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  1. Home
  2. / Investing

Toxic Chinese Stocks

Unfortunately, we have to operate under the principle of where there's smoke, there's fire.
By TIMOTHY COLLINS
Apr 08, 2020 | 12:12 PM EDT
Stocks quotes in this article: BILI, HUYA, LK, TAL, IQ, BIDU, PDD, JD, BABA, EHTH

We can add Chinese stocks to the list of stocks that are currently toxic. Cannabis was a sector that I had loved last year that became a hard pass by the winter. I'd love to say I got off that dock at the money dock, but I waited until the ship started taking water, jumped off the side, and swam back to shore. Still, that was luckier and less painful than many.

On the China side, I've been a big proponent of the eSports and streaming related names. It's worked out well with Bilibili (BILI) , but Huya (HUYA) , outside of some scalp trades, has been a disappointment along with several other names.

Luckin Coffee (LK) threw Chinese listed names a curveball when it announced a massive fraud that reached into the C-suite. The stock was halted on Tuesday and hasn't reopened since. Muddy Waters had this one pegged dead-on with fraud. After the bell on Tuesday, TAL Education Group (TAL) , a K-12 after school tutoring service in China, announced an employee conspired with external vendors to inflate sales. Unlike Luckin dropping some 80% on the news, TAL is only down 8%. The biggest reason: TAL estimates the fraud equal to 3% to 4% of total revenue, while Luckin's fraud looked to be about 50% of the revenue over the past three quarters.

While the fraud ended there, Muddy Waters took aim at iQIYI (IQ) yesterday, alleging the company fraudulently and materially overstates its users, revenues, acquisition consideration, and value of "barter" content. In conjunction with Wolfpack Reports, the two conclude this dates back to pre-IPO times. That would implicate Baidu (BIDU) as complicit in the fraud. IQ sold off hard before bouncing back to flattish yesterday. Shares were down roughly 5.6% in the early morning today.

Unfortunately, we have to operate under the principle of where there's smoke, there's fire. Anyone who remembers the reverse merger days of Chinese companies using that strategy to tap U.S. has struggled to trust Chinese financials. There were so many frauds from those days, it made heads spin and became a running joke.

That doesn't mean I think all the companies are fraudulent with their accounting. Heck, it may end with LK and TAL, but what we have to be aware of is the risk. If another fraud were to hit, Chinese names will be sold hard. If Muddy Waters issues another report, chances are the stock in the report will get hit hard. And, as investors and traders, we have no way to know what company that may be. It isn't a terribly big field though, so that means our odds of missing it are reduced. Chances are it will be higher growth, smaller type of name, so maybe we can limit some risk by avoiding those, but it is still tough. Already we're seeing puts being accumulated in Pinduoduo (PDD) this morning. A hit there could tie back to JD.com (JD) and Alibaba (BABA) .

The market is bouncing, but still fragile. The short-report from a hot hand can have a big influence. If you don't believe me, then check out the two-day action in eHealth (EHTH) , Muddy Waters latest target. Tuesday was the day those who knew the report was coming began shorting the stock. Today is the reaction to the report coming public. Shares have lost 15% on Wednesday and 26% over the past two days.

There are enough names that have been beaten down since the start of March, we have little reason to force a trade or investment in a toxic sector.

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At the time of publication, Timothy Collins had no position in the securities mentioned.

TAGS: Investing | Markets | Stocks | Trading | China

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