China Finance: How to trade the short-seller bounce
Short sellers are a big part of the China equities picture, particularly the established short sellers who issue reports aiming to expose fraudulant companies.
The fear of a company being subject to a short report from players like Muddy Waters or Citron Research - with historically strong track records of uncovering fraudulent companies - has some investors running for the hills in order to stay clear of this perceived risk.
But looking at the recent track record of short reports, this worry might be a bit overblown.
While the past few reports have created some lasting effect on the companies' stock price, they have also created some very real opportunities for traders looking to go long - by trading the bounce that always seems to follow these reports.
Muddy Waters and Citron Research both specialise in China concept stock, and they have uncovered some major frauds. But the low-hanging fruit might now be all but gone, or the attacked companies have just gotten much better at defending themselves against the reports. At any rate, it looks like these short sellers are having issues finding targets where their accusations truly stick.
Muddy Waters big hit was obviously Sino-Forest (TSX: TRE.TO), after which they have released documents on Spreadtrum (NASDAQ: SPRD), Focus Media (NASDAQ: FMCN), Fushi Copperweld (NASDAQ: FSIN), and New Oriental Education (NYSE: EDU). During the same period, Citron issued reports on Harbin Electric (NASDAQ: HRBN), Qihoo 360 (NASDAQ: QIHU), and Evergrande Real Estate (HKSE: 3333.HK). Of these companies, although we see some real downward pressure from the accusations, the initial drop always seems extreme and short-lived. This is where we can find some real long opportunities, either just trading the bounce or looking to pick up cheap stock to hold for longer time frames.
The best play here seems to be to trade the bounce, which happens in all of these cases, even when the report sets off an overall downward trend. In the interest of saving some space here I will only present the graphs for three of the most famous of these companies, but we see the same scenario in all of the cases.
Firstly we can have a look at New Oriental, which has seen some real long term decline in price since the short report. This is more likely due to the fact that there is a SEC investigation regarding the company's VIE (Variable Investment Entity) structure currently going on than any long lasting concerns raised by the actual short report. But nonetheless we see a very tradeable bounce following the initial reaction to the short report, where the price increased 29% the very next day.
Moving on to FocusMedia, which has recently had a highly publicised offer to go private, we again see a prolonged downward ressure from the short position. But once again there's a good bounce for a 34% gain the next day. We also see a fairly reasonable second bounce here, which once again seems to be a common occurrance.
When we look at Qihoo 360 we find that the company's stock price has increased by a good margin since the short report was first published. It should be added that this is despite the fact that short sellers have published numerous reports on the company since the first one hit, which means that we see a lot more dips and bounces on this curve. I've marked out the drop and bounce associated with the first reports coming out. The bounce is a bit slower here as more pressure piled on, and the initial increase the day after the first report is a mere 3%, but if we look at the effect after the stock bottomed from the initial short pressure it increased by 21% in a matter of days.
Investors looking for short term opportunities will find a lot of them in this sector, as the pattern appears to hold quite well, but there's no shirking the fact that this is a high-risk endeavour. Although we can say that most of the recent short reports have largely misfired, there's certainly no guarantee that the next one won't be a new Sino Forest. But volatility is always tradeable, and few things lately have caused as much volatility and panic reactions from the market as short reports aimed at Chinese companies.
The key to this strategy will be largely beyond the numbers, however. The real edge is for the traders with enough knowledge about China to sort the good accusations from the bad, as they will be the ones able to spot the bottoms to buy in. But with a good amount of panic among US investors thrown in the mix, traders with a good understanding of market psychology could also do very well indeed.
I write 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.