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TMFMmbop (35.05)

Beware Chinese Penny Stocks

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June 08, 2009 – Comments (12) | RELATED TICKERS: CGA , CFSG.DL2

This blog post a month back from bradford86 seems to have attracted a lot of attention -- at least as measured by emails I received about it asking me about the stocks and discussion of it on our Global Gains discussion boards. Further, the stocks featured in it have done remarkably well over a month-long time period making it appear that now is the time to buy Chinese penny stocks.

It isn't. And if you do want to dabble in the Chinese microcap sector, be prepared to do a boatload of due diligence. At Global Gains where we've earned some solid returns from China Green Agriculture (CGA), China Marine Food (CMFO), and China Fire & Security (CFSG), that's meant thoroughly scrubbing the filings, traveling to China to see the companies and meet management, talking with hedge funds who are both long and short the stocks, and doing substantial analysis of the competitive landscape.

I don't believe any of the stocks mentioned in that blog post were subjected to the same level of analysis. Take Orient Paper (OPAI), for example. Here's what bradford 86 had to say about it:

Oriental Paper (OPAI), as mentioned earlier under China Finance, is growing 30% a year by manufacturing and distributing paper and paper products in China. Cramer recently indicated that things are looking good in the world of Corrugated Paper. This makes Oriental Paper is look even better.

He further notes that because of the stock's valuation, it has appreciation potential of nearly 1,000% -- a 10 bagger.

Now, I'd be remiss if I didn't point out that the stock is up 140% since that blog post. That said, I'd steer very clear of this stock unless you have good answers for the following questions (all information gleaned from public SEC filings):

1. How do they keep such low inventory levels? Most paper companies seem to keep 8% to 12% of annual sales in inventory. These guys are at 2% and yet are growing at 30%-plus annually?

2. Why did they have a 25-year-old CFO who appears to have started working for the company when she was 23? Really, that's a legit C-level office for a public company? (To be fair, they just hired a new guy last month, but I would bet this company has some significant internal controls weaknesses.)

3. The customer list seems to be pretty volatile, yet the company has no advertising expenses and extremely low SG&A. Then they say in the 10-K that they rely on their CEO for his "personl and business contacts." Given that paper is essentially a commodity and this company seems to small to have any cost advantages (though they claim their proximity to the Beijing /Tianjin population center is an advantage), this may be a company that makes money by fulfilling non-competitive orders given by buddies that run SOEs. (I believe most book/newspaper/printing business in China would be sate run.) That's dangerous in that business could disappear pretty fast if the relationship sours or people move jobs.So, who are the customers, why do they do business with OPAI, and does the company have any sustainable competitive advantage?

4. In May 2008, the Company issued 5,000,000 shares of common stock to three consultants for services rendered during the year ending December 31, 2008, valued at $500,000.

So, that's value per share of $0.10, or an implied market cap for the whole company of $4.5mm. At the time the company had $53mm in trailing sales and $5.9mm in net income. So, really, you gave away shares and diluted your shareholders 12% at a P/S of .008x and a P/E of 0.7x? Either the financials are false or these guys care not a lick for their shareholders or they are horribly bad business people who don't understand what equity is. Which is it and how does that make you feel as a part-owner of this business? (Incidentally, they had between $1.3 and $2.4mm in cash at the time.)

5. Related Party Transactions

The Chief Executive Officer of Orient Paper loaned money (over a period of time) to the Company for working capital purposes, which amounted to $6,148,710 as of March 31, 2009. During the three months ended March 31, 2009, and 2008, Orient Paper did not make a payment towards this loan. On July 24, 2008, the Chief Executive Officer of the Company agreed to change the term of the loan from payable on demand to a period of three years, maturing on July 23, 2011 and with no stated interest.

On August 1, 2008, a member of the Board of Directors of HBOP loaned money to the Company for working capital purposes which amounted to $879,000 and $880,200 as of March 31, 2009, and December 31, 2008, respectively. The amount owed bears interest at 7.56% per annum and is due on July 31, 2011.

On August 5, 2008, a member of the Board of Directors of Orient Paper loaned money to the Company for working capital purposes which amounted to $1,098,750 and $1,100,250 as of March 31, 2009, and December 31, 2008, respectively. The amount owed bears interest at 7.56% per annum and is due on August 4, 2011.

It's a generally a troubled company that's resorting to loans from multiple insiders to fund working capital, yet the numbers on the financials would seem to indicate a quite healthy company. So what are prospective lenders seeing that we're not?

Beware the tout. And if you are interested in learning more about investing for the long-term in China in solid companies with a sound asset allocation game plan, we can help you with that at Global Gains. Click here for more information.

12 Comments – Post Your Own

#1) On June 08, 2009 at 11:30 AM, DeadmanLiving (70.07) wrote:

First please excuse my ignorance but I do not see how anyone would consider investing in any company in China.  I consider buy a Chinese stock close to the same as buy junk bonds with the exception that with buying junk bonds you may have a small percentage of actually recouping something of your investment.  Granted they are an emerging market with tons of opportunity but at the heart of the matter is that their government still is communist.  Nothing is in place to stop a company and its assets from being totally swallowed up by the government and all publicly held stocks just outright canceled whether or not the company is solvent or not.  But heck what do I know, just look at GM.

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#2) On June 08, 2009 at 3:00 PM, TMFMmbop (35.05) wrote:

The Chinese government is trying to privatize and consolidate most lines of business in order to make the economy more efficient and competitve.

Yes, there are risks in China, but I think you're doing your portfolio a disservice by writing off every Chinese company with such a crude broad stroke.

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#3) On June 08, 2009 at 3:58 PM, DeadmanLiving (70.07) wrote:

I have already conceded that there is a tremendous opportunity in Chinese stocks.  I am just stating that there is also a tremendous opportunity for loss, one that goes beyond the normal US stock or foreign stock of a democratic nation.  A communist government can not privatize anything and still be a communist government, this is an oxymoron.  At this point the government then becomes a dictatorship, which in my opinion is even more dangerous for investors.  A “private” company becomes state property in the blink of an eye when the powers at the top shift.  Why?  There are not laws or regulations forbidding it or keeping the government in check.  No courts for appeals, no other branches of the government designed to protect the citizen.  For myself this equates, both on a personal and economical level, a very valid reason for not investing in Chinese companies.

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#4) On June 09, 2009 at 10:42 AM, Medicalrecordman (< 20) wrote:

Many Chinese small-caps suffered from liquidity issues last year, but that's changing rapidly, as these companies are beginning to attract institutional investors seeking fast growing companies at dirt cheap prices. OPAI is actually my favorite Chinese small-cap based upon the mega amount of hours I've put in researching the Chinese small-cap sector. I've spoken with someone who visited OPAI's headquarters last month and he stated that their operations were enormous. The best part about OPAI ? Take a look at their May 27th PR from 2008, as I eieve the comany is moving forward with the contents of that PR. OPAI's trailing P/E at .50 is 2.3 and with earnings that wil continue to grow exponentially, your synopsis about OPAI couldn't be further from the truth. Another stock I found very attractive at .385 was LPIH, but even OPAI will blow away LPIH's performance when all is said and done. Educate yourself before slamming companies that are better run than any junk stock made in the U.S.A.

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#5) On June 09, 2009 at 11:56 AM, bradford86 (99.78) wrote:

Hey, Long time listener, first time caller.

Glad to see someone is reading my stuff.

Also, I like it when people present reasons for me not to buy any of the companies I own. I look for reasons not to invest before I look for reasons to invest.

I wish you great success.

Cheers,

Glen

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#6) On June 09, 2009 at 12:16 PM, TMFMmbop (35.05) wrote:

your synopsis about OPAI couldn't be further from the truth.

Every bit of information in the post was taken directly from 10-K and 10-Q filings. Even if OPAI continues to post strong growth, are you comfortable with a management team that had a 25-year-old CFO and did massive dilution at an extraordinarily low valuation to pay a consulting bill?

Just some questions. You may disagree with my conclusions (and have good reason to), but they are certainly based in fact.

Tim

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#7) On June 09, 2009 at 12:17 PM, TMFMmbop (35.05) wrote:

Glen,

Thanks for the post. I enjoyed looking at some of the stocks on your list and obviously share the belief that there's opportunity to be had in the Chinese micro cap sector.

Tim

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#8) On June 09, 2009 at 1:43 PM, bradford86 (99.78) wrote:

Haha,

I agree and disagree. I agree that this isn't a Dow Jones 30 Company with a 'strong, distinguished, and professional' management team. I agree that there was some dilution. I agree that CMFO is a good company. I agree that I do not go out and visit these companies. I agree that you are more likely to analyze companies at a deeper level than I do.

Unfortunately, I am a firm believer that companies that make more money than other companies will eventually reflect that in their market capitalization. I do not believe in market efficiency, as it yields and still yields remarkable value in the less risky Chinese and Foreign Stock markets and overvalues in my opinion very risky US treasuries.

I think as a whole, what you are doing is right for your audience. You need to make sure that each company you recommend is "safe." You are held accountable for each of them. My strategy involves the same knowledge, but is willing to eat "good" risk for breakfast. I do not think OPAI is risky. I can identify lots of risky assets. I called JNJ a great company, lousy investment last fall and caught a lot of heat for it, and it's plummeted ever since. Risk in the stock market comes only from overpaying. People love overpaying. Check out the coffee stocks.

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#9) On June 12, 2009 at 8:13 PM, winstontyen (< 20) wrote:

Being the CFO for OPAI, I feel obligated to clarify some of the points raised by Tim in his article: 

1. Inventory turnover: I feel awkward having to defend our low inventory level.  We make purchases of raw materials (recycled papers and pulps) almost on a daily basis and make sure we get the finished goods out on their way to our long-term customers within days of production, which in most cases is just a matters of a couple of days.  We rarely have interruption in production caused by raw materials because we have strong support from our suppliers, who have steady supplies of assorted recycled papers thanks to the close proximity to the cultural hub cities of Beijing and Tianjing, and accordingly, we can afford to keep our inventory low (assuming low volatility in raw material costs, which was not exactly the case at the end of year 2008). Maybe it will be a challenge to maintain this level of efficiency as we grow, but given the way we operate now we do not believe it’s unreasonable to keep days in inventory at less than 10 days and annual turnover at 40 times. 

2. If, let’s say for example, we were really a shame and inflated our revenue to make the turnover unreasonably high, it would not be possible for us to operate as such without creating fake A/R or cash in bank.  The fact is that our A/R has remained low historically. And if you have seen our bank statement for March 2009, I hope you would come to agree with me that the 130+ deposits (we had credit entries of customer A/R collections for more than RMB$57 million in March) in the bank statement are hard to fake. 

3. Tim mentioned related party loan as a sign of financial weakness.  If anyone takes a look at our cash flow statements for fiscal year 2008, you will find that in between investing and financing activities we have been expanding partly because of the financial support from our major shareholders.  We added an additional production line and other production machinery for over $14 million during 2008.  This wouldn’t be possible without loans from related parties.

4. I have no comment on why we had a young CFO and the shares issued to former consultants of the company, except that I wish I could have done the financial compliance job as well as she did when I was 25 years old.   

Winston Yen, CFO

Orient Paper, Inc.        

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#10) On July 01, 2009 at 12:30 PM, blaueskobalt (< 20) wrote:

Tim and Glen,

I enjoy reading both of your blogs/articles, and I'm very pleased to see your responding to each other.  Glen's article (mentioned above) highlights a number of interesting/exciting companies, but most of them contain related-party transactions that make me uncomfortable.  Some of them look a lot scarier now than when the article came out (e.g., China Finance's assets have lost a big chunk of their market value, Gold Horse may have defaulted on a loan, and JADA hasn't reported a new order in over half a year).  

Oriental Paper is probably my favorite from the list. I bought some shares several weeks ago, and I plan to hold for a long time. I am willing to (partially) excuse the related party transactions in light of the difficulty that these Chinese microcaps have in getting financing from the state banks.  I am also hoping that the new CFO will shore up some of the reporting issues, and I'll take the fact that he gave a lengthy comment here as a good sign.

 Just my two cents. Both of you keep up the great work!

 Sean

 

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#11) On July 04, 2009 at 3:22 PM, bradford86 (99.78) wrote:

I agree 100% with Sean.

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#12) On July 04, 2009 at 3:29 PM, bradford86 (99.78) wrote:

Also, I have friends signing up for your newsletter emailing me clips. I wrote this before I realized you compared OPAI to other companies and even mentioned bidu and google.

 http://www.thestreet.com/story/10529541/1/how-not-to-invest-in-china.html

 http://www.stockpickr.com/problog/1085/

 

i am not a buyer of google or bidu right now. there are other, cheaper, faster growing, companies.

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