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In my continued search for opportunities and anomalies to produce above average returns, I developed a special interest for the impact of 'up listing' of Chinese securities from the over the counter market (OTC) to a full fledged exchange. Efficient market proponents would tell you that a move from the OTC to a major exchange should have no effect on a stock, as it does not change the fundamentals of the company, but I beg to differ.

I believe a security 'up listing' from the obscure OTC market to a major exchange has powerful qualitative implications, implications that usually lead to a much higher valuation of the up listed security, as well as an improvement in the business of the 'up listed' company as a result of the higher valuation and the increased visibility of the business.

Perception vs. reality

Investing is as much about perception as it is about fundamentals, the perception of fundamentals in itself may alter the fundamentals of a given company, a business which is perceived to be fundamentally strong, may profit from this perception by issuing securities at inflated prices or by acquiring a stronger competitor with its inflated stock, thus growing into a truly fundamentally strong business; and vice versa, a business which is truly promising but perceived as fundamentally weak may falter due to its limited access or higher cost of capital.

The phenomena above is experienced by literally every publicly traded company, as investor’s perceptions rise and fall, company’s fortunes grow and shrink.

What can influence perception?

Perception is a freckle business, it may be altered due to a variety of factors, in this article however I will focus on one, which is: credibility.

In this day and age, the business of credibility is delegated, meaning we have delegated the business of establishing credibility and viability to others; there is no better example then the rise of the rating agencies and ensuing economic debacle, as investors embraced the triple A ratings as reality and drove into highly rated mortgage backed securities comforted by the fact that they were safe and credible investments.

Stocks, similar to bonds or mortgage backed securities have an array of credibility “boosters” such as:

- Analyst recommendations.

- Rating agencies ratings.

- Management track record.

- Company size (market capitalization, revenues, profits ..etc)

- Shareholder base (well known investors)

- Business jurisdiction.

- Listing exchange.

Out of this list, the element of interest to us is the: Listing Exchange; in a truly efficient market, where the company is listed should be inconsequential to the valuation of the company; what theoretically matter is the revenues, profits, the history of the business and its future prospects, however the listing does matter and it matters a great deal.

A company listed in the Bangladesh stock exchange may not enjoy the same valuation of a company listed in the NYSE even if they both had the same revenues, profits and prospects, for the simple reason that the NYSE is perceived to be more transparent, highly regulated and less prone to manipulation and fraud, this perceived safety enjoys a premium, the NYSE within the context of the United States jurisdiction has “standardized” credibility to some extent by developing a set of regulations and procedures applicable to all the companies listed in that exchange.

This same credibility boost is applicable to companies moving from the OTC to a major exchange such as the NYSE, NYSE Amex or the NASDAQ, when a company accomplishes this up listing successfully, it jumps into a new category of credibility, thus inviting a much larger investor base to consider the stock as a potential investment.

Increased visibility

The enhanced credibility of being listed on a major exchange will also lead to increased visibility, any listed company is in constant competition for a limited amount of investment dollars (even though the FED seems to think otherwise!, but this is a topic for another discussion), as the case for a beauty contest each participant is vying for the attention of the judges, in this case the judges being the retail and institutional investors; this enhanced visibility will ultimately bring in new investor money in the stock, assuming of course the business is or perceived to be worthy of investment.

The up listing growth dynamic

The combination of enhanced credibility and increased visibility often lead to an increase in the valuation of the listed company, leading to an expansion in the valuation ratios from the P/E to the P/S and so on; this expansion of multiples is of very strong benefit to the investor of the newly listed security as the company value will increase without the business necessarily enjoying an improvement in the business fundamentals.

The benefit for investors however does not stop here, smart management of newly listed securities, often profit from this valuation boost to raise funds from the market place to further grow their business, at a much lower cost of capital to what they would usually pay if they were an OTC stock; and it is this access to plentiful and cheap capital that can radically change the prospects of the newly listed security; a weaker business will strengthen and a strong business will get stronger.

Accordingly an investor in a newly up listed security will benefit from a combination of an expansion of multiples, as well as the likelihood of stronger revenues and profit growth as the business raise funds and deploy them to further grow and strengthen the business.

Following is an example of companies that benefited or about to benefit from the dynamic explained above:

RINO International (NASDAQ: RINO)

RINO International is a Chinese company focusing on desulphurization equipment, waste treatment equipment as well as anti oxidation systems, the company is profiting from the strong growth in infrastructure spending in China, the company has enjoyed a very strong growth in revenues in the last 3 years with revenues growing from $10.7m in 2006 to $139m in 2008, combined with a jump in profits from $3m in 2006 to $21m last year. The company has recently up listed to the NASDAQ, leading to a doubling of the P/E from under 5 shortly before the listing to just under 10 today, however the company current P/E remains at a third of the industry average of 32, the enhanced visibility and the credibility as a result of the up listing should take the company to an inline industry multiple and thus pushing the shares to $42 per share over time.

China Education Alliance (NYSEAmex: CEU)

The company like most Chinese companies targeting the local market is enjoying a surge in revenues and profits, the company offers both onsite and distant learning solutions on a variety of topics and to different age groups capturing both the young student population and the adult career enhancement market, the company grew revenues by 300% between 2006 and 2008, while increasing profits by over 370% during the same period. The company has recently up listed on the NYSE Amex leading to a multiple expansion of 100% from under 5 prior to the up listing to 10 today, yet the company P/E remain less then half the industry average of 24. CEU has recently filed a shelf registration, and it will likely issue some shares in the next 24 months to fuel its growth, should the company obtain a valuation similar to its peers, the stock price will exceed $12 per share.

China North East Petroleum (NYSEAmex: NEP)

China North East Petroleum is a low cost oil extractor operating in North East China, the company has enjoyed tremendous growth in oil production from 90000 barrels run rate per year in 2006 to close to 1 million barrels per year this year, meanwhile the company revenues and profits have grown by 1000% and 2000% respectively during the same period. The company has recently listed on the NYSE Amex thus leading to a P/E expansion of 200% from under 2 shortly before the listing to 6 today, yet the company continues to trade at 40% of the average multiple in the industry; the company has recently filed for a shelf offering and it is probable that new shares will be issued to fund the acquisition of new oil fields, if the funds are to be deployed at any rate close to the historical 5 years ROE average of 49.9%, the business stand to enjoy a strong boost in revenues and profits in the next few years, eventually should the stock obtain an inline valuation with its peers, the stock price is likely to reach $12.75.

The likelihood of the above mentioned companies reaching an inline valuation with their peers can also be confirmed by the performance of similar Chinese companies that up listed 12 to 24 months ago:

- China Fire & Security Group (NASDAQ: CFSG): the company up listed to the NASDAQ in late 2007, today it enjoys a P/E of 16.2 from a P/E in the low single digits shortly before the listing, the company P/E today is slightly higher then industry P/E of 16.

- Harbin Electric (NASDAQ: HRBN): the company up listed in early 2007, it had an under 10 P/E throughout 2006, today the company enjoys a 17 P/E which is just under the industry average P/E of 19.

In Conclusion

It does appear from looking at a number of companies that moved from the OTC to a major exchange that a multiple expansion is a natural outcome, followed by a steady appreciation in the up listed company valuation over a 12 to 24 months period, until eventually reaching an inline industry valuation, which is usually significantly higher then the initial company valuation ahead or just after the up listing.

Investors will be advised to consider some of the newly up listed companies for an investment that may yield above average returns over a one to two year time frame.

Disclosure: The author is long China North East Petroleum (NEP) shares.

Source: 'Up Listed Chinese Companies: Above Average Returns