Scrooge visits Chinese equity holders

Happy New Year indeed! Holders of AgFeed (FEED) and A-Power (APWR) were greeted with belated Christmas presents this year and quite expensive ones at that. To recap, on Monday FEED greeted investors, at least those who stuck around post the lowered earnings guidance of last month, with even more painful news; dilution at levels below the market. Tuesday brought the - not completely unexpected - news that APWR would be coming in light of its recently endorsed guidance. Both stocks suffered dramatic declines on the news, yet the damage to APWR is temporary while FEED’s is irreparable.

In the financial world of collapsing hedge funds and incredibly volatile markets, macro trends are the dominant influence driving investment gains or losses. Currently investors have more questions than answers: Has housing neared a bottom? How long will the US recession last? How much will the global slowdown impact commodities? Has the low been established in the US market?

Questions like these are quite valid and everyone, myself included, has an opinion regarding the answers. Truly, only time will reveal the answers and it’s a guessing game at best. This overwhelming uncertainty is evident by the volatility in the financial markets. Investors are scared and the result is wild swings in stocks, illiquidity in corporate bonds and irrational despair driving investment decisions. Concurrent to these gyrations in equities and corporate bonds is a flight to quality, hence the low yields on long treasury bonds in the US. This flight to quality is creating a classic contrarian play on the US long bond market.

Last week I wrote about “Irrational Despair” causing panic in the markets. Stocks had been beaten mercilessly, regardless of the fundamentals. Maybe they were too high to begin with? Or maybe not. The point is that many stocks had declined precipitously on the back of unrelated negativity. They have since fallen further. And, as a result of the recent dramatic declines, there are amazing buying opportunities.

Let’s face it; there is plenty to be worried about. The US financial system is in turmoil. Credit markets are frozen solid and leveraged companies are justifiably panicked. However, the central banks are coming to the rescue and, while business will not return to prior levels for many years, liquidity will return to the marketplace. When it does, it will be too late; stocks will rally before things get better.

In the aftermath of the great calamity brought upon by the creator of the phrase “irrational exuberance,” the formerly revered Alan Greenspan, the giant pendulum of investor sentiment has moved to a new extreme: Irrational Despair.

Across the board, irrational despair is driving valuations to unheard of levels. Sellers are desperate for bids as their investors clamor for money back having, belatedly, realized that risk management is an oxymoron in the hedge fund community. Hedge funds are instruments that reward managers for risk taking and they have done so very well in the past (rewarded managers, that is). The fact that they are imploding simply leaves investors holding the bag: the managers have taken their seven figure bonuses in cash most likely.

Investing in China is risky business at best. The local exchanges in China are dominated by former State Owned Enterprises (SOEs) where the public float is limited and short selling is illegal. It’s a perfect recipe for a recurrent bubble. And, as we all know, bubbles pop.

The Shanghai Composite index is down around 50% this year and still appears to be overvalued. Yet, China is the greatest growth play that investors are likely to experience in this century. Shouldn’t there be a safe way to play this phenomenon without getting caught in the wild boom and bust cycles of the domestic exchanges? There is and the answer lies in US listed Chinese companies.

The wild ride for China Precision Steel (CPSL) stock seems to have no end. Gains of over 100% preceed losses of equal magnitude (in dollars not percentage, thankfully!) with amazing regularity. This volatility has led to many investors asking questions about the business at CPSL. These concerns are misplaced, however as throughout this rollercoaster share ride, investors seem to be overlooking one key element of the CPSL story: gross profit continues to grow with regularity.

Looking back over the last two years, CPSL has had more volatility than Lou Pinella on steroids. This volatility has come in terms of both revenue and net income, and, combined with a large retail investor base, has directly resulted in incredible share volatility. Obscured by the volatility has been steady growth in manufacturing capacity and gross profit: numbers that should translate into higher net income now that the costs associated with going public are behind the company.