Background
Chinese small-cap stocks have been very unfavored by the market in recent years. Starting in the early 1990s, Chinese companies began to list in the United States in the hope of attracting capital and benefiting from higher standards, e.g. in terms of corporate governance. Between 1990 and 2010, they came in three waves:
"The first arrived in the 1990s, after privatization and at the direction of Chinese regulators. The second wave of listings included more state-owned giants, as well as an increasing number of private companies, many from China's burgeoning technology sector, including Baidu and Youku. The third wave of listings was larger by number- around 500 companies-though the companies themselves were much smaller, with an average market cap of less than $5 billion." (Source: McKinsey)
It was in the third wave where the problems started to brew. A few of those companies were listed by reverse merger ("an unlisted company acquires a shell that is already listed and registered with the US Securities and Exchange Commission (SEC), bypassing the more rigorous scrutiny of a standard IPO"). And by early 2011, investors started to witness fraudulent behavior and false accounting, leading to investigations and delistings of many companies (more than 100 were delisted or suspended from trading on the NYSE in 2011 and 2012 due to fraud and accounting scandals). This, coupled with capital controls and restrictive government-control environment, has often raised investor skepticism. As a result, the share price of most Chinese companies fell significantly, with only the large caps recovering in time. Currently, there are still many Chinese stocks, especially small caps, selling at very low prices - well below net current asset value (NCAV) and often far below cash value.
Portfolio Strategy Idea
If all were well, e.g. if these were relatively trustworthy American stocks, one would expect the price to recover to its true value in due time. Obviously, there are the concerns about accounting and if investors will ever receive benefits from owning the companies (e.g. will the companies ever pay regular dividends?). But given the great undervaluation of many Chinese small-cap stocks, it might be worth considering for investors to dip a toe in the water to allow for the chance to get exceptional returns if or when the market price adjusts to the companies' proper value.
In that regards, we would recommend a "venture capital" strategy. Basically, create a diversified portfolio by investing relatively small sums in multiple such companies, knowing that some may fail, but the ones that succeed will deliver great returns that outweigh the losers. Venture capitalists usually operate like this - allocating capital to many companies, knowing that maybe only 10% will succeed, but whose returns will outweigh the loss from the rest.
In addition, the small-cap stocks tend to be highly volatile. So, even though the companies might not be successful in the long term, they may still allow the potential for outstanding returns through short-term fluctuations. An example might be SORL Auto Parts, Inc. (SORL) that sold well below NCAV in early 2017 (approximately $3/share), but then sharply rose to above $8/share in less than a month. Another one could be Ossen Innovation Co. (OSN), which, after staying fairly "dormant" for a couple of years, rose sharply by more than 200% in early 2018. And even though the stock came back down relatively quickly afterwards, alert investors could have profited handsomely by taking advantage of the temporary sharp price increase.
This strategy may require some patience and ability to withstand short-term volatility. Building a well-diversified portfolio consisting of multiple such cheap Chinese stocks could result in investors benefiting through either sharp short-term fluctuations or gradual growth towards intrinsic value. By constructing a portfolio of many stocks, investors will diversify the risk of loss, regardless of that reason being suspected fraud, change in underlying fundamentals, or other, while allowing the potential for above average return due to the great undervaluation of the stocks.
In the coming terms, we will be featuring ideas for investors to use in constructing such a Chinese small-cap, net-net portfolio. In that regards, we will provide general analysis for individual stocks with commentary, ranging from income, balance sheet, and cash flow analysis to fundamentals to reasons for undervaluation.
As a head-start, you might be interested in looking at Renmin Tianli Group, Inc. (ABAC), whose management we recently engaged with in relation to excess cash position, capital allocation, undervaluation, and share repurchases. The company is a Chinese-based agricultural company engaged in hog-farming and related retail activities. It was originally listed in the reverse-merger format and made two acquisitions of unrelated companies in 2014 (that it subsequently divested of and refocused the business back to hog farming). There have never been any known substantiated fraud concerns, yet its shares sell at a significant discount to net current asset value. In April 2018, the price was approximately $2.5/share while the company's book value was roughly $11.3/share and its net cash value $7.4/share (cash & cash equivalents net of total liabilities), according to the annual report for 2017). Interested investors can learn more by reading our earlier article, "Renmin Tianli Group: Deep Value Analysis, Capital Allocation, And Activist Opinion".
Disclosure: I am/we are long ABAC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
