|August 27, 2011
In This Issue:
Unseen Forces Building
Harbin: A Case Study
The Unseen Forces Are Building
If you’ve been any sort of student of the way stocks move, you should know stocks make 90% of their moves in 10% of the time they trade.
In the China small cap sector this has been a very interesting summer. There’s been little movement in stock price, but there’s a lot going on behind the scenes that won’t be evident until that 10% point in time comes.
This is the quiet before the storm. If you live on the East Coast you just experienced an earthquake. The quake shook buildings and knocked goods off the shelves in the groceries store for about 30 seconds, but the energy that caused the quake was probably building up over the last 25 years. Forcing pushing two plates far beneath the surface of the earth finally broke loose, and a quake ensued on the surface. 25 years of build up for 30 seconds of action.
Such is the state of the China small cap sector today. The ultimate Mexican-Stand-Off has evolved over the summer. With very little movement, there are tremendous unseen forces building, and I believe this entire sector is giong to break one way or the other in the next few months.
The big question is which way? The short interest in many of the China small cap stocks is absolutely enormous as a percentage of the public floats.
At some point, all investors who are long any of these shares must give up and sell, or short sellers will eventually have to cover. It could certainly go either way.
As time goes by there is one undeniable fact- China small cap stocks are under tremendous scrutiny. Auditors have ratcheted up their vigilance and sharpened their pencils, and as time goes by the financial reporting will slowly become more reliable as the bad apples fall from the trees and rot.
Harbin Electric (HRBN): A Case Study
Harbin is one of the most fascinating spectacles to watch. One of the more vocal and high profile detractors in the China sector is Citron Research (www.citronresearch.com) . Citron has been a very loud critic of the company. In their last report, Citron claims HRBN has:
“fabricated customers, management taking money from the company, undisclosed insider deaings, and the worst accounting disclosures that either Citron or any forensic accountant has ever seen.“
Clearly, that’s pretty harsh cricticism, and if it turns out to be true, would obviously be a death knell for the stock.
On the other side of the story there’s the company itself and its actions. CEO and largest shareholder Mr. Tianfu Yang has formed an entity to take HRBN private in a leveraged buy out. HRBN would be bought out at $24 per share and taken private. The stock is currently about $17, so there’s some room for upside. The price of the stock suggests the market is not ready to believe in the buy out, but isn’t buying the Citron Research argument either.
Morgan Stanley, along with Lazard Freres is advising the company. Goldman Sachs is acting as special advisor to the CEO. Every big law firm out there is involved.
The transaction is expected to be financed by debt provided by the China Development Bank Corp and ABAX. The entity being formed will be borrowing the money to buy out the shares the CEO doesn’t own- about 60% of the issued and outstanding.
Now, let’s look at the interesting part. Here’s a chart:
Since Mid May, Citron has made 4 attacks at HRBN as you see numbered above.
Attack #1: Towards the end of May short sellers began circluating rumors about the management and claimed their CEO had “gone missing”. As you can see, the stock started to trade down on the rumors.
Attack #2: On June 16th, Citron published scathing accusations concerning the Chairman and CEO – claiming he had a history of using fraudulent loan guarantee documents. As you can see, the stock absolutely swooned- but only for one day. From a level of about $15, the stock headed to $6 in one day, and completed a round trip back to $15 a day later.
Attackt #3- published August 3rd. Citron claims the company is “Completely Exposed”, and goes into detail about the CEO taking money from the company. The stock drops from $18 to $14, but it heads right back to $18 a day later.
Attack #4- On August 22nd, Citron once again blasts the company for “violating every prinicple of transparency over recent years”. This time, the stock doesn’t even blip.
In conjunction with the 4 attacks, here is the NASDAQ reported short interest in the stock during the corresponding times:
- June 1st: 8.3 million shares
- June 15th: 9.7 million shares
- July 1st:7.2 million shares
- August 15th: 8.3 million shares
I find it very interesting the most current report shows the short interest at the 2nd highest level ever. At the same time, the as the attack reports are becoming less effective at scaring investors out of the stock.
The short sellers have had to increase their position by 1 million shares in the last month to keep the stock down.
This is not intended to be a suggestion to buy Harbin. It’s just a demonstration of how forces are building, and how something has to give one way or another.
In fact, I would avoid Harbin. Here’s the problem- if Citron is right and it eventually comes out the company is fraudulent, you could lose a lot of money. If HBRN is does succeed in going private, your upside is only $18 to $24. I think there’s a lot more upside in other stocks.
8.3 million shares is a lot of stock to find to close out a short position.
Some Other Situations
There’s some other Bull/Bear tug of wars that are going to have to be resolved at some point down the road.
One of my personal favorites, and one we all should own is Yongye (NASDAQ: YONG), the China based fertilizer manufacturer.
The demographics are exciting for this company. As more Chinese move to urban areas, there a fewer farmers growing fewer crops, and demand is increasing for more food from a less agrarian society. Critical food shortages have led to skyrocketing prices. This has led to increasing demand for their hi tech fertilizers to improve and modernize farming in China.
It is rumored Morgan Stanley invested $1.4 million in the due diligence process before moving forward with a $50 million investment in June. It was in the form of a convertible preferred. The preferred coverts into common stock at $8, and the current price is $4.60.
Therefore, the stock has to trade above $8 before Morgan Stanley makes any money.
The current short interest is 3.6 million shares in this stock, down from an April high of 7.6 million.
Of late, Morgan Stanley Private Equity of Asia has been purchasing the shares. August 18th and 19th purchases of 359,315 shares equated to a $2 million investment at about $4.50 per share by the Morgan Stanley Board. From August 24th to the 26th, Morgan Stanley purchsed another 430,200 shares at an average price of about $4.56. Morgan Stanley’s board has now purchased a total of 827,315 shares in addition to the $50 million it has put in. That’s an additional $3.7 million. It appears Morgan Stanlely doesn’t want to wait until the stock is above $8 to make money on this one.
Since June 1, CEO Wu Zishen invested $3 million to purchase 555,000 shares of his company’s stock at about $5.40 per share.
Insider buying of this nature is clearly an implied endorsement of the company. Especially, when one considers Morgan Stanley is using its own money to buy.
In a situation like this, where are short sellers going to find 3.679 million shares somewhere down the road?
Also, consider my personal favorite- Lihua International (NASDAQ: LIWA). On August 11th the China 360 3rd party due diligence report was released on LIWA.
In my mind, it vindicated the company of any possibility of fraud. At the time, the stock was $7.15, and it saw a high of $7.80 in short order.
Today the stock is trading at $6.50, thereby suggesting the report did nothing to alleviate concerns and stimulate buying.
From July 29 to August 15, the reported short interest in LIWA increased from 2.35 million to 2.73 millon- a difference of 380,000 shares. This means short sellers had to increase their exposure another 380,000 shares to force the stock down.
Across the entire China Small cap sector there are short positions of 30% to 50% of the public float.
While the price performance of most of these issues has been stuck in a “Mexican Stand Off” over these past few months with very little price movement, the forces I alluded to are building up.
LIWA trades down a bit on good news, but short sellers had to sell another 400,000 shares they don’t own to push the stock down.
8.3 million shares are short Harbin, yet the most scathing cyber smear no longer has much effect on the price.
Both the CEO and Morgan Stanley Asia are acuriing shares on Yongye International, and there’s 3.7 million shares owed there.
I can’t help but wonder where all these shares will be found. Short sellers have had the absolute perfect storm for the last six months- a number of high profile collapses and huge gains, followed by absolutely horrendous market conditions for equities in August nearly akin to the Fall of 2008.
If you’re short, is there going to be a better environment to close out? The sector is absolutely ugly, and the market environment is just as ugly.
In order to put the final death knell on the sector, it would take exasperation beyond what we’re seeing now. It would take the collapse of a giant China name- say a Baidu (BIDU) or China Mobil (CHL) to scare everyone to death.
I can’t say for sure which way it will go, but sometimes when everyone is convinced a group of equities can only go one way, the majority can get killed.
Last week all they could talk about on CNBC was the parabolic rise in gold, and look what happened this week. Gold got killed. US Real estate investors in 2007 learned that nothing goes up forever.
As I said, the forces are builiding. There will be one major event that will tip the scales., and it will explode- either up or down.
At present, I’m betting on the long side in a few select names, but I could be wrong.
Of one thing I’m certain- there will be a major breakout or another major breakdown.
Unseen forces are building.