Chinese Cmall Caps Affecting a Catalyst for Change

by Maj Soueidan

As a participant in the equity markets for over twenty years I am constantly seeking new profit opportunities to exploit. I came upon the US listed China market in 2005. My first investments in this venue were American Oriental Bioengineering (NYSE:AOB) and China Security & Surveillance (NYSE:CSR) when they were both on the OTCBB. Investments in this arena have continued to fuel above average returns for my portfolios, a large reason why I am always seeking new ways to identify new opportunities in the U.S. listed Chinese stock space.

I have never been a fan of investing in penny stocks, but the recent market turmoil combined with the nature of some of the China reverse merger transactions resulted in profitable Chinese firms selling for pennies, many times below book value. While I don't view book value as the most important criterion when valuing stocks, I believe in certain cases it can be a useful tool, especially when valuing companies growing their EPS. I have found that the Chinese market is full of this circumstance.

Obviously, one must ascertain why a stock is selling below book. Three major reasons why this may be the case in the China sector revolve around capital structure, liquidity and lack of exposure. The key to capitalizing on the investment opportunity is to identify a catalyst for change (see table below).

I have found that companies that can address these issues eventually see their stock prices gravitate to their book values. Here are some examples:

*Stock was not selling below book, but had potential liquidity issues
**The GeoTeam is currently investigating the Asia Cork story. Investors are urged to do their own due diligence before making conclusions.

The beauty about most of these examples is not only were they selling below book when we found them, but they were growing their earnings and/or have bright futures. It was an ideal situation in that these stocks had value and growth.

That being said, our initial goal with this strategy is to identify stocks for which the market will re-price risk away from a failure assumption (below book).

We have currently identified over 40 stocks selling below book value per share. Here are a few:

China Medicine Corp (OTC BB:CHME)
Lotus Pharmaceuticals (OTC BB:LTUS)
China Growth Development (OTC BB:CGDI)
Huifeng Bio-Pharma Tech (OTC BB:HFGB)
China Green Mat Tech Inc (OTC BB:CAGM)
China Agri-Business Inc (OTC BB:CHBU)
Sino Gas Intl Holdings (OTC BB:SGAS)

Due Diligence with Lotus Pharmaceuticals

Lotus Pharmaceuticals is the only company from the above list on which we have performed extensive due diligence, including an interview with the Company. We noticed Lotus was selling under book despite maintaining profitability. After reading SEC filings we came across many misleading paragraphs insinuating liquidity problems about which you can read more on GeoInvesting. An alert investor who read our notes suggested that our assumptions were incorrect and that we should call the company to get a better understanding of the situation. In a nutshell, it turns out that the verbiage in the filings was incorrect.

The company maintains that it is in good financial health. We are convinced that Lotus understands the importance of clarifying this issue in the near future. We are hopeful that investors will eventually re-price LTUS shares by eliminating liquidity issues from their analyses. The stock has actually seen its shares more than double from mid July levels.

Furthermore, the company is embarking on a 2010 growth strategy that it believes will lead to increased sales through the introduction of new products and increased distribution channels. It is somewhat impressive that the company has been able to grow its earnings in 2009 regardless of lower sales due to pricing pressures. We will be establishing a position in the stock based on a favorable risk/reward ratio.

Due Diligence with Asia Cork

We are currently investigating Asia Cork, a profitable cork-based building materials company we initially mentioned on August 20, 2009. At the time it was selling at $0.27 per share with a book value of $0.57. Although comments in its recent quarterly filing were bullish, the following commentary is somewhat worrisome:

"At the present time we do not have sufficient cash or cash equivalents to repay promissory notes should the investors demand payment upon maturity."

Ideally, a resolution to this issue (the catalyst) may pique investor interest.

As indicated on GeoInvesting, the GeoTeam established a position in AKRK, recognizing that there was a high risk for a dilutive event to rectify the current liquidity situation. There is also a convertible note outstanding which could lead to dilution.

We will soon be publishing a list of companies selling below book. We are not sure how long this market inefficiency will last, so do your homework and find a company's catalyst for change.

Disclosure: Long CGDI, AKRK, CKGT, CAGC, OPAI, CHGI