Walking into a Buzz Saw on CNBC’s Strategy Session

Sensationalism, Hyperbole and My Experience with David Faber, Herb Greenberg and Gary Kaminsky

I want to thank CNBC for giving me the royal treatment last Tuesday before my appearance on the Strategy Session.  They sent a limo to my hotel to pick me up, assigned a producer to me to help me understand the format and process for the interview, gave me coffee and doughnuts before the show, and a facial by one of their expert cosmetologists. I also met the CEO of CNBC, Mark Hoffman, on my way into the building.  He was quite pleasant and even held the door open for me.  CNBC is a first-class organization.

Having said this, I must admit I did not realize that I would be walking into a buzz saw on the Strategy Session.  The discussion unfortunately did not reach the level of discourse I had hoped for, and it lacked civility from the beginning.

However, I understand, as do the producers of the show, that letting Herb Greenberg attack RedChip and malign an entire asset class, smaller-cap Chinese stocks, made for good TV.  TV is an entertainment format, and viewers generally like blood.  Well, as you saw if you watched the debate, there was plenty of blood.

The hosts used a variety of pejorative terms to describe the China Reverse Merger space, and this alone should have given viewers a moment of pause.  The bias displayed against companies whose holders include such institutions as Blackrock, Prudential, Morgan Stanley, Goldman Sachs,  and Deutsche Bank, stocks like L&L Energy, which is trailing $186.3 million in revenue and $45.0 million in net income, Longwei Petroleum, Puda Coal,  Zhongpin, China Information Security Technology and many other China reverse merger stocks, all very profitable and generating hundreds of millions in revenue, was the first clue that my hosts were not interested in a fair and balanced discussion.

For Faber to actually question whether LLEN owns and operates mines in China was, as they say in show business, “off the charts” in terms of irresponsible journalism. I will say again as I said on their show, that Greenberg and Faber, despite their fifty combined years of journalism, have never visited the operations or management of even one of the 300+ companies they slandered.  Their reporting of events without any first-hand knowledge may make for good TV, but it makes for very poor journalism.  How do you smear hundreds of companies, many listed on the NASDAQ, AMEX, and NYSE and character assassinate the CEOs who run them, without having ever seen their operations or spoken to them, and maintain a modicum of credibility? It is apropos to quote the poet, Alexander Pope here, “A little learning is a dangerous thing.”

One stock broker at Oppenheimer, who has followed RedChip for years, called me and said:  “I have never seen anything like this in my thirty years as a broker.  It was the most unprofessional conduct by Greenberg and Faber that I have seen.  They did not give you a chance to speak, they kept cutting you off.  It was disgusting.”  I also received emails from viewers who had never heard of RedChip congratulating me for standing my ground against what they viewed as a “hatchet job.”  I also have my critics.  There are times I could have responded in a kinder and more gentle tone, and there is certainly much I should have said that I did not.

With the sensationalism and hyperbole in Greenberg’s dramatic opening statement, calling China RMs “penny stocks on steroids” and questioning the legitimacy of RedChip’s company-sponsored  research, you would think that I and the Chinese businessmen that run these companies had committed high treason against U.S. investors.  What Greenberg and Faber did not tell their viewers is that RedChip has been writing research for 18 years, that many of our analysts are CFAs, and that RedChip’s Investor Relations division has absolutely zero input on their analysis.  The fact is that our company-sponsored research for smaller-cap companies has been widely accepted in our industry for years by industry professionals. It is well understood that there is a dearth of coverage in the small and micro-cap universe.  Contrary to what Greenberg stated, everyone in our industry knows that we have both company-sponsored and non-company-sponsored research.

RedChip was the first to put independent research coverage on Starbucks in 1992.  Other names we have covered in our 18-year history include Daktronics, Winnebago, MarketWatch.com and many other companies that ultimately became blue-chip companies.  We currently have coverage on a number of U.S. companies that are not clients.

There are two other points that I did not make that I should have made. One is that both retail and institutional investors have made millions buying Chinese Reverse Merger stocks, including large and sophisticated institutions, many of which have teams on the ground in China that get to know management, visit their operations, talk to their customers and competitors, diligently analyze their filings, and check bank statements and other documents to ensure everything is on the up and up.

Faber stated that “many of these companies have questionable financials,” yet there are literally five or six out of a universe of approximately 350 that have gone public since 2003 in which there has been found any financial malfeasance.  That is not even 2% of the universe of stocks to which they refer.

While I tried to make the point that a number of large, blue-chip companies have also used the reverse merger process to go public, including Texas Instruments, Time Warner, Blockbuster Video, Occidental Petroleum, and even the New York Stock Exchange, I was stopped in mid-sentence by Faber.  But again, it made for good TV.

There is an excellent book on Reverse Mergers written by David Feldman and I strongly recommend it. He is truly an expert on the subject, and I have great respect for his work in this field.  In addition, one of our CFA analysts, Bill Matson, literally wrote the book on micro-cap investing, titled Data-Driven Investing. You can read his response to Mr. Faber and Mr. Greenberg via the following link: http://blog.redchip.com/index.php/china/cnbcs-irresponsible-innuendo

Our research team collected data on 306 Chinese companies that have gone public since 2003 using the Reverse Merger process and analyzed their returns over the seven-year period ending December 31, 2010.  The mean total price return for the reverse merger stocks was 30%, while the mean total price return for China IPOs in the United States was 54% for the same period.  We also compared the 2010 performance of the same universe of stocks and found that the average price return for reverse mergers was 16.3%, compared to 7.7% for China IPOs.  In other words, Chinese reverse merger stocks on the whole delivered more than double the returns of the supposedly “safer” Chinese IPO stocks last year.

What Greenberg did not tell you is that micro-caps are volatile by nature and are the highest-risk category of stocks, but that they also have some of the biggest returns. As with any asset class, smart investors buy micro-cap stocks in baskets, as one stock’s appreciation can more than compensate for loss in others.

2005 SEC Rule on Reverse Mergers

On July 1, 2005, the SEC voted to adopt a new set of rules regarding the use of Form S-8, Form 8-K, and Form 20-F by public shell companies.  According to the statement by the SEC, “The rules are intended to protect investors by deterring fraud and abuse in the securities markets through the use of shell companies.”

The most directly relevant portion of the rule for reverse merger companies was intended to:

Revise the existing Form 8-K items relating to acquisition or disposition of assets and changes in control to require companies that cease being shell companies, within four business days of the transaction, to disclose information comparable to the information that they will be required to provide if they were filing an Exchange Act registration statement.

The full requirements of the 2005 act can be found here: http://www.sec.gov/news/press/2005-99.htm

Also, most Chinese Reverse Mergers file S-1 registration statements, which must clear the SEC and undergo the same scrutiny as prospectuses for IPO companies.

In sum, I think it is important to recognize that that there are some companies in the space who have committed fraud:  China Sky One Medical and RINO International are two in which the SEC has found unmistakable proof of financial malfeasance.  The major issue now involving Chinese Reverse Mergers is the differences we are finding between the SAIC filings (State Administration Industry and Commerce) and the SEC filings.  Both the NASDAQ and the NYSE Amex will now check the SAIC filings to ensure that they are consistent with the SEC filings and if they are not, they will ask for an explanation before listing a company.

Most of the Chinese RM companies are holding companies and have multiple subsidiaries. Each subsidiary reports its financials to the district in which it operates, so all of the filings must be checked to get a clear picture.  We are currently doing more homework in the area of SAIC filings to ensure that we completely understand what is required in these reports.

RedChip takes its due diligence process very seriously, and each week we turn away potential client companies because they do not meet our strict criteria (see below).  We also have a team on the ground, an office in Beijing, with full-time bilingual staff responsible for visiting each company we represent, analyzing their operations, seeing their factories and products, reviewing customer lists – in essence learning as much as we can about their business.  We are also now looking at all client SAIC filings to confirm that their filings are consistent with SEC filings.  If they are not, we ask for an explanation of why and then determine whether their answers make sense in light of their business model and operations.  If we are not satisfied, we will drop them as a client.

We see the heightened scrutiny as a net positive for investors and for all who work in the Chinese Reverse Merger space.  We are witnessing a cleansing in the sector, and those who are not playing by the rules have been put on notice that they will be exposed.  But what we must guard against is hysteria, character assassination, guilt by association, and sloppy analysis and sophomoric reporting.

Appendix: RedChip’s Five Criteria

1.       Effective Management: Encourages innovation, ensures high morale among its workforce, and executes business strategy to create maximum shareholder value.

2.      Mass Appeal: Guarantees that the investment in a new product or service will be rewarded by a large market opportunity.

3.      Growing Sales: Provides visible proof of the market’s acceptance of the Company’s product offerings.

4.      Improving Margins: Testifies to management’s ability to translate new sales to bottom-line profits.

5.      Profitability or Near Term Profitability: Is the trend toward increasing margins leading to profitability? Minimum of 15 percent annual earnings growth.

Appendix: Basics of RedChip’s Due Diligence Process

1. On-site visits to see all aspects of company’s operations
2. Analyzing all SEC filings to determine if there are inconsistencies
3. Checking SAIC filings against SEC filings
4. Analyzing competitors in the same industry to be sure that we have a clear picture of the business to determine whether there are noticeable differences in the claims of the company and what our industry research shows.
5. Analyzing official documents that corroborate the validity of the company’s claims of permits, contracts, and land use rights.
6. Presenting management with a list of comprehensive questions about their business to ensure that their answers are consistent with what we find on the ground in China and in their SAIC and SEC filings.
7. Clearly communicating to management that if they wish to raise capital in the U.S., a third-party due diligence team will be hired for a forensic accounting process that will include, among other things, looking at contracts, bank statements and much more.
8. At times, if we have doubts about our findings, we will visit the government office to determine whether the documents there are consistent with documents we have been given.

Dave Gentry

President, RedChip Companies, Inc.