China Finance: Time to start piling back into Chinese stocks?

• Chinese mid and small-cap companies are cheap, largely on fears of fraud
• But short-sellers have stopped targeting China firms, so a rally is possible
• Despite China economic troubles, stocks may revert towards true valuation
• Some Chinese companies could increase in price by 3x or more

Chinese small- and mid-cap companies are cheap. Everyone knows they are cheap, but the suspicion is always that they're not being upfront and that any one of them could be the target for a new short report that will send the stock crashing, as I described in my earlier article, How to Trade the Short-Seller Bounce.

However, there are now signs that the short sellers are moving away from these targets, which means we could see a massive rally back to valuations actually based on the numbers they're reporting. If this happens many of these companies should increase in value by 3X or more.

This might seem a weird proposition considering China's economic troubles, which most people agree will start coming into play for real once we're past the leadership-transition economic-padding package. But it's not quite as crazy as it sounds, because many Chinese companies aren't currently valued by economic performance or future outlook. They're valued by perceived fraud risk.

That's why we're seeing some quite frankly absolutely ridiculous valuations especially within the China small-cap space.

A few things have happened that makes me think we might finally see some light at the end of this China fraud tunnel. First,  let's be clear about one thing: there have been a lot of fraudulent Chinese companies on the US exchanges. I'm not saying that investors don't have a right to be worried. But I'm suggesting that we're likely to see far fewer companies exposed as fraudulent, and as a result China stocks are by and large undervalued at present. Let's have a look at a few indicators that we might see an upswing.

Short sellers are opting out

When even the notorious Carson Block, owner and founder of short sellers Muddy Waters, said in an interview with Caijing that he was now looking elsewhere for short positions, you know the tide is starting to turn. Further, if we look at Citron Research's last few reports they have all been targeting American companies. But what was it that forced this change?

If you ask the short sellers themselves, then it's the poor availability of information in China that's the problem, and there is some merit to this argument. Access to the commonly used SAIC (State Administration for Industry and Commerce) files for private companies in China has been restricted. The SAIC files reflect what the company is telling the Chinese government about their business, and discrepencies between these and SEC filings in terms of turnover and income has often been used as a red flag for potential fraud. Further, there have been some worrying signs of crackdowns against the people performing on-the-ground short research. In other words, without the ability to conduct research, it's harder to determine which companies might be fraudulent and suitable short targets.

But while this is certainly a problem for the short sellers, these factors aren't new. They have been around for a while now and short reports have kept on coming. I think the reason they short sellers are now turning their interest elsewhere might be a bit simpler than the poor availability of information: I think it is a business decision. The short sellers haven't been very successful of late: some of their latest reports have failed to make any meaningful lasting impact. In fact, more often than not the companies involved have been able to refute all of the claims made against them.

It has even gotten to the point where Citron Research is now being sued, not only by Qihoo 360 for maing false accusations, but also by Mr. Kai-Fu Lee for making baseless accusations against him personally when he spoke up on Qihoo 360's behalf.

Companies are going private

Going private transactions are also on the rise, something which is a pretty good measure for undervaluation. There's a fairly strong trend of Chinese companies going private from the US exchanges in order to relist elsewhere where they think investors will be less likely to react so rashly to short reports, and where the companies will carry a higher value.  Two high profile offers that we have seen recently are Focus Media (NASDAQ FMCN), and 7 Days Group (NYSE: SVN).

This type of sentiment certainly doesn't prove that all Chinese stocks are undervalued, but it lends credence to the hypothesis that many of them are, and looking at some of the valuations we've seen it's very hard to argue otherwise.

Accounting compromise

One of the major issues for Chinese stocks has been accounting, and the fact that investors feel they cannot trust the numbers, as I wrote in Worried about stock fraud?  Look at the audtiors. Part of this has been a result of the fact that the PCAOB (the Public Company Accounting Oversight Board) has been prevented from actually performing their role of "auditing the auditors" in China because the CSRC (China Securities Regulatory Commisson) has seen it as their territory. Now, however, a compromise has been reached that will allow the PCAOB to observe the CSRC investigations in order to satisfy themselves that the audits are being performed in a satisfactory manner. While this isn't the same as having their own inspections, it will almost certainly mean that the PCAOB will "kick the can" on their deadline for inspecting Chinese auditors, which was at the end of this year.

So two things will happen from this, there won't be an auditor apocolypse where the PCAOB kicks out all Chinese auditors and no one can file any audited financials from China at all (which was never very likely, but nonetheless widely speculated about in the media), and the PCAOB will be on the ground to put some pressure on the accountants. All in all, I say this is a good victory for trustworthy accounts from China, and hopefully it'll help drive trust back into the market.

Conclusions

As we're starting to see some signs of a turn in the fortunes of smaller Chinese companies, we can finally start spculating that the timing might be right to start looking at taking some positions in these companies. The holding time is still likely to be quite long and it will be a rollercoaster ride upwards, but as the short sellers start opting out and the next batch of financials coming out will have been done under the eye of the PCAOB, so two of the major risk elements involved will be severly lessened.

This opportunity, while admittedly very tempting, is not for people who want to make a quick buck though. It's very hard to determine how quickly market sentiment will turn, and without good due diligence on the ground you do still run the risk of hitting a few duds. So getting in now is for the comitted investor who's looking to stay the course and has the capital available to hold the stocks for what is likely to be a significant time frame.

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Fredrik Oqvist writes regularly about Chinese equities, mainly those listed on foreign exchanges. If you'd like to comment on this story or be notified by email whenever a new China Finance story is published, become a member - it's free, and you can use your Twitter, Facebook, Google or LinkedIn login - and "follow" the China Finance blog during the signup process. You can also bookmark the China Finance blog page.