New Energy Systems ( NEWN.OB), SinoCoking ( SCOK) and Sino Clean Energy ( SCLX.0B) were all stocks that traded at a significant discount to their fair value and subsequently skyrocketed.

China Carbon Graphite ( CHGI.OB) has the potential to be the next stock to skyrocket.

In August 2009, I received an email from a New York-based hedge fund manager who was holding a very large position in a small-cap Chinese maker of lithium-ion batteries based in Shenzhen. He was concerned that this opportunity was "too good to be true."

He told me that the stock was trading so cheaply (at $2 and only two times earnings) that there could only be two conclusions. Either the company was a total fraud or this was the buying opportunity of a lifetime.

I arranged a meeting with management and booked a flight to Shenzhen where I toured the factory and met with the CFO, the CEO and the head of sales. As it turns out, I was very impressed by the company and by management. The factory was clean, well-organized and production was humming along at a busy clip.

I provided the hedge fund manager my conclusions and subsequently "loaded the boat" myself, buying all the stock I could get my hands on. In subsequent months, I continued to provide suggestions to management on how they could improve their capital-markets profile and I introduced them to a number of other investors and investment banks who could hopefully provide research coverage in the future.

Since then the company has completed two major acquisitions, announced its intention to uplist, begun a proactive IR campaign and made a presentation at the Rodman & Renshaw conference in Beijing. That company, New Energy Systems, subsequently traded from $2 to $10 and now trades at around $8. This stock wasn't "too good to be true" but rather was "too good to pass up!"

Just a few weeks ago, a Chinese friend in Beijing told me that I really should take a serious look at Sinocoking, which had just come to market via a reverse merger on Feb. 5. The reverse merger came with a concurrent PIPE where SCOK raised $7 million at $6 per share and investors received additional warrants at $12 per share.

On Feb. 9, the stock traded as low as $3.50 and looked cheap, but I assumed I would have plenty of time to get into the stock because it was not yet Nasdaq-listed, and there was no catalyst to move the stock. Within an the amazingly short time of two weeks, the company announced its approval to uplist to the Nasdaq, and the stock skyrocketed to over $45.

From my evaluation price of $3.50, that is a return of over 1,100% in less than one month! Sadly on this one I didn't "load the boat," but rather I "missed the boat completely." I did learn a valuable lesson, which is that when a stock is massively undervalued, it can move quickly, so it pays to get in quick and not be stingy about the price.

Still feeling the sting from missing out on SCOK, I came across Sinoclean Energy, also on the recommendation from a friend. The company, which makes a type of "clean coal," was trading at only two times operating cash flow and only four times projected earnings, and was clearly overlooked and underfollowed.

Accounting treatment of warrants and convertibles resulted in a huge fourth-quarter accounting loss, making the company look like a money loser, when actually results were quite positive. The market was clearly missing this. I'm glad I jumped in when I did, because this one has gapped up substantially, up 100% for the week on tremendous volume.

Based on these experiences I believe that the next "skyrocket stock" could be China Carbon Graphite Group, which was brought to my attention by the same savvy friend who told me about SCLX.OB as well as China Energy ( CHGY.OB), which is up more than 200% in the past two weeks. Unfortunately, I missed out on CHGY.

CHGI manufactures high-purity graphite from coal. According to a March 4 S&P report, the company has more than 50 customers in 22 provinces in China and its strategy includes efforts to double capacity from 15,000 tons to 30,000 tons annually and develop nuclear graphite capabilities and capacity for new nuclear power plants.

The stock trades at around $1.90 despite having a book value of around $2.50. That's worth repeating: This stock trades at a 25% discount to book value. It is also trading at a multiple of only around 2.5 times operating cash flow (about the same as where SCLX was before it skyrocketed).

The company has already given guidance for 2009 that indicated that both revenue and net income would increase 15% to 25% vs. last year. If so, that means that, based on reported market cap, CHGI is trading at only around four times 2009 earnings, despite 15% to 25% growth. If management can continue growth at this rate for 2010, we are looking at only three times 2010 earnings.

Ordinarily if a company is trading at 75% of book value and only two times cash flow, there is a strong risk of it being "too good to be true."

However, there are a few other things that give me comfort. First, the company just raised nearly $3 million in a private placement in December, which would (hopefully) indicate that institutional investors (including Silver Rock, Jayhawk Capital and Taylor A.M.) have recently done their due diligence.

Second, the company recently appointed BDO as its independent auditor. BDO is a world-class international auditor with extensive China experience, and I have worked with their affiliates before.

Finally, in October the company announced that it had a majority of independent directors, including the audit committee, which is chaired by Yizhao Zhang, who also happens to be CFO of Universal Travel Group ( UTA). In short, I trust the numbers.

In terms of uplist potential, CHGI is more obvious than most. In October 2009, CHGI put out an 8-K that contained the following language:

"With the election of Mr. Chen and Mr. Zhang, the Company now has a majority of independent directors. Effective October 28, 2009, the Company created audit, compensation and corporate governance/nominating committees and adopted a code of conduct."

This language is verbatim what is required for an uplisting for Nasdaq or Amex,and the only reason to pursue this course is to prepare for an uplisting. Also in October 2009 and right around the time of appointing the directors, CHGI upgraded its auditor to BDO. Orient Paper ( ONP) also upgraded to BDO right before its uplisting in 2009 and released a nearly identical 8-K.

As far as I can see, the only thing holding CHGI back from an uplisting is the share price, which needs to be above $3 for the Amex and above $5 for the Nasdaq. Ordinarily, I would recommend a company in this situation reverse-split its stock to achieve the uplisting. However, in CHGI's case I wouldn't take this route.

First, a reverse split would exacerbate already low liquidity. Second, and more importantly, the stock currently trades at such a huge discount to its fair value that it will likely find its way to the $3 to $5 range without any reverse split necessary.

Assuming this stock trades on the Nasdaq and earns $6 million in 2010, a P/E multiple of 15 would result in a share price of around $6, which is a three bagger vs. the current price of $1.90.

I'm not suggesting that the stock should gap to $6 all at once. However, based on the discount to its fair value, I think that a 50% to 100% gain in the short term would not be unwarranted -- and with very little downside risk vs. the fundamentals.

The author can be reached at comments@pearsoninvestment.com.

Please note that due to factors including low-market capitalization and/or insufficient public float, we consider CHGI.OB to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Pearson was long Sino Clean Energy and China Carbon Graphic. Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.