Intelligent investing is nothing more than maintenance and expansion of capital while managing risk in a world of imperfect information and uncertainty. To do this, one must think clearly and avoid letting emotion or fear corrode rationality.
Benjamin Graham, writing about investing during the Great Depression, after equities and bonds had collapsed, wrote:
At that stage, the same advisors who had recommended them [equities and bonds] at par as safe investments were rejecting them as paper of the most speculative and unattractive type. But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonable safe.
Market sentiment responded similarly when the Internet bubble popped in 2001 and when banking collapsed in 2008 and 2009: stocks that were once “strong buys” were suddenly “too risky” to own. When the opposite was true, the steep market discount post collapse made them undervalued, and thus less risky, not more. Those who have witnessed the rise and fall (and rise and fall) of the U.S. listed Chinese RTO space ought to consider the wisdom of Graham's observation.
One very simple conclusion I draw from Graham's point is that there are neither “good” nor “bad” stocks. Rather, there are only underlying businesses and their financial results, and their stock prices can be either “cheap" or "expensive.”
As I have written before, one of Benjamin Graham's most powerful ideas is this little gem:
The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.
It is a powerful idea because individual investors have the choice to follow or not to follow Mr. Market. Investors can choose to buy when a stock is "cheap" or when it is "expensive."
To determine if a stock is “cheap” or “expensive” Graham developed several metrics, including Intrinsic Value and the Blended Multiplier.
Recently, I wrote about L&L Energy (NASDAQ:LLEN) and evaluated it using Graham's Intrinsic Value formula. Here I am going to do the same with another China coal company, Sino Clean Energy (SCEI).
Sino Clean Energy
SCEI is a third party commercial producer and distributor of coal-water slurry fuel (CWSF or CWS) in the PRC. CWSF is used in boilers and furnaces to generate steam and heat for residential, governmental, and industrial use. SCEI sells CWSF directly to these customers. SCEI is the largest domestic third party supplier of CWSF in northwest China per sales volume and the third largest third party supplier of CWSF in all of China per sales volume.
CWSF is a “clean coal” technology. It is a heavy liquid fuel produced by mixing ground coal with water and chemical additives. CWSF can be stored, pumped, and burned as a substitute for oil or gas in certain furnaces and boilers.
Compared to coal, CWSF has less risk of unwanted combustion and a thermal efficiency near that of oil and gas, while significantly reducing air pollution and carbon release (75% less). It is also cost effective for end users. Currently, CWSF is the only economically viable “alternative energy” to the direct burning of coal by heavy industry.
For these reasons it is preferred by industry, local municipalities, and the PRC itself, with CWSF since 1981 a “core energy technology” per the PRC's Five Year Plans. This last point is of considerable import given the PRC's role in managing the Chinese economy and its continued growth.
Challenges to CWSF production and distribution, given water weight, include storage and transportation. Competition from nuclear, wind, geothermal, and solar may at some point make CWSF technology obsolete, though this appears extremely unlikely for the foreseeable future.
SCEI has very healthy margins, positive cash flow, little to no debt, and recently raised $33 million in a secondary offering, including the over-allotment (“the greenshoe”). Thus, SCEI is now also very well capitalized, with cash and cash equivalents approaching $70 million.
In the first nine months of 2010, SCEI sold 684,728 metric tons of CWSF at an average price of $728 per ton compared to 275,793 metric tons at $660 per ton compared to one year ago. Per company financials and SEC filings, for the first nine months of 2010, sales increased 172% to $73.6 million from $27 million in the same period of 2009, with income from operations increasing 223% to $24 million from $7.4 million.
Diluted GAAP earnings per share were $1.88 based on a float of 18.7 million shares.
SCEI also provided a non-GAAP figure of $1.04 earnings per share for the first nine months of 2010, in consideration of non-cash charges primarily related to the costs of private placement.
Repeated non-cash charges in the future should be treated as symptomatic of poor financial stewardship, or worse, in the same sense that 10-Ks with regularly recurring "non-recurring" charges should create immediate "financial red flags" in the minds of shareholders.
Management has reiterated its fiscal 2010 guidance and expects revenues of $105 million and an adjusted net income of $25 million, representing increases of 128% and 127% when compared year to year with 2009 results.
SCEI expects to end 2010 with 1,150,000 metric tons of total CWSF production capacity. SCEI plans on increasing CWSF production from this figure to 5 million metric tons by the end of 2012, representing a five-fold increase in less than two years.
Graham and Intrinsic Value
Graham, in the various editions of The Intelligent Investor, developed two "Intrinsic Value" formulas for securities analysis. I give them both below.
(1) Intrinsic Value = Trailing 12 months EPS [8.5 + 2(earnings growth)]
(2) Intrinsic Value = Trailing 12 months EPS [8.5 + 2(earnings growth)] (4.4) divided by the yield on corporate AA bonds
In the above calculations, I assume 5.92% as the yield on corporate AA bonds.
Also, I use year to year quarterly growth on earnings of 25% (a) and 50% (b) and 75% (c) and 100% (d) rather than the reported, audited figures. For reasons of margin of safety, I am deeply discounting SCEI's reported, audited growth figures over the last year because such strong growth is unsustainable, for any business, in the long term. For 12 months trailing EPS, I am using $1.75.
Working with the assumptions listed, "Intrinsic Value" is as follows:
SCEI - Method 1
SCEI - Method 2
As previously stated in my L&L Energy write up, Method 1 is to be preferred over Method 2: excluding market crises, external shocks, or extremely negative short term news, investor use of Method 2 will result in holding cash or bonds far too often.
In addition, I strongly disagree with Graham on the preferred asset class of the denominator, but that is a topic to be addressed elsewhere.
At a closing price of $6.61 (31 December 2010), SCEI appears significantly undervalued, currently trading far below even the most conservative of the Graham intrinsic value formulas.
This is an extremely rare occurrence for a business facing neither civil litigation, government investigation nor immediate bankruptcy, let alone a cash rich, debt free, profitable operation with a clear cut growth strategy and government supported demand for its product.
For example, compare SCEI's Method 2 results to L&L Energy (LLEN) and Puda Coal (OTC:PUDA), two other healthy, profitable, and "in the news" growing coal companies with mining and coking operations in China within the context of PRC supported coal mine consolidation.
LLEN - Method 2
On 31 December 2010 LLEN closed at $10.80.
PUDA - Method 2
On 31 December 2010, PUDA closed at $14.25.
Graham's Blended Multiplier
In addition to Intrinsic Value, Graham also used what he called "the Blended Multiplier" to assess whether a stock was “cheap" or "expensive.”
The Blended Multiplier is a simple metric:
(Price to Book Value)(Trailing 12 months P/E).
Any equity trading above 22.5 should be considered “too expensive.”
Graham considered his blended multiplier a good metric because any individual stock trading at more than 15 times past earnings with a price to book value greater than 1.5 would be screened out, yet it remains flexible with respect to differing, variegated “normal” P/Es and price to book values across divergent economic sectors and spaces.
SCEI has a price to book value of 2.50, and a P/E of 3.77. The blended multiplier is therefor 9.43, significantly below Graham's margin of safety figure of 22.5.
Continuing with the LLEN and PUDA comparisons, LLEN has a blended multiplier of 19.77 whereas PUDA's blended multiplier is 25.33.
Small Cap Considerations
Other Graham measures of performance include size of enterprise, financial condition, earnings stability, dividend record, management leadership, positive cash flow, and the ratio of price to net assets.
Assessing SCEI with these other metrics is difficult, given its limited history.
As a small company with a limited record of earnings and growth, and with a management team that has yet to prove itself able to handle rapid expansion, SCEI would likely fail to pass Graham's strict scrutiny reference size of enterprise, dividend payouts, management leadership, and earnings stability.
This underlines the inherent risk of micro and small cap investing, but it also reveals a potential systemic failure of Graham's metrics and methodology with respect to valuing micro and small cap equities. I plan to address this systemic failure, and how to value micro and small cap firms within a “modified” Graham framework, at a later date.
SCEI is a small firm and a singular production or distribution problem could choke off revenue and income entirely.
Other risks include potential poor management of growth, a small float lending itself to both merited and unmerited short selling, the possibility of domestic Chinese social unrest, cold and hot strife between nation-states reference borders, physical assets, routes of trade and currency manipulation, untoward, adverse actions by the PRC itself, the "dark cloud" hovering over U.S. listed micro and small cap firms operating in China in general, and possible late 2011 or early 2012 additional shareholder dilution.
In addition, volatility in the China small cap space is extremely high and will likely remain so for the near future.
Based on the above analysis, I am placing a one year target price on SCEI of $9.50 to $10.50. I am long SCEI at $5.90.
Disclosure: I am long LLEN and SCEI.