Beware Chinese Penny Stocks
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.