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For Chinese Pharmacy Chain, Sky's the Limit

There are two main risks. The first is competition. Although foreign chains are shut out due to regulations, China has an amazing 350,000 pharmacy locations, more than one for every person in the U.S. Large, well-known chains like Nepstar, Tian Tian Hau Grand Pharmacy and Lao Bai Xing Grand Pharmacy all compete in Hanzhou. Most pharmaceutical sales, about 80%, are through state-run hospitals. Such intense competition makes it unlikely that Jo-Jo can maintain over 20% operating margins. Expansion in stores will inevitably come with slimmer margins.

Second, there is the general bad vibe around these reverse-merger China small-caps. They are easy targets for short sellers, who can move the issues 30% or more by alleging fraud of some sort on a blog. We've seen this in Magic Formula Investing (MFI) with stocks like China Sky One Medical (CSKI) and Universal Travel Group (UTA). The risk has often been compensated with very low price-earnings multiples, and China Jo-Jo is actually one of the more expensive ones with a forward P/E of about 5.4.

There are no existing fraud allegations, as best I can tell, but the stock just started trading this year. The auditor is Frazer Frost, who also audits several other similar firms in China and does not provide much protection against shorts. The company does have some short-term loans from Hangzhou Bank, although they are secured by the "personal properties of the Company's shareholders," instead of the firm's assets. For what it's worth, China Jo-Jo does have a decent Web site and over 1,300 Facebook fans.

For MFI investors, China Jo-Jo should be treated as a speculative position with a limited amount of risk capital. The growth potential is huge, but the barriers are high, and the risk of the stock tanking due to shady allegations is very real. MagicDiligence believes the former outweighs the latter, and I have a "buy" opinion under $5.

The writer has no positions in any of the stocks discussed in this article.

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Steve Alexander is the founder and editor of MagicDiligence.com, a Web site that analyzes stocks appearing in hedge-fund investor Joel Greenblatt's Magic Formula Investing screens. Alexander is a private investor with more than a decade of experience in the stock market.
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