One month ago, on Monday, September 23, 2013, "Kingold Jewelry (NASDAQ:KGJI) was downgraded by analysts at Thomson Reuters/Verus from a buy rating to a hold rating", according to Zolmax News. At the time of announcement, shares had closed at $1.20. Within that week, the shares closed at $1.66, or up 38%. Currently the shares exchange hands for around $2.00 per share, representing a 67% gain within one month.
The stock price's recent appreciation in the face of two downgrades represents a rare kind of market anomaly; living proof of the fallacy of instantaneous market efficiency. But as a wise woman once said, contradictions do not truly exist; "Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong" (Ayn Rand).
KGJI produces gold jewelry and other trinkets by purchasing gold from the open market. It is a Chinese reverse-takeover listing, and therefore much maligned by the investment community. With a stated book value of $2.99 per share and net tangible book value of $2.50 per share, KGJI trades at a discount to a realistic appraisal of its net asset value. Discounts to book value act like market distress signals. More extreme cases in which market capitalization is significantly lower than net tangible asset value signals that the market believes that the company is better off dead than alive. With anemic margins and systemically low to negative free cash flows, this may be the case with KGJI. However, if one is to lend credence to its audited financial statements, there is a lot of value hidden within KGJI's books. In fact, simple algebra suggests an additional 22.5% of upside in the near future.
KGJI's margins are systematically paper-thin. Although this typically signals a poorly managed firm, this appears to be endemic of the Chinese gold retail market. The Chinese jewelry market is more akin to a commodity than a consumer discretionary business (as is in many developed nations). Because Chinese consumers typically buy gold jewelry for weight as opposed to craftsmanship, the sales prices of finished gold pretty closely mirrors the cost of sales. More information on the Chinese retail gold market can be gleaned by reading John Tumazos' question to KGJI's management in the most recent earnings Q&A.
The ramifications of KGJI's business model is that while KGJI can pass normal gold price volatility on to the customer, margins are very sensitive in the direction of rapidly changing gold prices. If gold prices shoot up, margins will follow because KGJI will have bought the gold cheaper than the market value. Recently, however, gold prices have plummeted, thinning already thin margins. This simple business model has both upsides and downsides. More information on spot gold price's effect on margins can be found on pages 5 and 6 of KGJI's investor presentation.
The obvious downside to the company's business model is that it requires a huge amount of gold inventory, gobbling up capital and exposing the firm to gold price volatility. Nevertheless, the sheer amount of tangible gold inventory on KGJI's books justifies a much higher value for the equity. You could buy the company outright, pay off all outstanding obligations, and still have a bunch of gold leftover.
Here's how it works:
|In thousands||Per fully diluted share|
|Cost of goods sold <ttm> :||$968,911||$15.08|
|Inventories (mrq) :||$163,232||$2.54|
|Cash & equivalents (mrq):||$5,692||$0.09|
|Total liabilities (mrq):||$11,658||$0.18|
|Shareholder's equity (mrq):||$192,182||$2.99|
|Market capitalization (current):||$129,230||$2.00 (current price)|
|Fully diluted outstanding shares (mrq):||64,253|
Simple addition and subtraction shows you can pay $2.00 per share, receive $2.63 in cash and gold, pay off all outstanding obligations valued at $0.18, burn the rest of the business to the ground, and leave with a profit of $.45 per share (representing an 22.5% return on investment). All that is not even counting the value of any receivables outstanding or fixed assets. At anything less than $2.45 per share, buying KGJI is kind of like piracy, except it's more like getting free gold.
Free gold did you say?! Analysts be darned! I am long KGJI and intend to hold it for as long as the financial statements appear to be legitimate, and the market-cap is well below net asset value of its inventories plus cash minus all liabilities. Short-term traders can set a price target to about $2.45. Longer-term investors, especially contrarians, can hold the firm even longer simply because there are many more positive catalysts than negative. The market is already pricing a large degree of pessimism into KGJI's share price. In other words, KGJI's market valuation should prove resistant to bad news and sensitive to good news.
Returning to the theme of examining one's assumptions, a simple analysis reveals that things may not always be what they seem (financial advice), especially when it comes from the sell-side. KGJI's recent appreciation suggests that we need to re-evaluate the following:
- Brokerage houses employing sell-side analysts do not speculate with client money;
- Sell-side analysts and brokerage-houses are looking after their clients' best interests; advice is unbiased; conflicts of interest are minimal; and,
- There is a wall between investment banking side of the house and the analysts;
If one of these assumptions is erroneous, then the contradiction ceases to exist. It'll be interesting to see next quarter's 13-F filings to determine if institutional holdings in KGJI had increased. If so, then this downgrade may be interpreted as a blatant attempt to cheapen the shares, or at least blunt the effect of institutional purchases on an illiquid stock.