tedious independent third-party audit nor disclose its financial records and information to the SEC or to prospective shareholders prior to publicly selling its stock on an exchange. Reportedly, some X companies, having become the Y company, then hire and pay a supposedly independent, unbiased research firm or outfit for favorable coverage in an effort to generate public interest in and demand for the stock.
It is estimated that over 350 small Chinese companies have used the reverse takeover, reverse merger or reverse IPO as a "back door" to quickly and inexpensively get listed as a public trading company. While some of these companies may, indeed, be guilty of fraud and deception with respect to accounting discrepancies, financial reporting or other improprieties, others may be perfectly legitimate but are suspect (and their low stock valuations reflect this) due to the concept of guilt by association.
Are all China RTOs suspect? The prudent and cautious initial answer is probably "yes". However, one also needs to know who is making these allegations against a particular company. In many cases, the persons or entities who have accused the targeted Chinese RTO hold substantial short positions in that targeted company. Once an accusation is made, the market response, borne out of fear and uncertainty, will likely trigger a massive sell-off of the stock of the targeted company. When the massive sell off is triggered, the accusers (short sellers) make huge profits.
As is the case with an investment in any stock, exchange trade fund or other security, it is up to the individual investor to do his or her due diligence and evaluate the risks. In the case of the China RTOs, it is even more critical, in fact it is mandatory that the individual investor takes the extra time and effort to thoroughly understand all of the facts surrounding the China RTO market and extensively research the stock of a particular Chinese RTO.
An excellent article on SeekingAlpha.com, describing some red flags for Chinese RTO stock investors to look for, is just one of many good starting points.
Good luck and happy and safe trading!
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