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Thursday, April 7, 2011

When Bad Things Happen To Good Stocks

By now virtually every investor has heard about the fraudulent Chinese companies that are listed on the various exchanges. As these companies have been identified they along with their investors have been taken behind the woodshed and just like “Old Yeller” mortally wounded. It does not help that we currently are operating in some of the most tumultuous times the world has ever known; truly all we would need to do is throw in a world war (God forbid) and it would this would be indisputable.

Given the frequency of events taking place around the world investor’s psyches have been damaged to a point where logic and reason are tossed out the window. News or information that used to take hours, days, weeks or even months to flow around the world now is disseminated to the masses in nanoseconds. While the speed of news flow is great for news junkies and talk show hosts it does make for irrational markets where no thought is given to a particular action but instead just the reaction of fear and or greed guides investment decisions. Time is not taken to investigate the true implications of the event, instead we live in shoot first ask questions later investment environment.

The current Chinese stock scandals have tainted virtually all Chinese stocks less than a certain market cap with the same brush whether deserved or not. Take for example one of my long time holdings Silvercorp Minerals (NYSE: SVM), with its market cap over $2 billion it has been unaffected by the Chinese fraud, of course it helps that it is in the precious metals space which is currently very strong. The flip side of this is Puda Coal (AMEX: PUDA) which for all intents and purposes is a solid company that happens to operate in China and is also in the coal space which has been very strong as well. Puda is in the wrong place at the right time in otherwords guilty by association not reality. Puda provides cleaned coking coal to steel manufacturers and currently has a capacity to “wash” around 4 million metric tons of coal.

Given China’s rapid growth and plans to continue particularly in infrastructure growth for the foreseeable future Puda’s products will remain in demand. The amount of steel required for China’s continual build out demands ever increasing amounts of coking or sometimes refered to as “met” coal, which is what Puda sells. The actual statistics of Puda coal would be enviable by many companies having 51% revenue growth year over year and a trailing PE of 8.5. The forward PE is a ridiculous 2.38. Puda’s price to sales ratio is a paltry .91 and price to book while not a Ben Graham’s “margin of safety” stands at a 1.17, which is very low for this market. Puda had $324 million in revenue over the last year roughly equating to $16.15 per share and earnings EBITDA of $35.9 million which gives the company a fully diluted EPS of 1.15 per share. If you calculate Puda’s earnings yield (Annual EPS\PE) you get a 13.5% earnings yield versus “risk free” US Treasury bonds whose rate is 4.58% for the 30 year as of this writing, indicating the stock is inexpensive. Moreover, if projections are correct and Puda meets the low end of analyst estimates for earnings next year at $1.44 per share and the forward PE is maintained at 2.38 the earnings yield would skyrocket to 60%. Additionally, Puda is a company that is growing generating year over year earnings growth in the neighborhood of 95%.

Puda looks strong from a debt perspective as well. They have total cash on hand of $156 million vs a total debt of $52 million giving them a low debt to equity ratio of 14.5%. Puda is well positioned to cover their debt with a current ratio of 3.26. The kicker here is that the company currently has $5.20 of cash on hand per share which, I am sure is reflective of the shelf offering they did back in December 2010, giving them a nice war chest. Puda is also in a unique position as they are one of the selected companies by their home government of China to be a mining consolidator. China is trying to get a handle on both the fragmentation of its mine supply as well as dealing with is environmental problems. As a result the Chinese government has granted certain companies the ability to become consolidators and take over this “hodge podge” of small and some family operated mines. The mines being taken over really have no choice as the government has declared that this is what will happen. The net result is Puda will be able to grow its portfolio and increase reserves at a reasonable cost providing organic growth for the company and better more stable supply for China. To me this factor makes Puda a winner in the long run.

Even with all that Puda has going for it has been lumped in to the specter of these Chinese companies that were either shell companies or cooking their books. It is not fair that this has occurred to a quality company like Puda nor is it fair that it will probably remain a stigma for some time. Even a recent investor conference that highlighted Puda and their potential was not able to lift the dark storm clouds from the shares. Yesterday the shares in all coal companies took a hit but Puda was beaten bady. To give you an analogy Puda was like the brother in law in the ”Godfather 1” where Sonny discovers that his sister had been abused again. Sonny tracks down the brother in law and beats him right on the street in broad daylight. He beat the guy senseless with his fists and then kicks him; for good measure he even takes the lids from the old steel garbage cans on the street and whacks him with those too. If you can envision that scene then you understand the drubbing Puda took yesterday.

Reading the various message boards there are many calling this the bottom in Puda especially since the reaction low of $9.60 was not violated even on such heavy volume. I am not sure that I subscribe to that point of view as Puda has been in a downtrend and distributed along the way. While Puda could bounce here as nothing goes straight up or down at least not in the stock market where the laws of physics are often suspended, I believe that there is further downside due to sentiment. On a weekly chart you can see that the long term uptrend dating back to March 09 has been clearly violated on high volume and would have to rally back above roughly $14.50 and hold to reinstate that trend and the break out level for that trend line is roughly $5. At this time it appears more to me like Puda is targeting the $5 area regardless of how good the stock is fundamentally.

In the long run fundamentals win out but as Keyenes once said, “in the long run we are all dead” so trying to guess a bottom here or holding on for Puda to recover is not a good strategy. Even on a daily chart you can see Puda has been in a downtrend and has formed a “Triangle”. Usually triangles tend to resolve in the direction from which they were entered, which in this case was up. The triangle that has formed for Puda appears to have resolved to the downside. I have included both charts below so you can make up your own mind.

The bottom line here is that while I love Puda and the concept of the stock I am not married to the issue. I think Puda has great potential but I would not go long until the uptrend is restored and that means either time or a steady grind back to $14.50 or so. Even at $14.50 Puda stands to return huge profits to investors as it will still be very cheap. Conversely, one could go short or use puts to capture the downside which seems like the stronger bet at the moment. Any bounces here would be good short entry points, however, keep your mental stops reasonable as anything can happen especially in the current market environment. I am looking for a move down to the $6 level possibly lower toward $5 if market conditions and sentiment are true to form. As I said if the stock either drops to the level specified or rises to the $14.50 level I would be a buyer as the risk is lessened in either scenario in my opinion.

1 comment:

Tim said...

I really appreciate your balanced insights in this article. I'd like to hear if you have any opinions on LIWA, as well.

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