By now anyone who invests in China stocks is familiar with the carnage going on with the stock of Rino International (RINO). On Nov.10, the Hong Kong based research duo (and dedicated short seller) known as Muddy Waters produced a 30-page report on Rino declaring it to be an abject fraud and with a target price of $2.45 vs. its then price of around $15.00.The stock has now been halted and the share price stands at $6.07, a decline of 60% in seven days. Their auditor, Frazer Frost, came out on Friday and confirmed that there were in fact phony contracts with revenues that didn't exist and other irregularities. I have been following this situation closely and I feel that there are a number of important lessons that can be learned from it. Readers may remember that Muddy Waters and I have a somewhat strained history following their report on Orient Paper ( ONP) in June 2010. By pure coincidence we had happened to tour the ONP facilities on the same day in January 2010. Where I saw opportunity, they saw fraud. What ensued was an acrimonious online battle of words between the two of us as to whether or not the company was a fraud. When MW first released their report, ONP stood at $8 and they declared a target price of "less than $1." The stock bottomed at about $4 but recently rebounded to as high as $7.67, almost a double. MW has gained significant credibility due to its extremely accurate and timely call on Rino and now many investors are rethinking their refound confidence in ONP and have been dumping the stock. It now stands at $5.58 -- 28% below its recent high. There is currently an independent investigation under way being conducted by accounting firm Deloitte & Touche and law firm Loeb & Loeb, so the final verdict on ONP will have to wait for the results of this investigation. There are a number of key lessons that investors can take away from situations like this.
Typically the stock does not fall by 50% on the first day, so be grateful that you have a chance to get out. While it is too late for this advice to be of any use to those who got burned on Rino, I hope it will be a valuable piece of advice going forward because I am sure this is not the last of the short seller attacks.
What this means is that everyone is piling into the put options, driving up their price. In theory, options should provide substantial leverage, meaning that a 30% drop in the share price would result in a gain of much greater than 30%. But I ran several scenario analyses on Rino puts and found that even if the share price were to drop by 30%, I would make less than 30% -- this is simply due to the option being overpriced. Herein lies the fundamental problem with put options: timing is absolutely everything. If you know of a terrible company that is not yet in crisis, the put options are probably very cheap and could provide a massive return. But if the crisis doesn't happen quickly enough, the option loses 100% of its value. Once a company enters crisis mode, such as Rino, investors can be comfortable with timing but then the price inevitably gets overbid making the options unattractive. As a final thought, what happens to a put option which has value but that is "out of the money" and then the stock is halted ? You can't exercise or sell it so does it expire worthless even when you had made a profit ? I have asked five different people and gotten five different answers. In crisis situations, there is a very real possibility of a stock halt and I wouldn't want to learn the answer to this the hard way. (Incidentally, I am scheduled to speak to several other option traders this week and I will let readers know when I find out the ultimate answer.) If you want to play the smart odds, stay away from put options. On average and over time they are a losing trade.
Rumors of Rino fraud have been circulating for more than a year The MW report was pretty much air tight in its accusations The stock lost analyst support and the company didn't respond to analysts The earnings call was cancelled Shockingly, the company made no effort to respond to any of the allegations This stock is only going one way -- down. Any time a stock like this enters crisis mode, the only thing you can be sure of is extreme volatility. Only play the buy on the dips if you feel that you have a very, very good knowledge of the company and that the short attack is without merit and that the company will prevail over time.
Once again I disagree with Muddy Waters, but this time I feel the "floor" value of the company could be even lower than cash per share. Why ? Because I have seen it in numerous post-crisis companies. Once investors don't trust the books of a company, they tend to not believe that the cash is all there. I have seen numerous cases where companies trade at a 10-15% discount to their reported cash value. As a result, I think Rino could trade as low as $2 despite having cash of $2.45 per share. Canacord analyst Michael Deng revised his rating to sell but did not set a new share price target. Rodman Analyst Amit Dayal has the stock under review and has not issued a share price target.
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