Orient Paper: Not a Short Squeeze, Yet

BEIJING (TheStreet) -- I had promised myself that I would not write a detailed article on Orient Paper (ONP) until after the release of its official investigation report. Now that the report is out with a very favorable conclusion, I am glad to be writing about my favorite stock again.

As my previous articles have all mentioned, I have been positive on this company without exception, but without the report I would either be beating the same drum or engage in uniformed speculation.

A number of people read my recent article on Rino International ( RINO) and noticed I no longer had a position in ONP. They were concerned that I had changed my view on the company or had concerns about the report, neither of which is the case.

I am still a big fan of ONP, as I have stated before. I was 100% confident that the report would entirely prove their complete legitimacy. However, previously I had bought a huge position in the $4 range and when the stock spiked as high as $7.77 on Nov. 9, I decided that the upside was limited until news on the report came out so I exited my position in the $7-$7.50 range. After earnings, the share price dropped into the $4 range but I missed it and I was hoping to buy on a subsequent dip.

On Wednesday (when the stock was at $5.49), the company issued a press release giving us a hint of what's to come. The press release was issued at exactly 9:30 am, right as the market opened. By 9:31, I was furiously hitting the buy button at the open and on a few morning dips getting some decent volume at average in price for the day of $5.97. I had hoped for a few more dips but the stock was a one-way street -- straight up 17%.

As a result I bought more on Friday in the $6 range and will continue to buy on Monday. I was hoping for a pullback after this 30% rally but I am quite skeptical that it will happen now that the report is out. Many people have asked whether or not this stock has moved too far too fast and have they missed the buying opportunity. I address that in the following paragraphs.

Some people are under the impression that this sizable rally might have been due to some short covering. I have confirmed that this (as of Friday) is not the case (or if so only minimally). For any given stock, there are a limited number of total shares that can be shorted. Today, I called three different brokers to ask about the continued possibility of shorting ONP by short sellers. In all three cases, I found out it is now the case that there is now no more "stock borrow" meaning that investors have already shorted all of the shares which are available to be shorted. Call your broker and give it a try.

There are two implications to this. First, the shorts no longer have ammunition to drive the share price lower. Second, the existing short position is huge and short sellers will have to buy back their positions, driving up the price of the stock. Clearly, they have not unwound their short positions yet. Both of these should contribute to a short squeeze which could make for a meteoric rise in the stock price. I am predicting at least 30%-40% in the short term. They have clearly been waiting for the release of the final report in order to cover so we could see it this week. I guess you have to give them credit for their tenacity if not for their common sense.

The impending short squeeze could be very painful for shorts. Investors may remember when the stock was driven down to $4.11 on the morning of Monday, July 1. On that same day, ONP came out with a detailed point by point response to the allegations, driving the stock to a high of $7.79 the next day. A swing of 90% in 24 hours! A power rally like that is often the sign of short covering, and given the high short interest in ONP, I am expecting short cover to make a substantial contribution to the rally. The current rally is simply not ferocious enough to be a short squeeze and the volume has not been indicative of a short squeeze either.

Given the moderate volume in the stock, it is clear that the institutions are not jumping back in before the report either. This is one of the few advantages of being a retail investor -- we can make decisions quickly, without taking our decisions to committee and without having a fixed criteria such as "wait until the final report is issued." Incidentally, this same advantage applies to selling stocks as well.

As I recently pointed out in my article on RINO, short attacks typically see a 15% drop upon release of the report. It is only in the subsequent days that the 50-60% plummet happens. I attribute this to the delay by institutional investors in getting committee approval to sell. I expect that many institutions will now be adopting a more accelerated policy when it comes to accusations of fraud allowing them to sell more quickly. So beware, the next short attacks may not give us that 15% window in which to sell.

Regarding institutions, I do note that as of Sept. 30, both Morgan Stanley and Goldman Sachs had acquired sizable new positions in ONP. Clearly some institutions are willing to do their due diligence ahead of time and buy in early rather than wait for the release of the final report. A link to their holdings can be found here.

So what will the stock do? That is an easy question, sort of. My target price for ONP is $10. That is where institutions were comfortable holding it before the short selling crisis and presumably they should be comfortable holding it (i.e. buying it) at that level now. Particularly given that ONP's future business prospects have improved substantially based on the high margin digital photo paper business and the corrugated business. While Q3 was slow, the prospects going forward are very positive.

However, despite my $10 target, I have cancelled my $10 limit sell order because I think there is some probability of a short squeeze which could drive it well above $10. This is because right now there are no sellers and there will be some desperate buyers. So I don't want to be stopped out at $10. I believe the "right price" is $10 but I am hoping for just a single day where it hits $11.

I want to get a larger position before the short squeeze happens, so I am buying with a sense of urgency. Keep in mind that right when the Muddy Waters report was released, the stock had been driven down to $8 (presumably by shorts). So the largest short positions may have begun $9 and are not yet feeling true pain.

With the stock at over $7, many people have asked if it is too late to buy ONP. I am still buying because I think it is highly likely that there is 40%-50% upside in the very near term from the current price of only $7.11.

A few things to keep in mind regarding the price:
  • Prior to the short attack, the stock consistently traded in the $8-$11 range
  • As recently as Nov. 9, the stock hit a high of $7.77 -- even with no news of the report
  • ONP's high for the year was $15.15
  • ONP has a current market cap of only $130 million -- this compares to Rino which has a market cap of over $170 million
  • Roth Capital previously had a target on the stock of $16 As for Roth, I think it is notable that they never switched to a sell recommendation or lowered their price target. As with most institutions, I assume that they are simply waiting for the release of the final report to reinstate coverage. This strikes me as a very appropriate institutional approach given the amount of controversy and uncertainty generated by short sellers. Once Roth reinstates coverage, I think it could provide a significant boost to the stock.

    Other high profile situations which currently have litigation pending include Fuqi International ( FUQI), China Northeast Petroleum ( NEP), China Green Agriculture ( CGA), China Natural Gas ( CHNG), China Biotics ( CHBT) as well as accounting questions on China Agritech ( CAGC). Once I get the chance, I expect to do some follow-up on them as well.

    Disclosure: The author holds a long position in ONP.

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

    This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

    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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