This article could be a book if it were truly to be as in depth as it should be, but I will try and cover some of the main points in this short article. The area of Chinese small caps that trade in the U.S. Is very intriguing yet filled with danger at the same time. There has been a lot written about them and investors have been quite vocal on both sides of the aisle. There is a lot of money at stake here, so let’s discuss what is happening.
Fraud Or Not?
To put it bluntly, many bloggers, analysts,and investors think that several, if not a vast majority of these companies are outright frauds that are lying about their revenues, profits, and contracts. These companies came to be listed on the U.S. exchanges by way of something called a reverse merger. This alone has caused many to believe that there are poor corporate governance practices going on. But are they frauds? Not necessarily.
Investors have been shooting first and asking questions later with regard to these stocks. The case of China MediaExpress (CCME) is a great example. The stock soared to around $24 a few weeks ago, only to crash to $11 after a report by a firm called Citron Research questioned the validity of the company. Investors are so scared of fraud allegations that the mere mention of it was enough to crater the stock in half. It may turn out that CCME is a perfectly legit company, but try telling that to the person that bought at $24. The company put out a few press releases challenging the claims, but that provided no more than a tepid bounce.
I wrote about a small cap that I loved called China Marine Food Group (CMFO) a while ago, but I underestimated the dark cloud that was hovering over almost every stock in this group. This is one reason the p/e multiples are so ridiculously low for these stocks. Investors are almost pricing in that they are frauds. For example, CMFO is trading at less than 4x forward earnings, and slightly below book value. This is for a company that is supposedly growing 20-30% per year. As you guessed, there have been allegations against the company that it is a fraud, so until that clears up, it is unlikely to go much higher.
So What Should You Do?
If you want to venture into this space, make sure to only do it with your risk capital. Don’t make any of these stocks your core holdings. Even if the company is legit, the suspicion of fraud by any random blogger can crush the stock. Sometimes the bloggers themselves have short positions in the stocks they are writing about, so keep an eye on that.
Another thing to keep in mind is who the auditor for the company is. Stick with firms that have Big 4 auditors looking over the books. These big auditors have credibility and it is tough to get away with cooking the books if they are looking over their shoulders. There are several stocks that do retain Big 4 auditors.
Lastly, do your own due diligence. If there is something that seems too good to be true coming from the company then it probably is. Try and see if anybody has visited its factories and posted something on the internet about it. These days, many of these companies are receiving random visits from interested investors. I have a feeling that huge gains lie ahead if and when the dark cloud of fraud is lifted from these stocks. However, be careful not to step on a landmine.
Chinese Small Caps: Goldmines or Landmines? is an article from: 
