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JaysRage (78.34)

Investing in Chinese small caps -- Navigating the mine field

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January 11, 2011 – Comments (4) | RELATED TICKERS: LLEN , CCME.DL , NEWN

I've been an investor in Chinese small caps for nearly two years now, and it has been really interesting to watch generic investor sentiment change dramatically during that time.   At first, there was hesitance because no one knew or understood Chinese stocks and there was a lack of availability.   Then there was a significant increase in listings of Chinese stocks on American markets and there was a huge buzz.   Now Chinese small caps are considered too risky under all circumstances and are again taboo. 

I'm a value investor.   I try and find opportunities where stocks are under-appreciated or unnoticed or over-appreciated or over-hyped and take advantage of those situations.    I think the biggest source of potential value continues to be the Chinese small cap space, primarily due irrational fear.   Is there risk?  Sure, of course.   I think there are several things that can be done to mitigate that risk and find the gems that are worth putting money on.  

The two largest risks associated with investing in the Chinese small cap market are fraud and dilution.  

HOW TO DECREASE THE RISK OF INVESTING IN A FRAUD

1)  Look at the auditor -- In some ways, this probably gets too much press, but it is important.   A top 4 auditor is great, but it's unrealistic for many of these companies to have a top-4 auditor, but there should be an effort to engage a quality well-respected middle-tier auditor.   

2)  Look at who else is involved -- Are institutional investors putting money into this stock?  Sure, they can make mistakes too, but they have resources to investigate on-site and do in-depth due diligence that is not possible by the casual investor.    Is the company bringing well-known or well-respected individuals to their board of directors or to high-ranking positions in their organization.....people who would have a lot to lose by being involved in a fraudulent company?  Who are the partners of this company?  Are they tied to well-known, well-established companies, such as GE, KO, MCD, AAPL, GOOG, etc?..... 

3) Check the numbers -- Look at the financial statements.   Do the numbers make sense?   If you are not comfortable that the numbers add up, don't invest.  

HOW TO DECREASE THE RISK OF DILUTION

1)  Check the history -- Once a diluter, always a diluter.   Avoid companies that have a history of using shares as a source of cash, without adding per-share value as a part of the transaction.   Diluting to fund a major acquisition or expansion that increases shareholder value does not necessarily qualify, but it should be looked at.    Smaller companies that are seeing share appreciation for the first time might also be higher risks.   Some see it as a coming-of-age to have a secondary offering to institutional investors, enjoying having the "big money" come to the party at the expense of current stake-holders.   Companies who have seen price appreciation over time without dilution are likely to continue that trend.

2) Check the cash -- Cash flow problems are another major cause of dilution.    Great cash flow will make funding on-going operations and future expansions or acquisitions much easier than a company without it.   Without cash, massive growth without dilution is difficult.

3) Insider Ownership -- Companies with directors that own a large number of shares are unlikely to have dilution that is not accretive.   Why would anyone want to hurt the value of their own stock?   However, insider-dilution can happen in these situations where shares are awarded for performance incentives.   Be aware of these situations as well.    

4) Consistent and manageable growth -- Companies that have recently been awarded landmark contracts, especially in capital intensive sectors like manufacturing could be forced to use dilution to fund the startup of the new endeavor.   The announcement of the new deal will often cause an appreciation in price that is shortly followed by an announcement of a secondary offering. 

If you weed through these criteria, you can filter out the higher risk companies and find some real gems in the Chinese small cap space.   My current short-term portfolio includes LLEN, CCME, NEWN, and CCGY.OB     There are many others that I follow in this space, and I have been in and out of some other investments in the past couple of years. 

I also hold a very small position in APWR, but I consider that a lesson learned.   It was one of my first and worst Chinese small cap investments.    In many ways, they are a lesson in what not to invest in.   I do like their upside at current prices, but they have not been a success story for me. 

4 Comments – Post Your Own

#1) On January 11, 2011 at 11:07 PM, soycapital (< 20) wrote:

Good points in your blog-thank you for posting it.

I took such a sound beating (was somewhat not aware of the fraud involved) in chinese small caps that I swore never to invest in them again. I sold out and instead I bought a mutual fund that is up 24%. I guess I don't have the patience or desire to spend that much effort researching a foreign small cap stock. More power to you, and some good luck.

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#2) On January 11, 2011 at 11:13 PM, checklist34 (98.47) wrote:

good post and great concept.  alot of people will make some nice returns in china small caps...  those who can, as you say, avoid the mines

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#3) On January 12, 2011 at 12:06 PM, Bays (29.22) wrote:

Great post,

Once a diluter, always a diluter.

Couldn't agree more. Stick to companies that grow the company organically, with positive cash flows. I wrote a blog awhile back on two investments I made in two small cap Chinese companies traded on the TSX.  Judging by your criteria above, I think you may like them.  Both have quality auditors. KPMG and Ernst & Young, both have positive free cash flows, and both are buying back shares.

Due to the recent fear of investing in China, both these companies are extremely cheap.  Sooner or later, investors will be flocking to these Chinese companies, and that's when I will make exit. ;)

Bays

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#4) On January 13, 2011 at 10:13 PM, rockbox64 (< 20) wrote:

For the time being, chinese small caps will never get the same valuations as countries that have true corporate governance. Thats just the way it is.  I've been round and round with these chinese stocks.  NOT worth it.  GLTA.

 

 

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