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global investing

John Foxx

Sino Forest is the latest company to exemplify what is fast becoming a truism: if a company has Sino or China in its name and was listed abroad via a reverse takeover, shorting it might be a very profitable play.

The Toronto-listed forestry company plunged more than 20 per cent on Thursday following a highly critical research report. It suffered further falls of 66 per cent on Friday in early Toronto trading.

China MediaExpress Holdings, a company that places ads on buses, had its Nasdaq-listed stock halted in March after falling nearly 50 per cent in six weeks. China Agritech, also Nasdaq-listed, had lost more than 60 per cent since late last year before its shares were suspended.

Allegations of false accounting at these companies, which they have all denied, have been serious. Any suspension from trading shows that regulators believe there are questions that need to be answered.

But it is worth stepping back from specific allegations to consider the wider trend. The rush to bet against Chinese companies has an obvious parallel in the earlier rush to buy into them.

And, just as many valuations appear to have been unfounded on the way up, a valid question now is whether fast-falling valuations for some of the foreign-listed Chinese groups are equally unfounded.

Or, put another way, has a China bubble given way to an anti-China bubble?

The skepticism about Chinese companies listed in the U.S. has got to the point that Jim Chanos, the most prominent of the China bears around, said last month that it was getting hard to find such shares to short, so big are the positions already against them.

Reverse takeovers are a strange beast. The upshot is that Chinese companies with "plausible growth stories" are able to go public abroad by acquiring foreign shells that have essentially worthless shares trading on exchanges for micro-cap companies. As more investors pile in, the reverse-takeover company has a shot at graduating to a leading exchange.

A short while ago, investors were all too willing to suspend their disbelief about Chinese companies which gained listings in the U.S. through this financial alchemy.

A Bloomberg index tracking Chinese reverse takeovers more than tripled from March 2009 to January 2010. But the tide has most definitely turned, with the index down more than 50 per cent since then.

Curiously, what made investments in these Chinese companies alluring in the first place is the very same thing that makes short positions in them now look so compelling.

Separated by a continent, a language and a legal system, it is easy to tell good - or bad - stories about them that are hard to verify.

The answer, of course, is due diligence. Amid the current frenzy to sell Chinese small-caps, it is telling that at least some private equity firms think they see some bargains.

Bain Capital agreed two weeks ago to buy China Fire and Security, a Nasdaq-listed company whose shares had been in the doghouse. A private equity arm of Morgan Stanley invested $50-million (U.S.) this week in Yongye International, a Chinese agricultural nutrient company that had also suffered on Nasdaq under the weight of short sellers.

For those joining the stampede to bet against Chinese companies, the words of Homer Sun, managing director of Morgan Stanley Private Equity Asia, could prove cautionary: "After extensive due diligence, we believe Yongye to be an exceptional company," he said. Yongye's shares have soared since receiving Wall Street's stamp of approval.