Benjamin Graham Goes to China

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            The investing world has long known of Benjamin Graham and his most famous student, Warren Buffett. While Mr. Buffett has since built upon the teachings of his teacher’s methods, they are as invaluable today as they were then. Benjamin Graham taught that stocks are part of ownership in a business and the most intelligent, surefire way to make money in the stock market is to buy stocks at a significant discount to what a rational owner would pay for that business. His favorite situation was a “net-net” - buying a stock for less than the sum of a companies’ cash and receivables minus ALL liabilities. While such situations have become increasingly rare over the years, partially because of the success men like Buffett have had applying Graham’s ideas, they still occasionally occur giving you the opportunity to profit.

            Despite the numerous examples of success using Graham’s methods over the years, the average investor needs to be careful. A stock trading for less than it is worth dead frequently has a large number of problems and is often losing money. This is why it trades for less than the value of its current assets minus all liabilities. But occasionally, under the rarest of circumstances, the right situation presents itself.

            Enter Gulf Resources Inc. (NASDAQ: GURE), a Shouguang, China based producer of bromine, crude salt, and other chemical products. Now I know what the reader is thinking: “There are tons of cheap Chinese companies trading at low valuations because we can’t trust their books!”. And the reader would be right; there is a massive bias in the markets today when it comes to American-listed Chinese equities. Countless stories of shady reverse-mergers and scandals like Sino-Forest come to mind. But does this mean every Chinese company is engaging in shady accounting practices and should be avoided at all costs? Not necessarily, and there are a few very good reasons that investors may want to start with Gulf Resources when looking for value.

            Gulf Resources’ market capitalization currently sits at $46 million dollars, which is less than half of the companies’ current net liquidation value. This is calculated by taking Gulf’s $78 million in cash, adding 30 million of receivables plus 5 million of inventory, and subtracting all of Gulf’s liabilities which comes to just under $13 million. The result is a stock that could be liquidated today for something around $100 million dollars. True, Benjamin Graham would cut inventory numbers by at least half but the $5 million in inventory the company currently carries is quite reasonable compared to the companies’ quarterly revenues of over $22 million. Not only that, but the company isn’t bleeding cash like many companies selling for less than liquidation value. While the company’s profits have fallen from 30 million in 2009 to $15 million in 2012, the point is they are profitable.

            Were Benjamin Graham here today he would no doubt at least take a closer look at Gulf Resources. He liked to say that eventually, stocks eventually reach their intrinsic value. This may be through the market simply realizing the true value of the business, acquisition by a competitor, or perhaps actions by management as is the case with Zhongpin Inc. (NASDAQ: HOGS) which is being taken over by its CEO because of the low valuation currently being awarded to Chinese companies in today’s marketplace. However Gulf Resources’ stock reaches it’s intrinsic value, management seems to be aware of the mispricing of the stock, announcing a stock buyback program in the amount of $2 million on May 22, 2013. This, coupled with the fact that Gulf has several owners holding over 10% of the companies’ stock, makes it likely that the company won’t sell for less than the cash it has in the bank for long.

            Benjamin Graham was one of the greats, and paved the way for countless investors to have a shot at superior market beating returns by attempting to buy a business for less than its worth. While we can’t say for sure if Mr. Graham would have added Gulf Resources to his portfolio the facts make it clear that it’s worth a closer look.

            As always investors should do their own research before making a purchase or sale of any security.  

Sean O'Reilly has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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