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Wednesday, April 13, 2011

PUDA The Magic Dragon ...and CEF Too

Many of you know the Peter, Paul and Mary song “Puff the magic dragon” which is what the title of my article plays off. What you may not know is that there was as a sequel after the 1978 animated version called “Puff in the land of the living lies” also with Burgess Meredith as the voice of Puff. I wanted to use the land of the living lies as the title but I thought people would not get it as it is not nearly as well known. Right now it does seem as if China at least from a stock perspective is the land of living lies.

In today’s missive I want to address last week’s article regarding Puda Coal (AMEX : PUDA). I received a couple comments telling me that I should rescind my article particularly since I caused people to invest in PUDA and lose potentially 25% on their money in one day, as I released my article one day before Alfred Little posted his expose. As an advisor and a writer you are going to cover many issues and will pull data from many sources. As for PUDA, on paper it looked like a wonderful company that produces real products namely coking or “met” coal for the Chinese market and earned real money doing so. Instead, the case surrounding PUDA is more complicated than just plain cooking the books as it involves the CEO essentially stealing the whole company and illegally selling it to another group of investors. Truth is stranger than fiction and you can’t make this crap up!

I found my information in publicly available documents and used it to determine if PUDA met my criteria for a sound investment. PUDA being listed on the NASDAQ is not some little pump and dump bulletin board stock that boiler rooms hustle on the telephone, but supposedly was subject to GAAP accounting and auditing in order to be listed. Sure PUDA is a small cap stock at the time with a market capitalization north of $300 Million, but hardly a “shoestring” operation. Additionally, PUDA was selected by the Chinese government to be one of the sanctioned coal consolidators lending more credibility to the company.

I along with many other advisors and newsletter writers got this wrong not because we could not see some blatant flaw in PUDA but instead because we had faith and trust in the system that the auditors and the system were doing their jobs. How come no one is out asking the question “where were the auditors in all this?”. Is Moore Stephens liable in this disaster? While Alfred Little with the help of Geoinvesting.com were able to get documents that showed this fraud, that no one else, not any of the investment houses or even famous short sellers like David Einhorn or Jim Chanos had an inkling even existed. I believe that based on Little’s history of exclusively targeting Chinese companies he has been able to uncover things that others without boots on the ground there ever could.

The past couple scandals have definitely left a bad taste in most investors mouths and the back lash is that other Chinese issues will suffer at least until confidence can be restored in Chinese stocks. I must say that If I were the former CEO of PUDA I would be a bit nervous as the Chinese have ways of dealing with these things especially if they feel it has caused the nation to lose face.

The former CEO could face punishment far worse than all the unsuspecting investors in PUDA, he won’t just lose his money but the Chinese have been known to execute people for these types of offenses. There are many examples of China taking bold action in these corruption cases, like the July execution of Zheng Xiaoyu. Xiaoyu, The former head of the State Food and Drug Administration, was put to death shortly after the country’s Supreme Court rejected his final appeal in cases related to lead paint on children’s toys exported around the world.

Xaioyu’s execution was on the most recent one I can recall but if you Google “china executes corrupt officials” you can read various articles on this topic. So far China has not addressed this situation but if I were a gambling man I would bet that China wants its companies to have access to the capital markets and that requires that their listed firms be trusted. So all you Chinese CEOs out there perpetrating fraud you better clean up your act or I suspect President Hu’s government will do it for you.

It is an analyst’s job to look at the company, check the numbers, evaluate prospects and weigh them against the macro environment to determine if the company and its security are a good deal. The industry and individual investors rely on the various exchanges, SEC and auditors to ensure that companies are reporting numbers accurately in order to be listed. Yes, there are times where you can look at the numbers and see that they don’t make sense or indicate hidden weakness or strength, but one expects the numbers to be at least “certified” by auditors. PUDA’s numbers did not indicate any problems in fact the story read very well but not beyond reason.

The bottom line here is that if we cannot trust the exchanges, SEC or auditors to enforce standards for reporting and pick up on fraud then how can we trust the market in general and would not every issue be suspect. Fortunately, these types of problems have been few and far between although several have cropped up in Chinese companies, which means either the entities in charge of the oversight process are not doing their jobs at least not well or the Chinese corporate leadership is not as sophisticated as their Western counterparts, yet. Still the number of problem issues is small on a percentage basis out of the thousands of stocks listed, unless you end up being a bag holder, in which case the statistics don’t matter.

Also people that read my article they should not have been investing in PUDA at the time based upon my recommendation. In the chart attached to the prior article one could see that PUDA had been in a down trend for a while and violated its uptrend line many days before Mr. Little released his report. The downtrend was occurring even while other coal stocks were headed north which should have acted as a separate warning flag even though fraud accusations were still weeks away. I clearly stated that PUDA had violated its long term uptrend line and was now targeting the $5 range which it may have gotten to if the issue had not been halted. I also stated that I would not be taking a position in PUDA unless it either dropped to the $5 level or resumed its uptrend and passed the $14.50 level. In some respects I wish that I would have gone short or bought puts but those that did ended up with a different problem. Since PUDA was halted and has not yet reopened all the players in the issue are essentially frozen until the stock is reopened for trading, assuming that happens. If the issue never reopens then the shorts make 100% and the longs loose 100% on their investment (although longs may benefit from class action suits). The options players have different issues to contend with but I am not going to delve into every complexity associated with this situation.

This experience has confirmed for me that it is critical especially in today’s market to have rules and discipline when investing. You cannot protect yourself from every misstep as it is the nature of the investing beast. You will on occasion be wrong or blindsided no matter how many precautions you take. This also validated for me that the use of fundamentals and technical analysis together help stack the deck more in your favor. As I stated before, the numbers painted one picture while the charts were providing a warning that all was not as it seemed.

In general there are two camps of people in the market at least among those that try and do their due diligence. The first party believes that the charts tell all and the second that ignore the charts and use only the numbers. The PUDA fiasco has unequivocally proven to me that one needs to be adept at both technical and fundamental analysis. Many of you out there believe that technical analysis is akin to reading tea leaves or divining prophecy by looking at animal entrails, but it saved my butt as I was long PUDA until the uptrend was violated.

My only regret from this situation was that I did not write the article earlier to hopefully help people get out before the revelation of wrong doing. I know there are many investors out there who are suffering as a result of the avarice of a few and I can completely sympathize as I have had my share of losses over the years. As bad as the losses feel right now take the time to evealuate what happened and learn from it. Some people will develop trading rules as a result while others will learn to use stops or position limits. It is events like this that make us all better investors because we learn form the situations. As painful and costly as this lesson has been for many it is the price of admission to learning successful market navigation. Don’t let anyone kid you every investor no matter how big or small has experienced losses like some of you have, anyone who says they have not is plain and simple a liar. Mr. Market is a fickle and unsympathetic creature and situations like PUDA show you the true negative side of investing. Remember like the old saying goes “this too shall pass” and you will recover and be stronger and much wiser than before.

Well now that I got that off my chest I wanted to mention something completely different regarding the precious metals space. A while back I had written an article entitled “Gold doesn’t have to weigh a ton” and I had mentioned some different ways to invest in the metals. At the moment there are many things interacting in the economy and market that are affecting the precious metals space like the end of QE 2, however, it appears to me that the precious metals want to push higher. In fact I had planned this week’s article to address the economy and the end of QE2’s impact, but dealing with PUDA obviously took precedence.

The long story short is that if you believe that precious metals are consolidating at higher levels and getting ready for another leg up you might want to participate. Right now I see an opportunity to gain exposure to bullion at the best price possible. The most cost effective method is to buy the Central Fund Of Canada (NYSE: CEF), which is a closed end fund not an ETF.

CEF recently completed an accretive shelf offering and that caused the premium on the shares to virtually evaporate. When I wrote the prior precious metals article mentioned above the premium on CEF, which is a proxy for buying vaulted gold and silver bullion outside the US was running at 5%, roughly comparable to buying the metals for your home safe.

The premium on CEF at the close today was only 3 tenths of 1 percent over spot and the day before the premium was literally at zero. You can’t buy bullion anywhere for that and if the metals continue up the premium will reflect the stronger demand for the shares but right now you are getting the shares for the same price a dealer would buy the precious metals from you. Additionally, the constant drum beat of the precious metal bubble crowd gets louder and louder. You have to ask yourself where were these people during the NASDAQ bubble, the credit bubble and the housing bubble? Since most investors have been taught for a variety of reasons not to like or understand the function of precious metals they can easily spot a bubble because they would not participate in the market in the first place, at least not yet!

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