So Long, YONG! 3 Lessons from Investing in Chinese Small-Caps
Simon is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It was a bittersweet day last Monday for investors in Yongye International (NASDAQ: YONG).
Back in June of this year, I suggested that Yongye take advantage of their undervalued stock price and buy back shares.
Looks like they did one better than that. On October 15th, Yongye received an offer from its CEO and Board to buy all outstanding shares and take the company private for $6.60 a share.
Great news, right? YONG shares jumped nearly 18% for the day, which gave a nice boost to anyone holding them in their portfolio. But for those who were interested in the long-term opportunity of Yongye (myself included), this offer would be a steal on a business that is worth much, much more.
The Good News...
Yongye was doing many things right:
- They were being recognized by the government through technology awards for their use of fulvic acid to improve the uptake of fertilizers.
- They were working to integrate their supply chain as a way to reduce raw material costs and improve margins.
- They were launching new products to better coincide with the unique needs of the different seasons.
- They sold through small, branded co-ops that were near to and trusted by rural farmers.
- And, perhaps most important to investors, they were making 2012 the "year of distributor management." Yong was adopting more conservative reporting practices with regard to revenue recognition to get better control on their bloated Accounts Receivables' balances.
...and The Bad News
Still, the market punished YONG. Most of the reasons were unrelated to the fundamental operations of the company.
I had originally intended to write this article as a recap of the deal and discuss what I believed Yongye's true valuation to be. But I then realized that information isn't necessarily so relevant any more. The deal specifics are out, and a detailed valuation of the business would probably put most readers to sleep. Suffice to say, I think it's worth much more than $6.60/share.
Instead, after having committed a significant amount of my own money and time following Yongye's rollercoaster of a ride over the last few years, I thought it might be more useful to write about three lessons that I learned from investing in a small-cap foreign company. Hopefully these could be helpful to other investors with green in their eyes that are looking for exposure to emerging markets.
#1: Investor Sentiment Trumps Fundamentals
At $6.60 a share, Yongye is being valued at a forward P/E ratio of less than three. Yet last year, the company grew earnings 50% and nearly doubled their revenue. Something seem out-of-whack here?
For one, fraud is a continual worry of investors in Chinese small-cap stocks. Auditor resignations at China Media Express and others have many wondering "who will be next" to turn up fraudulent. Western investors have a difficult time putting feet on the street and getting directly in touch with the company or its customers. Additionally, bearish research firms such as Muddy Waters or Absaroka Capital have continually published reports about why many of these companies should be sold short. This obviously affects investor sentiment.
As such, institutional investors shut the door on Yong. Aside from a $50 million investment from Morgan Stanley, big money didn't touch many of these stocks. Even with ridiculously low valuations.
Lesson learned = The fear of fraud does have an impact on the share price of small cap foreign stocks.
#2: Who Can You Really Trust?
Do accountants in China play by the same rules as the US? There is an extremely important negotiation on this topic within the Public Company Accounting Oversight Board (PCAOB). If things get messy, it could ultimately result in the deregistration of many accounting firms that audit Chinese companies and the delisting of US-listed Chinese companies. That would also include bigger-name Chinese companies that also sell on US exchanges, such as Ctrip.com (NASDAQ: CTRP) or Baidu (NASDAQ: BIDU). Ctrip is a holding company with subsidiaries that engage in leisure travel booking. Their subsidiaries pay dividends up to the holding company, which is headquartered in Shanghai but actually incorporated in the Cayman Islands. This company then sells equity in the form of depository receipts on the NASDAQ, and they have a $3 billion market cap. Equally as complex is the organizational structure of the Chinese internet search giant Baidu, who is also headquartered in China, domiciled in Grand Cayman, and listed in the US. And with a market cap of $40 billion, you can see how things can get fairly complicated.
If the paragraph above gives you a headache just reading it, imagine the nightmare when it comes to the accounting. The impact of the negotiations is that a delisting of those companies due to accounting disagreements could potentially make things very ugly for investors.
Secondly, Yongye's very listing on the public markets came about through a fairly dubious process that is sure to raise a few eyebrows. Before selling organic fertilizers, Yongye had its humble beginnings in the sunless tanning business. The following is directly from their 2011 Annual Report:
We were incorporated in the State of Nevada on December 12, 2006 under the corporate name “Golden Tan, Inc.” At that time, we were engaged in the business of offering sunless tanning services and selling tanning lotions.
Yongye..ahem..'Golden Tan' then went on a reverse-merger acquisition strategy and took the steps necessary to get listed on a public exchange. I'm far too ignorant in corporate law to follow exactly why they took the steps that they did. But through my lens as an individual investor, it seemed like they knew what they were doing and that it was legal, so I took their word for it.
The bottom line is, this isn't Apple - which was started in Steve Jobs' garage. Yongye, along with many other smaller foreign companies, have to take complicated maneuvers that sometimes affect their ownership structure in order to get listed on US exchanges. That induces risks.
Lastly, in addition to the accounting debate and the reverse-merger fiasco, regulations and permitting in China seem to be much less transparent than they are in the US. Yongye applied for the rights to a lignite coal mine in the Wuchuan province to help the company reduce its cost on raw materials. From a business perspective, this makes a lot of sense. However, the approval process from the government at times seemed a bit sketchy. Yongye continually had to explain on conference calls why the approval was taking so long and why they had not yet been able to utilize the mine.
Lesson learned = Foreign companies' accounting policies and relationships with the government often raise potential red flags. Things that look out of the ordinary (whether legitimate or not) induce risks and scare investors.
#3: Volatility That Will Make Your Stomach Churn
Take a look at Yongye's stock chart over the past three years (the starting point is ~$7/share in 4Q '09):
If you're a portfolio manager, would you want to invest a significant portion of your client's assets in this company? You would be getting phone calls every few months to have to explain the 50% pops or drops in the share price over short periods of time.
Lesson learned = Expect volatility in small cap foreign stocks and don't let it keep you up at night.
Foolish Bottom Line
On September 25, The Motley Fool celebrated Invest Better Day. As a part of the movement, several staff writers published articles that chronicled their most important lessons learned over years of investing. I found the advice to be incredibly enlightening and tried to make mental notes from as much of it as possible. After all, experience is the greatest teacher, right?
Yongye International was one of the first foreign companies that I committed a decent amount of capital to. I bought in at various price points both above and below the share price that shows today. If the CEO's offer goes through, I will just about about break-even on my total cost basis.
Even if I don't make or lose any money, some of the lessons I learned from Yongye are invaluable. When investing in foreign companies, there are a great number of factors outside of the numbers and the fundamentals that investors should make note of and pay attention to.
TXinvestor82 owns shares of Yongye International and Ctrip.com. The Motley Fool owns shares of Baidu and Ctrip.com International. Motley Fool newsletter services recommend Baidu and Ctrip.com International. 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.If you have questions about this post or the Fool’s blog network, click here for information.