China Stocks: Price vs. Fundamentals

BEIJING (TheStreet) -- New Energy Systems (NEWN.OB) announced Friday record revenues and EPS for the quarter ended March 31. In comparison to last year, revenues increased 753% and gross profit increased by more than 800%. EPS increased by more than 300%.

How did the stock react? It fell by nearly 4% on moderate volume solely due to the overall negative sentiment in the market. Contrast this to China Wind Systems ( CWS) which was lucky enough to announce very positive guidance on a strong day in the market. The stock jumped as much as 25% as investors cheered the results and the strong market further fueled the upswing.

Both of the stocks highlight the current fact that individual company fundamentals are now taking a back seat to overall market sentiment in determining stock prices. I feel that this creates an opportunity to occasionally pick up value stocks on the cheap when they trade down for no reason other than market sentiment.

NEWN's 4% drop is a very good example. The company re-affirmed full year guidance at $1.23 earnings per share (excluding non cash charges). This puts the company on a PE of about six times guided earnings despite tremendous growth with a high degree of earnings visibility. Assuming full year EPS of $1.23 breaks down to about $0.31 per quarter. Yet NEWN's $.037 was about 20% higher than that. This over-performance is quite a notable fact given that the first quarter is typically the slowest quarter of the year in China due to two weeks of Chinese New Year holidays.

Management has a history of being conservative with projections and then over-delivering on results. They have already repeatedly and prominently communicated the $1.23 number so I am of the opinion that they are quite certain of meeting or beating it. Based on the first quarter numbers, I am starting to suspect a reasonable chance of NEWN beating this $1.23 number for the year which would place the current PE ratio somewhere in the 5-6 range. For a company with this type of growth and which has stated it needs no external funding, this is a bargain, especially compared to other battery comparables which traded in the mid-teens. The catalyst for a big move upwards will be when the stock uplists to the Nasdaq which could still take some time given that there are still some required board changes that need to happen.

Along with Orient Paper ( ONP), my favorite price vs. fundamentals play is Duoyuan Printing ( DYP). DYP traded down to an almost absurd level of $7.84 when the market had its mini meltdown. But similar to China Wind Systems, DYP announced results that significantly beat expectations on a day when the market was rebounding, in a rally fueled by European stimulus money. As a result the stock leaped by over 25% in 2 days to as high as $9.74 on significant volume. I was gobbling up shares below $8 while I could and continued buying up into the $8-9 range.

Despite the rapid jump in the share price I didn't sell a single share for two reasons. First, I think the stock has room to run by about another 50%. Second, the fundamentals are so strong that even if it trades down I don't lose any sleep over it. This is my safety stock. DYP has a market cap of $280 million, but has $140 million in cash and receivables on its balance sheet. Cash flow from operations in the first quarter alone was nearly $20 million. The company beat revenue guidance by a wide margin and continues to enjoy gross margins of more than 50%. Revenues grew by 34% vs. last year. In terms of valuation, in the $9-$10 range, the company trades at less than eight times earnings, despite being a NYSE listed stock with huge growth and margins. In the past I have compared this for valuation purposes to Duoyuan Global Water ( DGW) which has slightly less attractive fundamentals and yet trades on 3-4 times the earnings multiple. DGW and DYP are both run by the same chairman and have similar fundamentals and I feel that the valuation discrepancy makes DYP an easy choice at current levels.

Biostar Pharmaceuticals ( BSPM) has turned out to be a case of snatching defeat from the jaws of victory. I correctly picked this one out at just under $4 and noted that the $4 threshold share price was the only thing holding BSPM back from its uplisting. Sure enough, seven trading days after reaching $4, the stock uplisted and shot as high as $5.50 - a 38% run in a few days. What followed was a perfect storm of negative events.

The company received notification that they were in conflict with China SFDA advertising rules and the stock took a hit. Despite fully resolving the issue and quickly communicating the resolution to the market, the stock took a quick hit. Then the news of the SEC investigation of Goldman Sachs ( GS) hit the market and BSPM took another hit, then there was Greece and the Euro then there was the 1,000 point drop in the Dow. And so on.

BSPM now trades right around $4 again, despite giving full year guidance of $18-20 million in net income. This is a stock that has already uplisted to the Nasdaq and yet still trades at five times guided earnings due to an overall negative market. Without a big upward push in the market, the catalyst needed to make this stock move may well just be next quarter's earnings which should prove the company is on track to meeting full year guidance. So it may take some time. I also think that since BSPM is now Nasdaq traded it will be easier to attract institutional research coverage. However when or if that happens is not predictable, so I am not looking for any immediate gratification on BSPM but rather think it is has strong potential over the coming months.

With both NEWN and DYP, a key contributor to their recent low prices has been the fact that both trade with unusually wide bid ask spreads. This means that when just a few investors panic and decide to sell out in a tough market the bid price drops quickly. As a result the selling investors panic even more and drop the share price further. In general I try to avoid putting myself in that situation. I only own stocks that I like based on fundamentals. When it comes time to sell I try to do so when the market is having a strong day rather than selling into a weak market and pushing the bid price down.

When the stock is down, I don't worry about my portfolio's value for the day because I am fully comfortable with the longer term prospects.

In addition, the wide bid ask issue cuts both ways. On both DYP and NEWN, when investors were clamoring to get back into the stock following the mini meltdown, the ask price jumped up quickly with every subsequent buy. The result is that there can be large price jumps even on only moderate volume.

In short, the market has been looking ugly and volatile lately. A lot of stocks deserve to come down significantly and may still have further to fall. But for value stocks where I truly like the growth story and fundamentals I don't get overly worried about dips in their prices even when the price drops look severe like they did last week. In fact, it seems that these are the best times to try to pick up shares on the cheap and wait until the market gets a bit more rational. Buying stocks with double-digit earnings growth and single digit PE ratios is a combination that has so far not failed me.

Disclosure: The author holds long positions in NEWN.OB, DYP and BSPM.

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

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.

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