The period since early July has been an extraordinarily painful period for most investors. Needless to say, the arrows for almost all stocks alike – growth, value, American, Europe, emerging market, real estate, bank, consumer discretionary, tech, you name is – are down. Lately, however, there is a trend emerging: the valuation gap between overvalued and undervalued stocks has been narrowed somewhat and is continuing to become narrower each week. I think this is a very encouraging development for the financial market and economies in the world because, like the outrageously big inequality of wealth and income among people touted by OWS movement, the valuation gap between groups of stocks has really gotten to an absurd level that totally demolished the mechanism of optimal capital allocation to various resources that create measurable benefits to the people of the world and the sound, stable wealth creation for all investors.

On one end of the spectrum, the valuations of overly hyped and cooked momentum stocks with shaky outlook and unrealistic growth targets (especially for bottom line) such as NFLX, AMZN, CRM, LNKD, GRPN, RENN, YOKU, and SINA have dropped. Among all the stocks that were flying high and overly priced at the beginning of the year or IPO, with the exception of DangDang, most of them do not have real profit-generating business models that can be sustainable in the long run. I don’t think I need to spend more time on NFLX because it is obvious that everything I said about its ridiculous valuation level and unrealistic future revenue and earning growth prospects (if there is any at all) hyped hard by many sell side analysts is proven true and acknowledged by most investors. Now, take CRM for another example. Although I do not think Salesforce’s short-term business outlook is as dire as Netflix’s, in my opinion the gap between its fair value in five years and its current valuation level is almost no less unthinkable than that of Netflix when it was at $300. Using Yahoo Finance’s number, the stock is trading at a whopping 546 times TTM EPS! In fact, the company had a net loss on GAAP basis and still a pretty pessimistic 34 cents per share earning after the management team exhausted all ways to adjusted the numbers to create a good looking non-GAAP EPS. Many articles enumerated the deficiencies in its reported numbers and risky business outlook under increasing competitions and possibly decelerating growth of the industry under serious economic troubles all over the world right now. For example, the two articles below summed it up pretty well:

http://seekingalpha.com/article/309393-salesforce-com-management-is-still-throwing-up-red-flags?source=yahoo

http://online.barrons.com/article/SB50001424052748704101304577038252329448774.html?ru=yahoo&mod=yahoobarrons

Yet, there are still plenty of irresponsible sell-side analysts shouting it a bargain to retail investors, trying to convince them to overlook all kinds of huge red flags, risks, challenges, threats that have mounted to the company, and luring people into buying a stock trading at 6 times revenue and 500+ times EPS. Oh yeah, according to those big name crooks, it would be just find because the EPS will just somehow grow 50% YOY for 10 consecutive years so that the company’s EPS would be $12 after 10 years, justifying a $120+ price under a P/E of 10. Well, if the company is in its 3^rd year with proprietary disruptive new technology like personal computer to Microsoft in 1990, I might give the benefit of doubts to it. For a 12-year old company competing with tons of competitors for a stuff that has been hyped for so many years without generating realizing real radical change and “jaw-dropping” efficiency/cost gain for corporations, this kind of day dream won’t fly. I mentioned the lesson learned from Blockbuster, Movie Gallery, and AOL as a prelude to the doom fate of Neflix, similarly many investors have forgot the painful lessons learned from countless failed B2B stocks burst during dot com bubble. At current stage of the industry and the already big scale of the company, CRM will bump into some serious steel wall obstacle one way or another, somehow, somewhere (or maybe everywhere). In 5 years, under a good scenario it probably can only grow its top line to $4 billion and earn $400 million per year in its MATURED STATE rolling along 10% annual growth rate. In this case the company should be valued between $6 billion (15x P/E) to $8 billion (1.5x revenue), or roughly $44 to $60 per share assuming current shares outstanding. In a more middle of the line scenario, the company likely will only have $3.5 billion annual revenue and just break even to earn a couple million in its “steady state” after 3 ~ 5 years. In this case the fair value should be around $3 billion, or roughly $22 per share assuming current shares outstanding. Remember, big bellwethers such as HP, Microsoft, IBM, and Oracle have just started pushing hard on their own cloud and SAS (software as service) efforts. We’ve seen how Microsoft can easily undercut smaller competitors’ prices and dump them into dark hole – example: Netscape and whole bunch of office suite makers. I see no reason any of these companies cannot dish out a serious blow to CRM and other smaller fishes any time. Note that I am not predicting that CRM will go bankrupt in five years, although there are some chances for that to happen. I am just saying that the road to continuous growth will be much much tougher for the company in the next five years than in the past five years. Accordingly, the stock should in no way be valued at this sky-high valuation multiple from now on (even if they ever should be justified for that high multiple in the past).

That’s all I have to say for current situation for these overly hyped stocks. On the other end of the spectrum, valuation of stocks with very robust business model and stable earning stream but heavily out of favor and out of Wall Street’s radar due to various temporary reasons such as LPH has been gradually climbing up from underground levels. The street seems to be just starting to apprehend and appreciate the immense earning power and value in stocks like LPH with proven business model and secured, robust current earning and future growth prospect. Some readers asked me over the last 4 months why I haven’t published a new article about LPH for a while. Does it mean that I am less assertive on the company’s valuation or less bullish on the company’s current or future business? No, absolutely not. In fact I have become more confident and bullish on the company and the stock than ever over the past several months from the developments happening lately. I have not written about the stock because I think I have said most that can be said about the undervaluation of the stock and that I want other investors to observe and think about it by themselves. Chinese small cap group have had the worst year ever due to uncover of several bad apples that destroyed the attractiveness of the entire basket. After almost a year and dust almost settled, it is apparent by now that the generalization that all Chinese small caps are phony companies simply irrational and fallacious. In the case of LPH, what the company and the management team have down over the past few months clearly show that the company’s business operations are real and that the assets and earning streams that the company provides should definitely be valued at a much higher level. Now, I am not saying that the management team is perfect and that they have satisfied all investors’ demands and wishes (if it is even possible for any management team to accomplish that). However, to me the following several key facts are undeniable and are enough to stamp an approval of the company, the management team, and a much higher price of the stock:

The following three points are even more table-pounding than the previous two:

First, some investors, especially retail investors, are not very conscious about the decrease in number of shares outstanding as a result of share buyback. Some are doubtful on whether the company actually returns money to all shareholders or only the big or privileged shareholders (including insiders) since nobody see whose share exactly a company buys. On the other hand, when a company pays dividends all shareholders see a hard dollar cash return to their brokerage account and thus are certain that they have reaped real fruit from their investments in the company. Secondly, because of the first point when a BOD decides to return part of the profits the company earn as dividends to shareholders it shows the market that the BOD and management really cares about all shareholders and really keeps the financial doctrine of “maximizing shareholders’ wealth” in mind when they run the company every day. Thirdly, Because the first point and because dividends are viewed as having a strong tendency of continuation (unless the company explicitly says it is a one-time dividend), a company that pays dividends is always regarded as having sustainable and stable profitability and cash inflow. As a result, the company’s shareholder base will consist of mostly strong long-term focus investors, making the company’s share less susceptible to short-term volatilities of the overall economy or stock market, rumors, and manipulations. Fourthly, because of the previous three points almost no company that is a fraud or scam ever pays dividends. Thus, paying dividend will be completely all unfounded rumors about the company being a fraud or scam. Fifthly, paying dividends will impose hard cash “penalty” on shorting the stock. This is why most dividend-paying stocks have very low short interest. Not that shorts are of much concern to LPH right now. The short is so low that can only be seen under microscope. However, this extra deterrence may come in handy if the stock appreciates several folds within a short period of time, when some shorts might feel itchy of making quick profits by betting on a technical pullback. Last but not the least, many large mutual funds are restricted to invest in only stocks that pay dividends; some fund managers are not required by the contract to do so but still prefer stocks that pay dividends. Therefore, when a company starts paying dividends it will immediately increase its potential shareholder base, or the “consumer base” of its stock, by a large degree.

I saw some comments on discussion boards saying that some investors would like to see the biggest shareholders voluntarily exclude themselves from receiving dividends. Well, I have to pour a bucket of old water on these people because I think the wish is totally unreasonable and I don’t think it will ever happen. Most minority shareholders are Americans who only put a small part of their personal fortune in LPH, sitting on couches and hitting buy or sell buttons on their screens and waiting for the company to make money for them. On the other hand, the two big insider shareholders are working diligently with all other executives and employees every day on the ground to run the company’s operations and trying hard to grow the company. As said earlier since they were the founders of the company, have been running the company for so many years, and have left the majority of their original stakes in the company after IPO, they probably have an overwhelming portion of their families’ wealth tied to the company. Unlike so many CEOs and other executives of overly hyped companies or frauds, they have got very limited pay-backs from their work for the company and need to get some returns from the success of the company’s operations in order to make their lives better. Just on what account can minority shareholders, who are purely investors, ask them to receiving no return for their hard work and giving all paybacks to others? I don’t think the founding principal or U.S. constitution gives minority the right to discriminate against the majority because they were discriminated in the past in some other way. Shareholders of LPH should be happy that they are fortune enough to have a BOD and management team that treat them equally and do not simply steal their money like the insiders of over hyped or fraud companies do.

Now, when exactly will the company start paying dividends and how much dividends will it pay? My guess is that the company will probably start paying dividends in the first quarter of fiscal year 2013, i.e. the third quarter of calendar year 2012, after it has increased inventory in its new Huajie facility to a stable level. As for the amount, I think the BOD might decide to declare a quarterly dividend of 5 or 6 cents per share as a start (20 or 25 cents annualized). By that time the company should be earning 30 cents profit and net cash inflow with Huajie facility running at the management team’s short-term target throughput ($300 annual revenue and $40 net profit). 6 cents per share dividends means roughly 20% payout ratio.

Before I ended my writing I’d like to address a question I got from a reader. The reader asked me if I am concerned by the slow-down of the growth in LPH’s revenue and net profit in the last quarter and going forward. The answer: not really. If the stock is trading at more than $10, I think the concern might be real. However, with the stock still being traded at just $1.25, the slight slow-down in revenue growth is really a muted point. Looking forward the next four quarters (1/1/2012 to 12/31/2012), it is very unlikely that the company will not be able to earn at least one dollar per share after Haujie facility is onboard. As a table in my last coverage update showed, most listed oil stocks, including those that have very low growth rate, trade at 8 or higher multiples of EPS. How ridiculous is LPH’s current forward multiple of about just 1? Consider this: even a private, small, retail oil operating asset can find plenty of buyers willing to pay at least 4 times of annual net profit. In other words, even for a private oil operating asset with very limited liquidity such as a gas station, many owners will be more than happy to earn just 25% return on capital, or pay back period of 4 years on initial investment. If I offer to pay just $1 million to buy any gas station earning $1 million net profit a year, the existing owner will tell me to have my brain checked and shut the door. Even if I offer two million bulks I will still be told to get some pills. Unless China GDP contracts 10% in a year, oil consumption will still grow and so does the company’s revenue. In addition, as a black-gold wholesaler in an oligopoly situation the company’s margins are very stable. As such, the stock is actually a very good hedge against economy downturns in China or other parts of the world. Until the stock is awarded at least 8 times forward EPS, whether the company is growing at 30%, 20%, 15% or even 10% really doesn’t matter. The fact Longwei’s revenue growth temporary slowed down a little bit in the summer during temporary softness in Chinese economy under the effect of debt crisis in Europe is another proof that the company’s financial results are very reasonable and understandable and that the management team is not interested in cooking the book.

The stock’s prices and volumes lately suggest that most weak or pure speculative hands were washed out in the summer during the panic selling all over the world. For me personally I am caring less and less about how soon the market will increase the stock’s valuation because like the insiders I am happy to own the stock as a private investment that pays 20 – 25 cents return (dividends) a year, which grows at 20% or faster in average over the next 10 years. Unlike earning or sales multiples, dividend yields have a very tight band because it is a hard cash income stream that nobody can ignore or dispute about. Chinese energy stocks that pay dividends yield around 3% % (e.g. PTR and SNG). Knowing that 10-year U.S treasury is yielding only 2% fixed yield (unless its price drops of course), I would be happy to earn 3% interest that grows 20% per annum for the fixed income portion of my portfolio, and I think the managers of many current income focused funds will concur. To generate 3% yield under 25 cents annual dividends, the stock should be priced at $8.33, validating the lower end of the company’s fair value band using comparable P/E multiples.

If the stock somehow still stays below $3 for considerable period of time, I still think that it will be bought out by the two biggest shareholders or by external entities. Again, I don’t think this is just a wishful thinking or hypothesis. It is as real a scenario as possible right now. Look no further than HRBN (http://seekingalpha.com/article/303735-harbin-electric-buyout-approved-implications-for-u-s-listed-chinese-stocks), SNDA (http://finance.yahoo.com/news/Online-game-company-Shanda-go-apf-3632803610.html?x=0&l=1), and GEDU (http://www.reuters.com/article/2011/11/21/us-pearson-brief-idUSTRE7AK0O320111121?feedType=RSS&feedName=innovationNews&rpc=43) for examples. This article - http://blogs.wsj.com/deals/2011/11/23/take-privates-capture-asian-bankers-fancy sums up the situation nicely. If you are wondering I don’t think LPH’s current revenue and net profit definitely pass the listing requirement on Hong Kong or mainland China, at least for ShengZhen exchange (it was not qualified two years ago when it chose to be listed on Amex). As in the cases of HRBN and SNDA buyouts, if LPH CEO gets funding ready when the lending market is China comes back in order next January and offers to buy out all shares at $5 (assuming the stock is still trading below that price), the outsider shareholders will have no claim in court to argue that the price is unfair to block the buyout because they have more than two years of time to buy however many shares under four dollar , three dollar, or even two dollar but chose not to do so even after the management team has told the market repetitively that the company is doing great and that they think the stock is seriously undervalued. A court will side with minority shareholders’ argument that the buyout price is unfairly low only if the management team intentionally hid good news of the company and paint a gloomy future of the company before suddenly offering to take it private. A court will not pity minority shareholders if they are fooled by rumors or fears spreading over the stock or a group of stocks and subjectively decided to shy away from the stock even at dirt cheap price levels.

A closing thought: taking a two-year time-frame it can be argued that the fair value of LPH and CRM may be very close - $20 for LPH and $20 - $40 for CRM. Yet one is valued at almost 100 times of another’s price. Like income gap between rich and poor in the U.S. the valuation gap between overly hyped and overly dumped stocks has really reached an unprecedented, unsustainable, insane level in my opinion. Like the issues of income gap, budget deficit, and political deadlock, the issue of valuation gap needs to be solved and decreased significantly in order for this country and its financial system to keep on marching toward self-destruction. For the benefit of 99% of investors I hope it will be corrected sooner rather than later.

PS: I will update my price target after the acquisition of Haujie facility is formally closed. Although I will not rely solely on the management team for the estimate of Haujie’s revenue run rate for the next four quarters (calendar year 2012), it is a meaningful reference point for me.

Disclaimer

I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.

My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.