Paying Attention to U.S.-Listed Chinese Stocks

by: The GeoTeam

Over the last several weeks I have been staring at my screen observing broad strength in many micro-cap U.S. listed China names. China Armco Metals Inc (CNAM.OB), a stock I began to follow on August 18, 2009 at $2.39, and Sinocoking Coal (NASDAQ:SCOK), noticed on February 10, 2010, are just two examples. Like many others, I missed most of the SCOK run during the middle of my due diligence. Conversely, my investment in L&L Energy (NASDAQ:LLEN), a stock that has risen to over $10.00 since GeoInvesting’s profile coverage on May 27, 2009 at $2.10, has paid off.

China Hybrid Stock Era

Last year, in what was ironically the Year of the Bull in China, investors began to find a largely unnoticed market sector of over-performing U.S listed Chinese stocks - a group of companies which I refer to as “China Hybrids." As we roll into 2010, the Year of Tiger, the momentum has continued to lift many of these companies’ shares as more investors discover this space.

What I find interesting is that select China Hybrid companies are beginning to attain price to earnings ratios in line with what has historically occurred with many growth stocks. When I first stumbled upon this sector soon after the turn of the millennium, I could not believe my eyes; stocks with earnings per share growth in excess of 30%, P/E multiples of less than 5, bullish guidance and prices well below book value. This in essence showed the inefficiency of the market. I sensed that the success I experienced in the U.S. stock sector over the last 20 years could be replicated with exponential returns in China Hybrids. As such, I have not looked back from my initial entry into this market niche with investments in American Oriental Bioengineering (AOB) and China Security & Surveillance (NYSE:CSR).

Recently, some stocks that I have taken advantage of, such as Telestone Technologies (NASDAQ:TSTC), China Agritech Inc (OTCPK:CAGC) and Hong Kong Highpower Tech (NASDAQ:HPJ), briefly attained P/Es of 25, an initial barometer I use for assessing fair short term valuation. More encouraging is that Hybrids are beginning to trade independent of the market; a good sign that we are back in a stock picker market.

Currently, one of my favorite China Hybrid plays is New Energy Systems Group (OTC:NEWN), a sleeping giant that has transformed itself from a domestic manufacturer/supplier of battery shells into a vertically integrated international player with several product lines. The company is selling at a P/E of 6 times its 2010 EPS guidance 0f $1.23, which excludes contributions from its international ventures. As an ideal candidate for an up-listing, once it graduates from the bulletin board I am hopeful more investors will find this stock.

Another stock I own, China Yida Holding Co (OTC:CYID) derives revenues from media activities and the management of tourist ventures in China. CNYD could be entering a period of superb EPS growth as it will begin to generate revenues from the management of new tourist ventures. What many investors may not realize about CNYD’s business is the exciting growth potential of its media advertising arm which includes the integration of television programming on railway travel; it is currently the only on board third party media program authorized by the Ministry of Railways. In the 4th quarter of 2009 the company saw its tax adjusted EPS grow over 80%. However, it is somewhat concerning that the company may routinely tap the equity markets, a move that could be mitigated if it were to be immediately accretive to EPS.

The Future of China Hybrids

It is important for investors to erase from their memories the panic experienced in 2008. Barring a market or political catastrophe, it is quite possible that the market run can continue within this sector. However, there will still be psychological pullbacks to take advantage of as stocks move from price to earnings ratios of 5 to 25 while China likely tightens monetary policies to maintain healthy growth. When investing in this space, we also need to be cognizant of the quality of the company and keep an eye out for equity offerings that, on the surface, make no economic sense.

The key questions to ask with respect to offerings are (1) is the company going to use funds for immediate expansion and (2) when will the offering be accretive to EPS? As more investors gravitate to the China Hybrid space, financing terms will hopefully improve.

Before 2008 the Hybrid rallies were quick and sporadic. The rallies are now becoming more sustainable. I feel there is an outside chance that this sector will eventually experience a dot com type of run before reaching its bubble. I Base this partly on supply and demand. I monitor about 600 China Hybrids. Keep in mind that less than half the China Hybrids are likely worthy of investment in (And that is being generous).

I estimate that there are about 20 thousand stocks that trade on U.S. venues. Through consultations with various search engine experts and online tools, I found that there is a wide gap between the search of broad stock related terms such as “stock market” and “stock trading” and Chinese stock terms such as “Chinese Stocks” and “Asian Stock Market”, with the former averaging millions of Google searches per month and the latter averaging less than 20,000. In fact, most of the China related search terms don’t even crack 1,000 per month. This tells me that the U.S. investor has still not discovered this space. My beliefs are further supported by emails I receive from hundreds of visitors to my site thanking me for introducing them to this sector.

The difference between the dot-com era and now is that in the modern day gold rush for China Hybrids, investors can actually value shares.

Ask your neighbors if they are investing in China and they will likely say investing in the market is complicated and risky. When you explain to them the finer details of investing in listed Chinese stocks, they may become slightly intrigued. Then ask yourself what happens when millions of investors begin to chase the limited supply of China Hybrid stocks.

As always please use discipline when investing.

Disclosure: Long CNYD, CNAM, TSTC, LLEN, NEWN.OB, HPJ, SCOK, No Positions in AOB or CSR