dillbeans (68.93)

China RTO is kicking my hiney

January 30, 2012 – Comments (5) | RELATED TICKERS: SIHI , CMM , LPH

Back in May of last year, I wrote a post expressing amazement at what I called an “antibubble” in Chinese Reverse Takeover (RTO) stocks. Due to increased concern about the legitimacy of these companies after a few of them turned out to be frauds, share prices and valuations were driven down to wacky levels. CAPS player China RTO went from zero to 93.53 in a matter of a few weeks by betting against these companies en masse. I opined that the flight from these companies was overdone.

Let’s take a moment to review how things have gone since then.

In a sentence: This sector has gone from bad to worse. Since my original post, ChinaRTO’s CAPS rating has gone from 93.53 to 99.76. That may seem like a modest enough gain until you invert the numbers. Last May, 647 of every 10,000 CAPS members were beating him. Now, 24 of every 10,000 players are beating him and the other 9,976 are eating his dust. I think it would be pretty difficult to come up with any single criterion, even with the benefit of hindsight, that would better predict a stock’s performance over the past eight months. In contrast, my CAPS rating has dropped from 90 to 75.

So: Time to concede defeat? Of course not!

A key feature of bubbles (and, I guess, antibubbles) is that they can go longer and higher (or lower) than you ever imagined possible. And if things seemed (anti) frothy in May, well they seem now to be whipped into a veritable ultra-grande foamy latte of revulsion. Is the revulsion deserved? Up to a point, it clearly is. But I continue to believe that the degree of revulsion is not deserved and that there are attractive opportunities here for the investor who is willing to take a sizable risk.

And I will start my argument with a rare bright point: China Mass Media (NYSE: CMM). Last May, CMM was selling for about $1.50 while it sat on a cash pile of about $4 per share. Although CMM is an ADR and not an RTO, the market’s skepticism of Chinese microcaps was clearly in play. In November, CMM decided it didn’t need all that cash and declared a special cash dividend of $2.30 per ADR. I admit I harbored my own skepticism but on Christmas Eve that dividend appeared in my account--cash dollars! Score one for my China basket, and thanks to the Fool for the recommendation.

Although additional revelations and accusations have trickled in, most companies have not been subject to any credible accusations and uncertainty abounds. How is a person to balance the risks vs. the potential rewards? One reasonable way would be to steer clear of the sector altogether. This is the path widely taken. So widely, in fact, that it has left opportunities for those who dare. By traditional valuation metrics, a lot of these companies are trading at an 80%-90% discount to fair value. My best guess is that about 20% of these companies are fraudulent. Using a Bernoulli process, let’s take a gander at what that means:

If I buy five of these companies, my chances of having at least one clean company in the bunch is 99.97%. If that company eventually returns to a normal valuation, I break even. There is a 99.3% chance that at least two companies are clean. If they both return to normal valuation and the others go bankrupt, I double my money on the basket. There is a 74% chance that four of them are clean, and my money quadruples. There is a 0.03% chance that all five are fraudulent and my China basket goes broke.

Twenty percent fraudulent companies may be too optimistic; same with the assumption that the remaining companies all return to “fair” value. So let’s look at a scenario I believe to be on the far pessimistic edge of credibility: Let’s say 50% of these companies are frauds and the remaining companies only return to 50% of a “normal” valuation. In that scenario I have a 3% chance of losing everything; an 81% chance of breaking even; a 50% chance of making a 50% profit; and a 19% chance of doubling my money. Dicey, but not bad for what I consider an extremely pessimistic scenario.

I’ve put together a basket of five Chinese microcaps that I thought had favorable risk-reward profiles. So far, aside from CMM, none has failed to disappoint in some way or another, though none has yet been accused of fraud. SmartHeat (NASDAQ: HEAT) has swung from profit to a loss. Longwei Petroleum Investment Holdings (AMEX: LPH) failed to get a loan for a new storage facility. Sinohub’s (AMEX: SIHI) profits have decreased. And Shengkai Innovations (NASDAQ: VALV) produced a childish press release accusing its investors of scaring off its customers.

These are interesting times. I look forward to seeing what comes of them. 

Disclosure: I am long CMM, HEAT, LPH, SIHI, and VALV.