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The China Small Cap Bloodbath-Historical Opportunity

The China Small Cap Bloodbath

The first half of 2011 was pretty darn ugly in the China small cap sector. It was a bloodbath akin to the last 6 or 7 I have lived through.

I've been professionally involved in the markets one way or another since early 1987. I've somehow survived the October of '87 crash, the Asian Contagion, the Demise of the Dot-Coms, 911, Enronitis, and the Real Estate/Sub Prime market meltdown.

Of them all, the recent 2008 market melt down was by far the scariest as it seemed it was possible for our entire financial system to collapse. This was a once in a millennium event, so it was kind of nice to get out of the way early in the 21st century.

This crash and all the crashes that have come before have a lot in common, but at the same time were each unique in their own way. Bubbles and Crashes go way back in history.

Jonathan's Coffee House in London is credited by many as being the first formal stock exchange. In London of 1690 there were at least 100 stocks actively traded, and brokers would gather at Jonathan's to trade the physical shares. Jonathan was the first to post a daily list of prices. When Jonathan's shop burned down in 1748, it was the end of an era, but led to the building of the first London Stock Exchange.

The first stock market bubble, which started at Jonathan's, burst in September of 1720. Shares of the South Sea Company rose from 140lbs all the way to nearly 1,000 lbs in the summer, but collapsed back to 200 lbs by October.

Since that time irrational markets have been inflating and deflating constantly, fueled by the human emotions of fear and greed.

And, speaking of fear and greed- the fear side of the equation has dominated the China based small cap sector in the first half of 2011. Those who did their homework made the profits of a lifetime in just six short months. From my perspective, I'm glad it happened. Despite having been mistakenly on the long side, I'm an admirer of the markets working thanks to the efforts of those who were temporarily smarter than I was.

However, as with all crashes, there is opportunity. One of the greatest investors of all time, J. Paul Getty, summarized it perfectly when he said

"Buy when everyone else is selling and hold until everyone else is buying. That's not just a catchy slogan. It's the very essence of successful investing".

There's a lot of risk associated with staying on the sidelines. One lesson comes from the uniquely American treasure Mark Twain who tells the story of the frog who burned his bottom while sitting on a hot stove.

The frog learned his lesson, and would never sit on that hot stove again. Eventually, the frog froze to death. That's a story about risk.

I don't plan to freeze to death. I believe there is now a lot of money to be made in this sector.

The Great Bargains of History

I'm now shopping for bargains. There are only brief periods in time where one can accumulate companies with 30% to 50% top and bottom line growth at 2 to 5x their trailing earnings. These kinds of opportunities don't come along too often. Here's some case studies to consider:

  1. In 1984 to venerable Disney Co, that had traded in the $30 range over the previous few years, hit a low of $.73 per share. Disney was close to going out of business. The management brought in Eisner and his team who purchased other media companies like ABC which allowed the company to integrate its brands. The stock went back to $41. Not bad if you bought under $1.
  2. In 2002 (the heart of the Dot-Coms turning into Dot-Bombs), Yahoo! traded as low as $4.05 after peaking at $108 two years earlier. At the time, the stock had more cash per share than its price. Three years later the stock was $43- that was of course before Google came along and changed the Search landscape. You could look at Amazon, Akamai, Cisco, and many others in the same time frame.
  3. How about Jack-in-the-Box in 1993 when the company had customers die from eating meat tainted with E. coli bacteria. The stock traded down to $2.06, but the company survived the publicity, and made a high of $37 in 2007. Not bad.
  4. Apple Computer was probably one of the greatest bargains in history. Apple was trading at $3.28 in 1997 despite having a book value of $6. Microsoft's domination of the PC market at that time was really hurting their business, and large shareholders were calling for a liquidation cash out. Management, led by Steve Jobs, decided to transform Apple into a digital entertainment powerhouse, and the rest is history.

There's four examples of opportunities to make fortunes when Wall Street and the Wall Street media hated those stocks.

Consider an even more current story. In early 2009 my neighbors bought Apple at under $100 (now $360) and Ford at $1.70 (now $13.50) when everyone hated equities- especially the media. Why? Simply because they had just purchased a new Ford Flex and really liked the car, and they used a great many Apple products and loved them.

At the time you couldn't find one talking head on CNBC to suggest any equity was worth owning, but that's when you'll make the most money if you make the right move.

This Time It's Different, But It's Always the Same

"If I had 8 hours to chop down a tree, I'd spend six sharpening my axe"
Abraham Lincoln

One of the common characteristics of the complete wash out of a market sector is the loud voices assaulting us from every direction shouting clearly that no stock in the sector will ever come back. In the case of the China small caps, the loud voices are screaming everything is fraudulent, and the entire sector is dead forever.

Not likely.

I'm amused almost every day when I read from numerous sources that any Chinese company who's a "Reverse Merger" is a fraud.

This is patently ridiculous. It is true that the path to becoming a public company in the US is far easier with a reverse merger. Less review is done at the front end by less qualified merchant banking types, so you're likely to have a higher incidence of problems.

When a company has been publicly traded for 3 to 5 years and done multiple financings and registration statements during that time, its origins are no longer of any importance. It's like saying Warren Buffet is a poor investor because he didn't get a Harvard MBA.

And, speaking of Warren Buffet- did you know Berkshire Hathaway has its roots as a reverse merger, along with the NY Stock Exchange?

Fraud is fraud and you will find it with the most pedigreed company on the NYSE (see Enron), and the smallest China company you never heard of.

As I look over the carnage in this sector I see opportunity. This melt down is a bit different, but it's always the same.

It's different because you can't trust the SEC filings or the audited numbers coming out of these companies- much akin to the Enron/Worldcom disasters in the early 2000's out of which came an atrocious piece of legislation known as Sarbanes Oxley.

When you think about it, this is a less daunting challenge than buyers of Disney or Apple had to face at the bottom. In those cases, you needed faith the company would turn around.

In the case of China small caps, all you need to do is identify the companies that aren't publishing fraudulent numbers. Their business doesn't need to improve. They just have to be honest.

Sounds simple, but not quite that easy. In searching for a good way to "sharpen my due diligence axe" I came upon the answer at a conference in NY earlier this year.

Alan Refkin and his team at China 360 have become my sharp axe, and I expect to chop some huge profits out of this sector on the long side.

I have learned more about China fraud from Alan than I have from reading every Muddy Waters reports they have published.

There are hundreds of great China based growth companies trading with US listings. Some of them are committing fraud. The majority have probably already been uncovered by short sellers.

In order to confirm a China based company is not committing fraud, the company simply has to cooperate with an internal investigation implemented by the folks at China 360.

It's not a re audit of the company's books. Primarily, the review focuses on confirmation the company's China government filings correspond closely the SEC filings.

The most important filing is the VAT (Value Added Tax) return- the equivalent of our Federal Tax return.

In China, you don't mess with the Central government. If a Chinese company files and pays its taxes, you can be 99% sure those are the real numbers. The penalties for cheating the Central government are too severe.

Hence, my belief I can find some nuggets of gold in this vast river of China small caps. I just have to lift the right rocks with gold underneath.

Investigations are underway funded by yours truly. If you want to follow the outcomes and know which stocks I'm recommending, simply subscribe at www.emergingchinastocks.com. I'll find those nuggets of gold for you.

 

 

Warmest Regards,

Larry Isen