One valuable lesson I learned on Wall Street is that the decision to hold a stock is identical to the decision to buy a stock. Either way, when you wake up the next morning you are long that position. If a stock is really considered a hold or a neutral, then clearly it should be a sell. If the stock isn't expected to appreciate (or if it's not a clear buy stock), then why allocate funds to it? Investors are better served selling this type of stock, doing their homework and finding a stock that will appreciate. Holding a stock that has no identifiable upside is inherently dangerous because all stocks have downside risk, which is presumably only tolerated because of its upside potential. Another lesson I learned is that although stock prices are unpredictable, stock fundamentals and company performance are often very predictable. Companies that have consistently generated strong profits in the past tend to keep doing so, while companies that have consistently lost money tend to keep doing so. Late last year I wrote an article comparing an unlikely pair of stocks, A123 Systems ( AONE) and Orient Paper ( ONP), which illustrates this concept very well. A123 Systems, which is in the hot space of lithium ion battery technology, has lost money every quarter it has existed and in fact has negative gross margins. On a firmwide basis, it doesn't even make money on each individual sale. Meanwhile, Orient Paper is in the boring space of paper production and has gross margins of around 30% on a firm wide basis. But on individual sales they can effectively get 50% margins. In other words, for every ton of paper they sell, they double their money.
A123 Systems went public in September at $13.50 per share, immediately soared over 50% to over $20, and subsequently hit a high of $28.20. Stock prices are unpredictable, but fundamentals are often very predictable. In November, the first quarter reported after the IPO, The Wall Street Journal reported "A123 Systems Inc.'s third-quarter loss widened, hurt by higher costs and expenses, even as the electric-car battery maker saw revenue rise slightly." For a company with negative gross margins, an increase in revenue means they lose more money, so this shouldn't really surprise anyone, and thus an increase in revenue shouldn't really be much to cheer about. Compare this to Orient Paper. Two days after A123 released its results, Orient Paper posted quarterly results and commented on its outlook. Revenue increased 67% year on year, while gross and net profit more than doubled and the company expects the growth trend to continue. Once again, fundamentals are often predictable -- companies that lose money tend to keep losing it, while companies like Orient Paper that make money tend to keep making it. But once again, stock prices are not predictable. Not surprisingly, Orient Paper has risen sharply on the back of its strong results and positive guidance. However, A123 Systems has (surprisingly) also remained very strong, holding in the low $20s. In my opinion, A123 Systems is not being driven by fundamentals but by hype and speculation. A123 Systems has announced several great new contracts, which are clearly very exciting. These include a joint venture with Chinese automaker Shanghai Auto (a partner with General Motors and Volkswagen). This could be huge. Even Goldman Sachs initiated coverage on A123 Systems in November -- with a polite Wall Street neutral rating.
So right about now, readers may be thinking that this could look like a great opportunity to short an overvalued stock. Because stock prices are unpredictable, I would certainly caution against it. The best example of the risk in this type of trade is China BAK Battery ( CBAK). China BAK Battery looks like a great candidate to short because it is another consistent money-loser and will most likely need to continue diluting shareholders by financing with equity. But an unfounded rumor in December suggested that it had won a contract from Google ( GOOG), sending shares soaring 65% in one day on 30 times normal volume. In September, China BAK Battery rose from around $3 to nearly $5 in two weeks for no reason other than the hype surrounding the A123 Systems IPO. A few weeks later it reported that it once again lost money for the quarter, but less than in the previous three money-losing quarters. Because money-losing stocks do not trade in line with their fundamentals, they are an easy way to lose money whether you are long or short. As a result, it only makes sense to stick with companies that are strong and consistent money makers. This sounds obvious, but clearly many investors do not make this a practice. A good comparison here is Synutra ( SYUT) vs. American Dairy ( ADY). Both of these companies are Chinese dairy operations, however that is where the similarities end. After being massively impacted by the melamine tragedy in 2008, Synutra has lost money every quarter. By contrast, American Dairy has been consistently profitable.
Yet for some reason, Synutra has a market cap that is $250 million greater than American Diary. Stock prices are unpredictable, and investors don't always focus on profitability. Companies that consistently generate profits and cash their stock prices can't hide in the low digits for very long. In addition to Orient Paper, a good example is China Agritech ( CAGC). With China Agritech, each quarter shows continued improvement, and any surprises are consistently positive. As a result, the share price has traded from the single digits in August last year to nearly $40 at present. Among battery makers, consistent winner Hong Kong Highpower Technology ( HPJ - Get Report) has seen its share price rise from $1.18 in August to nearly $9 at present. Similar to China BAK Battery, Hong Kong Highpower has been the beneficiary of a lot of short-term news hype, including obtaining research coverage from Rodman & Renshaw, a contract with Siemens and approval for relisting to Nasdaq. But unlike with China BAK Battery, the gains in Hong Kong Highpower's stock price tend to not rapidly fade away but rather keep boosting the stock higher. The next task is to figure out how much more share-price upside remains with these profitable winners. I recently visited Orient Paper in Baoding, and based on their continued capacity expansion and expansion into even higher-margin product lines, I think there is still plenty more upside. With Hong Kong Highpower and China Agritech, both stocks have risen very far very fast and will likely continue to deliver profits, but their share prices may be fully priced at present. And again, the decision to hold the stocks is the same as the decision to buy them -- either way you end up long at the end of the day.
American Dairy looks fairly cheap, but I don't see it being a double or triple in 2010. Therefore, I am sticking with smaller and also very profitable dairy stocks like Yayi International ( YYIN) and Rodobo International ( RDBO). I have no particular motivation for investing in the China dairy space, other than that these two stocks just look plain mispriced. They have rock-solid fundamentals and trade on dirt-cheap valuations, giving them the potential to be the next doubles or triples. With Rodobo, I still have a bit more homework to do. With Yayi, I have already met management and attended the groundbreaking ceremony at their new facility near Xi'an, and they have invited me to tour and film their new production facility in Tianjin. I expect to do a more complete write-up on these two stocks in the next week or so. Lastly, there is Subaye ( SBAY). I have finished all of my homework on Subaye, including spending over five hours with the CFO (See that interview here.) and believe it has the potential to be an easy triple. The stock trades at only two times forward earnings before interest, taxes, depreciation and amortization, or EBITDA, consistently generating net income and cash flow and has already applied for a Nasdaq uplisting. Separately, with the recent boom in U.S.-listed China stocks, it is getting harder and harder to find the next doubles and triples, but I intend to keep looking and will keep readers posted.