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Worthless Stocks from China
By Dune Lawrence
Oxstones Investment Club™ The New Silk Road

When a retiree in Texas discovered that some Chinese companies listed in the U.S. are frauds, he unleashed an army of short-sellers.

On an April afternoon, in his home office outside Austin, Tex., John Bird was hunched over his computer trying to figure out if a Chinese company some 6,500 miles away was anything close to what it claimed to be.

Some things, however, Bird takes very seriously, including what he calls the “sanctity of math,” which on that afternoon was being defiled in his eyes by the claims of China Sky One Medical (CSKI), a maker of products such as “magnetizing” hemorrhoid ointments and patches that would “dispel fat.” Sky One, according to its annual report filed just a few days earlier, was selling out of its inventory every seven days.

They’re turning their inventory over faster than a doughnut shop, thought Bird. Or, as he later put it, “It’s like somebody telling you they just drove over here at 600 miles per hour. It’s not going to happen.”

Sky One, Bird would find, wasn’t the only stock recently arrived from China. Sky One, which declined to comment for this story, is one of more than 350 small Chinese companies to have listed in the U.S. since 2004 through a process called a reverse merger, in which an operating Chinese company takes over an all-but-defunct publicly traded U.S. shell company.

The capital at stake is significant. Shares of such reverse mergers are held by many funds available to retail investors, including Oppenheimer Main Street Small Cap Fund (OPMSX) and the PowerShares Golden Dragon Halter USX China Portfolio, and are scooped up by small-cap index funds.

It came up with a list of 94 companies with market capitalizations of between $50 million and $1 billion that trade an average of at least 50,000 shares daily, with a total stock market value of more than $20 billion.

Bird’s involvement would evolve from irritation that a company could get away with making a claim that so obviously defies basic business logic to the conviction that many pieces of the Chinese miracle that trade in the U.S. are, in his words, “flat-ass” frauds.

And what started as a retiree looking into a company has drawn in the Securities and Exchange Commission, auditors, and, according to recent reports, the U.S. House Committee on Financial Services.

Although the stocks trade on U.S. exchanges, and thus project a sense of having to play by American rules, the assets and the principals of many of the companies reside in China. The companies operate on their terms, leaving injured parties and the SEC powerless. Bird says the carnage is just beginning. “The whole thing has no place to go but to blow up,” he says. “That’s a rational position for an investor to start with, that every one of these Chinese reverse mergers is a fraud.”

“As these companies are scrutinized, investors will uncover the facts behind the ‘Chinese Curtain,’ ” Kaplan wrote in a Dec. 3 report. “Many of these stocks may prove to be valueless.”
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Lawrence is a reporter for Bloomberg News.
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