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Article / 23 September 2012 at 18:13 GMT

China Finance: How to trade the short-seller bounce

Founder / ChinaRAI
China

China short sellers

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.

The stock fell off a cliff when the short repor hit, but lasting effects are more likely due to SEC VIE investigation

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.

 Focus Media bounced 34% the da after the short report hit

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.

Qihoo 360 has been under some overwhelming short pressure but has still managed to come out on top

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.

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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

5y
nana Wan nana Wan
Without help of the SEC and the OSC, Muddy Waters etc couldn't have done the huge damage to the Chinese companies. Look what the OSC has done in the Sino-forest case:

The OSC did not know that China had a policy of not issuing the certificates to foreign invested forestry companies and said:"absence (of certificates) is per se evidence of fraud."

Furthermore, the OSC denies the validity of confirmations issued by the Chinese forestry bureaus, reasoning in the SOA that "certain PRC forestry bureau employees obtained gifts and cash payments from Suppliers of Sino-Forest,further undermining the value of the Confirmations as evidence of ownership."

The OSC's lacking of trust of or effective communication with the Chinese government has led to a situation that there is no way to prove the ownership of Sino-forest's forestry assets in China, and thus the resignation of the auditor (E&Y), and the consequent delisting of the company's stock from the Toronto Stock Exchange.
5y
nana Wan nana Wan
The Independent Committee, established by the Board of Sino-forest immediately following the release by Muddy Waters of the MW report, disproves allegation made in the MW report that Sino-forest is a fraud, and verified the firm's cash balances and confirmed registered title or contractual rights to timber assets. Forestry Experts have also physically inspected the timber.

The OSC's lacking of trust of or effective communication with the Chinese government also led to uncertainty and difficulty for the sale of the company and estimate of the value of Sino-forest's forestry assets. According to the FTI Consulting, the Monitor appointed by the CCAA court, "to complete any meaningful amount of verification could take years, at a minimum."

If the current Restructuring Plan is approved, it will be just like the media reported,"Sino-forest's assets far exceed its liabilities, but shareholders are likely to end up with nothing..."
5y
Fredrik Oqvist Fredrik Oqvist
I think you have some very good points here about the lack of communication and trust between these countries and China in general. I also suspect this plays a large part in creating the over-reaction to these types of news that create these sometimes extreme bounces.

That being said, the reports from the Sino-forest IC certainly didn't exonerate the company, and one of the major other issues raised was the company's corporate structure.
5y
nana Wan nana Wan
I appreciate your very objective views on the Sino-forest case. Such objectiveness has rarely been seen in the entire crisis of China-concept-stocks.

The system of China has been continuing changing, from a completely communist to the present who-knows-what-it-is. Sino-forest's corporate structure, the lacking of certificates and many other problems are part of the system failure.

The short-sellers fabricated the story of fraudulent activities based on the phenomena which are difficult to understand by Western people. The OSC is wrong because it believes the short-sellers' story. We shareholders of Sino-forest will lose all investments due to the mistake made by the OSC.

The most important thing for shareholders is: does Sino-forest legally own the timber assets it claimed to own in China? If the answer is yes, then shareholders should get the money they deserve.
5y
Fredrik Oqvist Fredrik Oqvist
Thank you, I do try to keep my emotions on the sidelines when it comes to investment and analysis.

I think one of the major problems that Sino-forest didn't manage to address well enough was the issue of ownership. Here I'm not referring just to the confirmation of the timber holdings, but to the whole structure of ownership set up for the PRC part of the business. In my mind the company and their legal counsel made a mistake here as they neglected to include a WFOE to tie all of their contractual relationships together.

This would have made the arrangement akin to a VIE structure, but as this is lacking the company faces a problem: without a WFOE you are not allowed to conduct business activities within China. Which means they must, at least on some level, answer the question of how they maintained and benefited from these holdings without conducting any business activities.

I think overall the debate has lacked a bit of clarity from both sides though.
5y
nana Wan nana Wan
I have read your wonderful post of the research on the VIE structure. Experts like you are the persons the OSC should have referred to, and we shareholders highly appreciate your help for the communication between the regulators, the company and the governments.

If you google "sino-forest corporate org chart pdf", you can find a PDF file of the Corporate Organization Chart of SFC. It is relative complicated, but I can see that the SFC Canada controls the BVIs and BIVs controls the WFOEs. Could you explain a little more why this structure raised issues and how the company could prove its innocence or the OSC can allege fraud of the company due to the corporate structure alone?
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