GeoTeam To Assess Risk Position of ChinaHybrids

In 2009 investors began to discover the ChinaHybrid space which boasted companies that were exhibiting spectacular EPS growth and low P/Es, a combination that U.S. investors had not been accustomed to. For a time being, during the rally, EPS growth did not even matter. After a strong start, 2010 has thus far had a different outcome. Investors have decided that EPS growth does matter and many of the stocks that recklessly raised money (some still are) are receiving their punishment, magnified by the market uncertainty.

Those who follow the GeoTeam by now realize that dilution was our most pressing concern with ChinaHybrids. While still the case, we now have risk aversion concerns to contend with as short-selling investors investigate the space. Ironically, we also have to be aware of those companies that need to raise money who will not be able to access capital in the existing market climate.

Yes, ChinaHybrid P/Es are low and at times are priced to fail, which means a recovery is in order, but we must be on a quest to find those firms who will ride past temporary price adjustments and take portfolios to new heights. We need to sift through the carnage and gain an idea of the challenges individual firms face in the their plight to emerge as winners, all the while avoiding those companies whose interests are not aligned with shareholder values. To that end, as our readers may have noticed, we have been publishing updates on ChinaHybrids in order to help investors gain a sense of the outlook for these companies, their liquidity needs and the current roadblocks they face.

We are also compiling a check list to assess the risk position of firms in the ChinaHybrid space. For the time being this will consist of the following: (this list is likely to grow substantially)?

1. Is the company's auditor ranked in the top 100?
2. Is the auditor located in the U.S.A? If located in China the PCAOB (Public Company Oversight Board) may be denied access to investigate the practices of the auditing firm. Short sellers have been using this information as a tool to validate their opinions.
3. Are the company's internal controls satisfactory?
4. Are their any outstanding legal issues?
5. Do the company's top ten customers represent less than 10% of revenues?
6. Is operating cash flow divided by current liabilities is greater than 1. The higher the better. (we will use annualized cash flow run rate and eliminate non-cash charges from account liabilities ).
7. Is cash divided by Current Liabilities greater than 1. This is the most conservative liquidity ratio.
8. Is the company buying back stock?
9. Do the Chinese financial filings match the SEC filings (In process of verifying)

In the interim, we have placed GeoBargain and GeoSpecial China Hybrid stocks on their respective GeoInvesting on the Radar lists as we go through our checklist for each company.

We looked at close to 50 companies, some that were winners in 2009, but have become dogs (rightfully so in some cases). We were amazed to find only a few that are currently largely free of obstacles. The task at hand is to decide which of the beaten up firms are worth owning.  New Energy Systems Group (OTC BB:NEWN) and Deer Consumer Products (NASDAQ:DEER) were two stocks that currently seem to face few obstacles and appear to be shareholder friendly, but even owning them is fraught with perceived risk.

Yuhe Intl (NASDAQ:YUII) was a firm on the verge of eliciting excitement in our camp, but our short-term conviction has somewhat waned, a sentiment related to future dilution concerns.

We have high hopes for Soko Fitness & Spa (OTC BB:SOKF), but they have yet to put money from a recent raise to work, a fact that has us moderately worried about short-term dilution.  We still believe that the long term story is solid.

We are staying away from firms like China Yongxin Pharmaceuticals (OTC BB:CYXN) that seem to have no regard for shareholder value as evidenced by a recent private placement they consummated at $0.06 (pre reverse split).

China Green Material Tech (OTC BB:CAGM) just raised money that could limit EPS growth for the remainder of 2010.

Keep in mind that just because a stock is a GeoBargain or GeoSpecial does not mean it is timely. Our goal is to identify stocks in the "meat" of their growth cycle, regardless of the market pulse. Investors must decide on their entry points. Despite what the experts may portray, you need stable markets for a long fundamental strategy to work. The key to building wealth is to never stop doing research and build an arsenal of stocks to prepare for the next run. Be willing to admit when you are wrong and take profits when you succeed (execute sell discipline). These are efforts we will continue to aid investor in the same way that they helped produce stellar results in 2009 and part of 2010. We used the down time in 2008 to perform research and prepare for 2009. We slowly reentered the market in December 2009...a mistake at first, but rewarding in the end.

Here is the question for those who want to be involved in ChinaHybrids now: What do we do about the stocks whose performance has been lackluster? This depends on your risk threshold.

First, you must read our findings and understand roadblocks. For example, avoid stocks whose capital raises make little sense from an EPS point of view.

Second, you must understand that the current information-driven market could instantly create or eliminate roadblocks. A new effort by shorts to "expose" financial fraud is one example. (See also notes on ONP)

Third, you must realize that if dilution activities continue, a lasting stereotype could be left on the sector.

Fourth, always be prepared to experience more pain before things get better and accept the fact that some of these firms will never get it right. Don't punish yourself and judge performance day by day.

Finally, The dilution activities of 2009 and 2010 requires that we look past one or two quarters to identify stocks that will grow EPS over 30%.

For investors who may have missed the first China run, another chance is emerging, as this sector is becoming cheaper by the day (although fewer choices will emerge). We are looking at some new reverse mergers too, so stay tuned. At the moment, we are sticking to our revised outlook that as we get closer to 2011, the ChinaHybrid space has a chance to reclaim its lost glory as new reverse mergers become seasoned and old ones work through dilution.(we are also sticking to our strategy of having a portfolio weighted to U.S. stocks to reduce our risk profile.). It is certainly an opportune time for long-term, risk tolerant investors to consider carefully chipping away at quality names that are priced to fail.

Ultimately, to reclaim investor confidence, ChinaHybrids need to start proving that they can grow by using internal funds, improve financial reporting quality and implement shareholder friendly moves such as stock buy back programs. Gladly, we are beginning to see such moves from firms like China Mediaexpress Holdin (NASDAQ:CCME) and Deer Consumer Products (NASDAQ:DEER) as well as from companies like China-Biotics (NASDAQ:CHBT) and China Marine Food (NYSE AMEX:CMFO), two companies that are battling short investors' attempts to discredit their stories. In the end we are hopeful that the quality gut check the space is experiencing will separate the children from the big boys resulting in premium multiples for the firms that "get it."

Please see our message to China company CEOs.

***Very Important GeoTeam note. We have yet to verify if the Chinese filings for ChinaHybrid stocks we monitor match respective SEC filings. We are in the process of completing this task.  Conservative investors may want to limit exposure or buy put options on stocks, that have this availabity, as insurance against long positions, until we publish our findings.  Odds are we will identify some promising companies that will fail this litmus test.

Positions: Long NEWN, DEER, SOKF, CCME, CAGM; short ONP & CHBT at time of this post

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