Chinese Stocks Are Hot: How to Profit from Them

I wouldn't be too far off in saying that the US recovery has been led by Chinese stocks - just do a comparison chart of FXI and DIA on Yahoo. China's stimulus is boosting domestic demand and China does not have a choking budget deficit. The list of Chinese stocks in the US is growing, and many present amazing profit opportunities.

There are roughly three types of Chinese stocks listed in the US, each with its unique characteristics and trading behavior.

1. Red Chips

Giant industrial companies in which the communist state often has a stake: ACH, CEO, ZNH.

Since these trade in both the US and China, their price moves are impacted by trading in China, resulting in daily gaps (up and down) to reflect the results of Chinese trading overnight. Take ZNH (China South Airline), for example (closing prices): July 27: $16.71; July 28: $18.17; July 29: $17.34; August 3: $19.45; August 5: $18.30.

The daily volume in some of these giants is pretty low, meaning large spreads between the bid and the ask.

These can be profitable at times but you must have a strong stomach to trade them due to daily gaps and large spreads.

2. Chinese IPOs

The best private Chinese companies like BIDU and FSLR. These often have strong fundamentals and interesting stories but may be relatively high priced by their US underwriters.

3. Reverse Mergers

Many Chinese companies find their way onto the US market through the back door - by doing a reverse merger with a US shell: buying a US listed company with no operations and merging into it, filling the US shell with Chinese operations. This approach is cheaper, easier, and faster, and is often facilitated by a US operator. This explains how hot small profitable Chinese companies often appear in the US seemingly out of nowhere.

Reverse mergers often have no lockup period and the main benefit to the Chinese owners (and their US sponsors) is the ability to sell stock, which they often do. Many companies have spotty financials, questionable reporting, and sometimes dubious stories. As many have become outstanding zoomers as have run into the ground and disappeared.

Many Chinese stocks have weird charts and trade differently from their US cousins. I suspect there are several reasons:

- Chinese investors act differently from their US counterparts. Excessive enthusiasm often turns into panic, causing frequent wild swings in the stock price.

- Industrial China is so huge that it's hard to be unique there. When a new Chinese company appears in the US, it may be unique and interesting to us, but not in China. We don't know the other players or local conditions; Chinese investors do. That makes them flightier and more eager to take profits when they can. The concept of buy and hold may not be as strong among people who survived the Cultural Revolution.

- Many small Chinese stocks are favored by hedge funds for quick profits. Their aggressive trading exacerbates moves in either direction.

The good news is: few Chinese stocks are unique. If you miss one, there will be another one. They come and go all the time.

On the other hand, you have to be on your toes: if you hesitate, your quest for profits may turn into a sudden loss.

You have to keep an eye on the Chinese market. Chinese stocks do well in the US only when the Chinese stock market is doing well. And that market seems to have more booms, busts, and bubbles in a year than we have had since WW2.

How do you do due diligence on a Chinese stock? You don't. It's hard enough on a US company, virtually impossible on a Chinese one. Just accept the numbers and the story at face value and go with the flow. That's why reading charts is so important. As long as the stock is going up, you are OK. Hopefully, you will get out before disaster strikes.