Chinese Pump and Dump

Addison Wiggin – May 13, 2011

  • Deception, delisting, and death threats… surviving the thicket of Chinese "reverse mergers" on the Nasdaq
  • "Simply incredible" accounting fraud at a few bad-apple Chinese firms… and how it's spoiling the rest of the barrel… we'll tell you which ones to buy
  • "Transitory" inflation claims ring hollow with new U.S. CPI figures… either the phony or the real ones
  • How you can score a 26,900% return in 58 days!… and more. Readers share survival tips when your hosts ply you with baijiu in Beijing

From an undisclosed location in Asia, Carson Block is making a lot of enemies. He and his family have become targets.

"Are you," reads one email he's received, "Kathy [the Mrs.] and your dad ready for a bullet?"

That's a bit harsh, right? We thought the same until we heard the vengeance with which journalists, businessmen and publishers we've met with this week have spoken about the man.

Mr. Block's crime? He blew the whistle on RINO International Corp., a Chinese "green tech" company listed on the Nasdaq.

Block is still alive… and RINO is now delisted. After Block's report, RINO's auditors found, in the dry and cautious language of auditors, "flaws."

RINO shares fell 96% between October and December.

Block's outfit, Muddy Waters Research, makes a habit of calling BS on such firms. He called China MediaExpress — which slaps advertising on the side of city buses here — "a pump-and-dump scheme."

Soon after, in March, its auditor cut the firm loose, its CFO resigned and Nasdaq halted trading after it fell 47% in four days.

So it goes in the wild-and-wooly world of "reverse mergers" — a technique many Chinese companies use to raise capital.

Here's how it works: A private company buys enough shares of a public company to become publicly traded. It's a lot cheaper to get on an exchange this way than via the traditional IPO route. Less red tape, too.

More than 600 companies got onto U.S exchanges via reverse merger between January 2007 and March 2010 — 159 of them were from the China region — with a total market cap of $12.8 billion.

Many are legit. But those that aren't have cost investors $34 billion over the last five years, according to a study by TheStreet.

"The modus operandi by these stock promoters is to find what the hot area for retail investors is," says James Chanos — the guy who blew the whistle on Enron and today is one of the most notorious China bears. "So 15 year ago, it would have been the dot-coms, a bunch of years ago oil and gas and now it is China."

This year, the market is littered with stories like these. In addition to the two blowups cited above, Nasdaq has halted trading in these Chinese firms during the last two months…

  • China Agritech
  • China Century Dragon Media
  • China Intelligent Lighting and Electronics
  • China Electric Motor
  • NIVS IntelliMedia Technology Group
  • China Ritar Power
  • Duoyuan Global Water
  • China Integrated Energy

Are they all bogus?

Some undoubtedly are. At the very least, when your own auditor starts looking into "allegations that the company may have issued materially inaccurate financial statements to the investing public" — as in the case of Duoyuan Global Water — it's not a good sign.

The problem now is the scammy companies are giving good companies a bad name.

Here, China's government has to shoulder some of the blame. It's a lot easier to list on the Nasdaq via reverse merger than to jump through the Chinese government's hoops to list on a Chinese exchange.

"It makes no sense for Chinese companies to have to go halfway around the world to get capital," says Paul Gillis, an accounting professor at Peking University.

So rightly or wrongly, Chinese companies are quickly acquiring a bad reputation.

This isn't helping matters…

Shares in Yahoo have tumbled 13% this week — and today it's the most-actively traded share on the Nasdaq — thanks to its dealings with the Chinese e-commerce firm Alibaba Group Holding.

Yahoo holds a 40% stake in Alibaba. It made this significant investment because of Alibaba's plum holding, an online payment business called Alipay. In other words, a major Asian competitor of PayPal's.

Sounds good… until news got out on Wednesday that Alipay had been "restructured" so that 100% of its shares were held by a Chinese domestic company majority owned by Alibaba's CEO.

Forbes reported Alibaba did this to "expedite obtaining an essential regulatory license." Yahoo's response: Gee, wish someone would've said something to the Alibaba board, on which we hold a seat.

Today, Alibaba said the board was, indeed, notified about this… in July 2009.

We have no idea who's to blame here… but the whole issue casts a further pall over the idea that Americans can get wealthy investing in China.

"Yahoo's experience with Alibaba," writes Strategic Short Report's Dan Amoss, "reflects the pitfalls of doing business in China. Corruption is becoming a major problem, and it's only going to get worse in China as the supply of money and credit continues to grow rapidly.

"The Chinese economy is already suffering from a key pitfall of central planning: shocking gluts in certain sectors (high-rise buildings) and acute shortages in others (food and energy). There is every reason to suspect that the balance sheets and income statements at other Chinese companies — especially banks — don't accurately reflect reality.

"Over the longer term, it remains to be seen if China's leadership would allow a destabilizing restructuring of its bad loans. But for now, it's choosing to support its real estate bubble on the backs of the Chinese middle class: by steadily debasing its currency."

Consumer prices in the U.S. rose 0.4% last month, according to the ass-calloused figures from the Bureau of Labor Statistics (BLS). Half the increase was driven by gasoline.

Over the last 12 months CPI is up 3.2% — rather more than the Federal Reserve's 2% comfort zone. Ben Bernanke's line about rising prices being "transitory" is starting to ring a little hollow.

Looking at the CPI figure the way it was calculated back when Billy Carter was embarrassing his brother in the White House, prices have risen 10.7% from a year ago.

Stocks are giving up some of yesterday's gains, traders evidently unimpressed that David Gilmour and Nick Mason joined up with Roger Waters last night in London to perform a couple of tunes from The Wall… only their second time since 1985.

The S&P sits right at 1,344. That was its February high, and the number around which the index has oscillated much of this week.

Gold is holding steady a notch above $1,500, the spot price $1,505 at last check. Silver has firmed a bit to $35.16.

"There are warning signs that Brazil's boom needs a breather," writes Chris Mayer of a BRIC country he visited last fall.

"In the four-month period beginning on Dec. 20, 1994, the Mexican peso lost 50% of its value. Some wag dubbed it the Tequila Crisis." Chris doesn't see anything so severe for Brazil, but he does say it's due for a "caipirinha crisis" — the caipirinha being the national cocktail.

"Brazil's boom is fueled in part by the free flow of credit. The debt service burden on consumers is very heavy. Brazilians pay high interest rates. And per capita incomes are still low.

"Prices are also rising. While I was there last fall, I was surprised how expensive things were. Your stay at a Marriott Renaissance hotel in Sao Paulo costs 50% more than at a Marriott Renaissance in Manhattan."

Too, the World Bank ranks Brazil ranks 127th out of 183 countries in its "ease of doing business" survey.

It's true that Brazil is now among the cheapest of the large emerging markets. "The price-to-earnings ratio based on earnings forecast for the next 12 months is only 9.5. This compares pretty favorably with Mexico and the MSCI Emerging Markets Index."

"The Brazilian market has traded sideways for almost two years now. Combine that with rising earnings and the market just keeps getting cheaper. A Caipirinha Crisis would likely make them all cheaper still."

Chris is keeping his powder dry for that possibility. In the meantime, he still has two junior gold stocks on a very short buy list. One is still under $2… on its way to $27. You can learn about both, and secure half-price membership in Chris' premium advisory, Mayer's Special Situationsbut only through this weekend.

A few months back, on Feb. 9, Somali pirates pulled off the seemingly impossible — seizing the Irene SL, a supertanker carrying 2 million barrels of crude.

Turns out it wasn't the crude they wanted.

"Instead," reports the Robert Young Pelton in BusinessWeek, "they used the 1,000-foot-long tanker as a destroyer-class warship." Basically, they pulled up alongside freighters and opened fire from high atop the tanker's hull.

"Screw the oil… We've got a world-class pirate ship!"

This went on for 58 days until the Irene's owners forked over $13.5 million to the pirates.

"That two-month investment," Pelton writes, "netted them a 26,900% return on estimated expenses of $50,000." That's a return worthy of one of our promotional headlines.

But… there's always a but… that's an unusually high payout. Still, even the typical pirate job is better than a ten-bagger — a $300,000 investment for a $4 million ransom.

"Expenses break down as follows: weapons and ammo ($2,000); skiffs and outboards ($14,000); grappling hooks and curved ladders ($1,200); GPS and radios ($4,000); food ($70,000); miscellaneous equipment ($30,000); bribes ($180,000)."

"There must be some truth to the stories about how the pirates have moles within the world shipping and insurance community," Byron King wrote at the time of the Irene's hijacking, "identifying potential targets, cargo load, time of passage, course and speed."

Now It's a growth industry.

Today, "more than 480 people are being held hostage on more than four dozen ships in Somali waters," writes Pelton, "all awaiting ransom and rescue" as their captors await their pay.

"I entered China back in 1981," writes a reader enamored of our early experience drinking baijiu, "with a group of investment people when most Americans didn't know China even existed. Great experience, I may add, but the highlight was one night in a fine dining restaurant with our guide in tow…

"Back then, you went nowhere without your guide, and ours was a very nice, intelligent young man. Great roasted pig was on the table. One of the best dinners I have ever had.

"So as dumb Americans we connived and planned and got our guide drunk as a skunk on baijiu. Boy, talk about white lightning. We didn't see him again that night. Last we saw, he hadn't gotten in trouble. We did bid him salud a few days later after his hangover ended.

"I might mention we were on our own the rest of the night while our guide slept and we partied and danced all over town."

"Here is a survival lesson for those gan bei (bottoms up) sessions at dinner.

"The host and fellow colleagues will toast the Westerners around and around until someone falls off the chair, and then its over for all and the Chinese declare another victory and victim.

"My strategy after being a victim one time too many was to graciously receive the toast of the host. My response was then to take the empty glass, the cute girl serving the Maotai, head to the host, get him on his feet and toast him directly… down the hatch.

"He then, by culture, must respond with another toast to me (all others are cut out this time I am standing next to the host), and thereafter there are a series of quick one-on-one toasts until one of us calls it quits.

"I always survived with the host giving the final toast and declaring the party over… heh, another one in the bag… my bag. I usually had sufficient time to make it back to the privacy of my hotel for a looong talk with the Great White Telephone.

"Cheers, and enjoy China. I always do."

The 5: At the very least, we've picked up another instance of government hubris gone awry. You may recall the good ship Vasa from Stockholm on April 19. Well, these buildings are just outside my window in the hotel here in Beijing:

The one just behind the funky L-shaped structure is being rebuilt right now. Last year when we were here, it was just a tall, crispy husk.

Together, the buildings make up the campus of the state-owned China Central Television — CCTV. On the eve of the grand opening of these buildings, the company ignored city regulations against such a thing and hosted a fireworks show from the top of the shorter building.

Given the fact the entire husk is being replaced two years later, can you guess what happened next? Yeah, the fireworks ignited some chemical on the exterior of the glass… et voila… a celebration the likes of which the crowd in the street below could never have anticipated.

Have a good weekend,

Addison Wiggin
The 5 Min. Forecast

P.S. "I think the time is right," our friend Ron Paul said today on Good Morning America, finally making his run for president official. "Coming in No. 1 in the Republican primary is an absolute possibility — many, many times better than it was four years ago."

Even if he doesn't make it, he will once again be an agent of change. Dr. Paul can take the lion's share of the credit for making skepticism of the Federal Reserve downright fashionable these days. Were it not for the consciousness raising he performed during his last run four years ago, Ben Bernanke wouldn't feel the need to give regular press conferences to create the illusion of transparency.

One of his key awareness-building tools this time around is his new book, Liberty Defined — with 50 bite-size essays covering just about every major topic under the sun. Even if you think you know what Ron Paul's all about, you're bound to learn something new in this dandy volume. Get yours from Laissez Faire Books right now for 20% off.

P.P.S. If you missed it, Saturday evening in Shanghai, we're hosting a cocktail reception with Bill Bonner. Let us know if you'd like to join us… or even know someone whom you'd like to force from a long distance to come and have a good time.


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