Here at Hoover’s we maintain profiles for all the companies that trade on the two major US stock exchanges, the NASDAQ and the NYSE. (There are about 2,700 companies on the NASDAQ and 2,300 on the NYSE.) Earlier this year we noticed we were lacking coverage for about 150 smaller companies that were now trading but hadn’t filed an S-1, the form used to register with the US Securities and Exchange Commission.
These small-cap companies were either already trading as penny stocks on the over-the-counter (OTC) market or merged with a blank check company that already reports its non-existent operations to the SEC. And their requests for capital were small, with the companies seeking to raise less than $5 million on average for their initial stock offering.
We noticed A LOT of these companies were Chinese, even the ones that filed a traditional S-1 in the past year. According to our own IPO Central, out of the 115-or-so companies that filed to go public in 2010, maybe a dozen were Chinese. Out of the 150 we missed, however, about 35% were Chinese. The overwhelming majority of companies that file to go public in the US are American, save for the handful of companies that move their headquarters to tax-friendly locales such as the Cayman Islands or Luxembourg.
Apparently other media outlets, including the Wall Street Journal, Barron’s, and TheStreet.com, noticed the plethora of Chinese IPOs. Why were all these Chinese companies suddenly taking advantage of the US capital markets? (Besides the obvious, of course, that China’s economy is growing and their stock exchanges hardly bring to mind the idea of a free market.)
Many of them used what is known as a reverse merger or a reverse takeover, when a private company buys a publicly owned shell company. These public companies are called “blank check” (and usually have “Acquisition Corp.” in their name) because they formed in the US with the specific intent to buy another company in order to become operational. So these Chinese companies have been buying US-based blank check companies in reverse mergers and changing the names to their own. Which is fine; there’s nothing out of the ordinary about a reverse merger. But now some of these companies are being investigated by the SEC for allegedly fraudulent practices.
Who wants to invest in a company under investigation? What’s the real draw of a penny stock for the average investor, anyway? You’ve got a cheap stock in a high-growth economy, which sounds promising in the short term (because we know that all bubbles must eventually burst). According to an August article by Barron’s, the market cap for these stocks has shrunk by 60%. Using the Halter USX China Index, Barron’s noted that “the most seasoned 158 China reverse mergers shows that in the first three years of each stock’s trading, the median among them underperformed by a dismal 75%.”
So like anything else made in China, be prepared to get what you pay for.