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Those who know me well know that I look for value. I strongly believe that markets are inefficient and that investors are emotional creatures driven by fear and greed regardless of the fundamentals. As a matter of fact, I even developed a theory called the Cyclical Efficient Market Hypothesis (CEMH) to help me, as well as help fellow investors, better profit from market inefficiencies.

However in this article I will not deal with CEMH, but I will look at stocks which are deeply undervalued or perhaps “insanely” undervalued; If you are looking for companies trading for 50c on the dollar, fast growth companies trading at under 2 P/E or companies with 0.5 or lower PEG, in this article you will learn about them, and you will see that there is a whole lot of them: they are called the Chinese Micro Caps.

But before going into the juicy details of those bargains, you need to remember three stocks, which I call the Happy Three. I call them the Happy Three because those three stocks moved in a fashion similar to a smile drawn on a graph, and they did it from the depth of the 2001/2002 bear market:

click to enlarge

The above shows the graph for Sina (NASDAQ:SINA) which is a Chinese online media company, it clearly shows the climb of the stock close to $60 in June 2000, followed by a collapse to $1 in October 2001, followed by a jump to $50 by January 2004 for a gain of 5000% in about 2 years.

The above graph shows the stock price of another Chinese online media company Sohu (NASDAQ:SOHU) between the year 2000 and today, where you also clearly see the stock sinking from $13 in July 2000 to a low of 81c in April 2001, followed by a rebound to a high of $43 in July 2003 for a gain of 8600% in just over 2 years; meaning a $10000 invested in Sohu in April 2001 would have climbed to $860,000 in the summer of 2003 and be close to 1 million dollars if held until today.

Likewise for the Chinese company Netease (NASDAQ:NTES), the stock sunk from a high of $4 in June 2000 to a low of 13c in July 2001 followed by a rebound to $18 by October 2003 for a gain of 13800% in about 2 years, and a gain of 21500% if the stock was held until today, thus transforming a $10000 investment into $1.38 million in about 2 years, or over $2 million if held until today.

So the question an investor must ask: why did those stocks sink so low in 2001/2002 and why did they rebound to such levels within two years and are hitting new highs today? The answer is a combination of two points:

  • Market inefficiency
  • Strong fundamentals

Often companies sink to oblivion because they have poor fundamentals, but companies with strong fundamentals are bound to come back since the undervaluation is not driven by logical factors, but is created due to a combination of fear and emotional uncertainty in the depth of a bear market. In such conditions investors shy away from small caps, they refuse to pay an appropriate multiple and accept to part away with a dollar of investments for 50c in cash.

If you look at the fundamental performance of the above companies throughout the period of their undervaluation you notice the following:

SOHU (Sohu)

Between the year 2001 and 2003 the company revenues grew from $6 million per year at the start of 2001 to over $80 million per year at the end of 2003 for a growth of 1300%, and a growth in net income from a loss of $14 million to over $26 million in profits per year during the same period.

Sina (SINA)

Between the year 2001 and 2003 the company revenues grew from $26 million per year at the end of 2001 to over $38 million per year at the end of 2003 for a growth of 146%, and a growth in net income from a loss of 36 million to over $9 million profits per year during the same period.

Netease (NTES)

Between the year 2001 and 2003 the company revenues grew from $3.7 million per year at start of 2001 to over $65.5 million per year at the end of 2003 for a growth of 1700% and a growth in net income from a loss of $20 million to over $39 million profits per year during the same period.

What is of interest in the above is that as those companies stock prices were sinking to new depths, the underlying businesses were steadily improving in terms of revenues and profits, and it is this disconnect between the continued improvement in the business operations and the stock price that lead to the sharp gains in 2003 and 2004. Gains after which the stocks never looked back and continued to hit new highs.

What we saw with Netease, SINA and SOHU is happening today with a host of Chinese micro caps, some of which are:

China North East Petroleum (CNEH.OB): This company grew revenues by close to 1000% between 2006 and 2009, as well as grew EPS by over 2400%, yet the stock trades at 1.5 P/E! and under book value.

Yucheng Technologies Limited (NASDAQ:YTEC): This company grew revenues from $37 million in 2006 to over $98 million while growing net income from $5 million to over $13 million, yet the company trade at 0.5 PEG.

China Green Agriculture (NYSE:CGA): This company grew revenues by close to 50% in one year from $15 million in 2007 to over $22m in 2008 while growing net income from $7m to $9m in the same period, yet it trades for a PEG of 0.15!

Harbin Electric (NASDAQ:HRBN): This company grew revenues from $40m in 2006 to over $120m in 2008, while growing net income from $18m to over $25 million, yet the stock is trading under book value.

Other companies worth to look at with similar features are: Agfeed Industries (OTC:FEED), China Organic Agriculture (OTC:CNOA), China Natural GAS (OTC:CHNG), among others.

What is of key interest is that all the above mentioned companies are showing very similar behavioral patterns to the Happy Three in the 2001 to 2004 period, all of the aforementioned companies stock prices have dipped to new lows, while their business fundamentals continue to improve; and I do expect that as China leads the world economy out of its slump, those Chinese micro caps will offer similar returns to what the Happy Three offered from their lows.

Disclosure: The author is long China North East Petroleum (CNEH.OB).

Resources for this article:

Source: The Happy Three: Chinese Smallcaps with Big Potential