Are All Chinese Stocks Created Equal?

by: Alex B. Gray

Yet another announcement at the end of last week regarding Sino-Forest (OTC:SNOFF and TRE.TO) as Canadian securities regulators in Ontario halted trading in the stock. According to regulators it appeared that certain officers of Sino-Forest may have materially misrepresented some of its revenue and potentially exaggerated its timber holdings. The order from regulators also noted that there have been significant non-arms-length transactions contrary to Ontario securities laws and the public interest. Furthermore, the order called for the company’s CEO, Allen Chan to resign as well as four additional executives. While the regulators later removed the requirement for the executives to resign including the company’s CEO, the announcement of the resignation of CEO Allen Chan soon followed.

The fallout from stocks such as Sino-Forest, RINO International (OTC:RINO), Harbin Electric, Inc. (NASDAQ:HRBN), China MediaExpress Holdings (OTCPK:CCME) among many others has been severe and wide spread. Much of this fallout has been justified, but considering the wide and heavy net it threw over Chinese stocks, there is bound to be some opportunities.

LJ International (NASDAQ:JADE) may be one of those opportunities. Hong Kong based LJ International is a global wholesaler of jewelry and operates 166 jewelry storefronts in China under the ENZO brand. The company’s stock has been under pressure despite positive growth and being listed on the NASDAQ since 1998. JADE recently reported second quarter revenues increased 26% to $41.56 million and net income increased 67% to $3.85 million or $0.10 per fully diluted share. Most of this growth was a result of the ENZO retail segment which added 16 new stores in the second quarter and has already added 12 new stores since the end of the second quarter which should bode well for the third quarter. The wholesale segment underperformed in the second quarter seeing year-over-year revenue drop 19% driven by a 26% sales drop in the U.S. and a 6% drop in Europe. Asian wholesale revenue climbed 49%, but Asian revenues only represent 9% of the total wholesale revenue.

JADE states it is on track to add 14 more stores by the end of the third quarter and another 20 in the fourth quarter bringing the totals to 180 and 200 respectively. This should be the catalyst to drive sales and earnings through the end of the year giving the company in excess of 60 more stores by the end of 2011 compared to the count at the end of 2010.

While there is still significant risk with a company like LJ International, the fact they recently appointed Deloitte Touche Tohmatsu as its new auditor is certainly a step in the right direction to restore the confidence of investors.

L&L Energy (NASDAQ:LLEN), on the other hand, may or may not be a value opportunity. LLEN is a company that has been on my watch list for some time, but I have only recently started more detailed research and due diligence. LLEN originally caught my eye because it was based in the United States, however seeing what happened to Canadian based Sino-Forest should not add much comfort.

LLEN is a coal mining company based in Seattle, Washington with an operations center located in Kunming City in Yunnan Province, China. LLEN began operations in 1995 as Lee and Lam Financial Consultants Company, Ltd. and was primarily a consulting company as well as an investor in various ventures. It was not until 2006 the company made a major move to cease consulting operations and made its first acquisition in the coal industry. Since that time the company has continued to acquire coal mines as well as coal washing, coking and wholesaling operations primarily in the Guizhou and Yunnan provinces of China. LLEN also has a financial interest in a coal mine located in Paonia, Colorado. The company’s stock began trading on the NASDAQ Global Market in February, 2010, but it became a SEC reporting company in 2001 via the dreaded reverse merger.

The company recently reported its fiscal year ended April 30, 2011 results which saw revenues jump 105%. Fully diluted earnings per share came in at $1.21 however, numbers fell short of the company’s guidance due to cooperation with local authorities to slow production and enforcement of safety standards.

On August 2, 2011, Glaucus Research Group issued a research report calling into question the company’s ownership structure of subsidiaries, mining rights, character of management, and potentially misstated financial results. You can read the Glaucus report in its entirety here. Three days later, LLEN issued a press release refuting most, but not all of the claims made by Glaucus. The company’s CEO stood behind the ownership of certain entities and denied that its financial statements may be materially misstated. My concern to the rebuttal by the LLEN CEO, Dickenson Lee, was that it did not touch on every point made by Glaucus. Given the current environment surrounding Chinese companies he should have taken the weekend to write a more detailed response and put investors minds at ease. If Mr. Lee truly wants to restore confidence he should take a page out of the JADE book and hire a large and reputable accounting firm. Mr. Lee did show some confidence that the stock was undervalued by converting a cash loan of $420K in exchange for common stock at a rate of $8.50 per share representing a nearly 150% premium to the stocks recent closing price.

While all of the claims made by Glaucus may not be entirely accurate it did create some smoke. For investors in LLEN, I hope it is only smoke, but for me, I will wait for the smoke to clear before spending much more time on LLEN. If the company does turnout to be legitimate, the upside from here is considerable, however, if a fire exist, we have all seen the downside is substantial.

This article should not be considered an endorsement of either of these companies or any other Chinese stock that looks like a bargain. While I am sure all of this unrest has created some true values, finding the right ones to invest in can be a daunting task and detrimental if you are wrong. However, as primarily a value based investor, I do believe this is an area that deserves at least some research time. I recently read that Jim Cramer is telling investors to just stay out of Chinese stocks all together and that may be the best advice he has ever given. He did mention Baidu (NASDAQ:BIDU) as the only Chinese stock he would even consider, but maintained that investors just stay away from all of them, including Baidu.

It is important for U.S. investors to look beyond the borders for investment opportunities. Investors should plan to spend much more time on research and should understand the company well before committing any capital. Other than a small position in JADE, I am generally more comfortable investing in larger more diversified companies when looking abroad.

Disclosure: I am long JADE.