Bear Market Rally

The equity markets have decided to ignore any bad news on the economy and rejoice at the “second derivative” turning positive, meaning things are getting worse at a lower rate than when the economy was in the equivalent of cardiac arrest in late 2008. If you believe the market is undervalued right now, you have to be thinking that the economy is returning to 2006 levels and this whole crisis was just an inconvenient blip. I don’t think anyone actually believes that, but who can pass up a good rally? Besides some key holdings, I’d rather sit primarily in cash and wait for valuations to improve.



At this point, there is significant systematic risk in the market right now and I think the market is due for at least a 20% correction in the next six months. There are just not enough jobs right now for the consumer to pay off debt to heal the banking sector. Our solution for the banking sector is to keep current management in place, let them earn excess income by keeping interest rates artificially low so the banks can earn higher net interest margins on loans, bide time by mocking the public’s intelligence with “stress tests”, try to get toxic assets off their balance sheet by manipulating the price through leverage and non-recourse loans, and hope the economy can improve enough so they can earn enough to heal its balance sheets. It’s a nice deal for current management and the creditors, it gives them all the upside. Hopefully it works, because the taxpayer is on the hook for any downside. It’s kind of like taking the worst things about capitalism and socialism and mixing them together. I really don’t care if it “works” or not, this too-big-to-fail policy by the government is just wrong.

Now that I got that rant out of the way, I will highlight a tiny company that I believe is a good long-term play. I have begun a position in Oriental Paper (OPAI.OB), a small manufacturer for the mid- to high-end paper market focusing on the northern Chinese region. The stock can be bought at around $0.26 per share right now even though it had 2008 earnings of $0.20 per share with healthy growth rates and solid operating cash flows. In fact, it is forecasting revenue growth of 30% in 2009. As comparison, they had guidance for 20% revenue growth in 2008 and delivered a 64% increase. Hopefully they will continue this practice of under-promising and over-delivering.

Competitive Advantages:
While it is a small player and I admit they do not have an unfair competitive advantage, there are aspects that show why this company has been successful. The company believes it has a regional advantage in the Hebei province. The CEO states, “[Hebei] has been our focus not only because the region provides growing demand for our products in the urban centers of Beijing and Tianjin, but because we also enjoy a price advantage in the region over competitors from other locales in China. We are approximately 75 miles (120 kilometers) from Beijing, the cultural center of China and our largest target market. Tianjin, another large urban center, is also approximately 75 miles from our facilities. We continue to see the benefits of our regional advantage, and believe that Orient Paper, Inc. is well-positioned to capture additional market share in 2009.” The company is the only paper manufacturer in Hebei province that has obtained Pollution Discharge Permit, and the company's sewage processing system of 30,000 tons capacity allows for production and operation in accordance with environmental protection regulations. Due to environmental regulations, many small paper mills have been shut down.

Business Model
The company has over 140 customers and none of them represent more than 10% of sales (The top ten customers comprise about 40% of sales). The company has shown to be good at collecting on revenues, as evidenced by a 64% increase of sales in 2008 but only having a 28% increase in Accounts Receivable. I listened to the Heckmann Corporation (HEK) quarterly conference call this Friday and they mentioned a difficulty from small-to-mid sized companies in China to get access to cash. So cash collection will be a major issue to monitor and I will look to make sure OPAI continues to manage this effectively but I do like how this company does seem to collect cash for its sales.

A major upside to this stock is a new production facility that would add production to its current 170,000 ton capacity. The company believes this increased capacity will allow it to meet domestic demand for paper, which is currently exceeding domestic supply. They announced in May, 2008 that they are building a new facility which will have an annual production totaling 1.2 million tons by 2010. The company predicted this increased production would add sales between $800M-$1.3B, with net income in the range of $160M to $230M. For a company with 45 million shares outstanding, that is pretty significant. Although completion of the facility has been delayed, I have confirmed with their company spokesperson that they are still actively preparing it for production. This new facility would change the dynamic of the company as it would have to compete in Southern and Eastern China where it may not have the cost advantages it enjoys in the Northern region.

Risks
Besides the obvious risk of being a Chinese microcap selling on the over-the-counter market, the company has some sizable debt but they should be able to pay off all the short-term debt with existing cash and upcoming operating cash flows. The company needs to do a better job with investor relations (they have told me they plan to hire an investor relations firm, for what that is worth) and there is low liquidity in this stock.

At current prices, I'll take the risk on OPAI.OB and hope it drops from here to add more on weakness.

Portfolio Allocation Considerations

The following chart illustrates how I will manage risk in the portfolio based on valuations and sector/market conditions.



The top row reflects periods of time when valuations are favorable and thus acceptable to engage in long-term investing. The bottom row reflects periods of unfavorable valuations in which speculative investments should be properly hedged to reflect this risk. As the chart depicts, I believe we are in a late bear market period in which valuations are starting to turn favorable. Unfortunately, market conditions are still unfavorable and better entry points are likely for most investments.

Valuations:

Current market valuations are based on the S&P 500. According to the S&P 500 website, peak earnings in 2006 were $83.11 and is estimated at $16.00 in 2008 due to Financial Sector. While I do not believe 2008 is representative of future earnings, a tightening of profit margins due to less leverage and increased consumer savings will produce lower earnings going forward compared to its peak in 2006. I will use earnings of $60 and apply an average multiple of 13x to get an intrinsic value of 780 for the S&P. After today's rally due to the latest Giethner Plan, the S&P stands at approximately 823. I consider the market appropriately valued right now with severe downside risk after the recent rally.

Sector:

During the past year, everything that wasn't a U.S. Treasury or gold-related was being sold off. While overall the selling was warranted, especially in the financials, it did open up appealing valuations in different sectors. The graph above shows where I believe certain sectors are headed. Obviously I am more bullish on oil and agriculture in the long-term than I am in the U.S. dollar. However, the U.S. dollar continues to be the safest haven for investors and nothing is changing that in the near future, despite the Fed and Treasuries best efforts. I am still bullish on China in the long-term but so far the country has not shown any indication that internal demand is increasing to correct its imbalances. I fear China still has a painful transition ahead of it. The Euro is another area of weakness, it will be interesting to see how Eastern Europe fares in the future and what costs these countries impose on Western Europe.

A good graph to track the weeks trading in the different sectors is available from the Wall Street Journal and published on www.investmentpostcards.com each week.



Market Conditions:

Despite the recent rally, it is hard to consider market conditions to be anything but unfavorable. The government has made it clear they will do whatever is necessary to combat deflation and prevent bank failures. It is hoping that leverage will be the cure to prop up asset prices long enough for the economy to recover and all to be well again. I fear these actions are prolonging a necessary correction period and any recovery will be generally weak.

What does all this mean? I believe we are in a period in which valuations are fair but market conditions are unfavorable. Certain sectors may start decoupling soon and show strength but for now I believe most investments will be down and not up in the months ahead.

Government Action Falls Short

The Geithner Plan was announced today and caused a major sell-off in the market. I was hoping his speech would cause this type of reaction because I was hoping it would mean the government is announcing a hard-line stance against troubled banks with bold action to eliminate ‘zombie banks’ but that wasn’t exactly the reason for the sell-off. Instead, the sell-off was probably more due to the many unanswered questions in the plan and the uncertainty in its meaning.

It seems that whatever side of the fence you are on about what is best for the financial system depends on your diagnosis of the problem. The Treasury appears to be fighting this problem like it is a liquidity issue that is causing temporarily depressed asset prices. The plan in both its original and current form is to pump enough capital to the banks to keep them afloat until the prices correct and everyone gets their money back (or at least most of it). The other camp is arguing that the banks are insolvent because they are holding permanently impaired assets and the government is artificially keeping them in business even though they are technically bankrupt. Their solution would be to assess the banks needing government intervention, wipe out the current shareholders and management of those banks deemed insolvent, and use some form of bankruptcy proceedings, nationalization, or negotiated private industry sale to start-over with a recapitalized bank.

In the end, maybe Nouriel Roubini is right in his assessment the Treasury seems to be following a course of action based on political reasons. The consensus opinion is that Bank of America and Citi are effectively insolvent while Wells Fargo and JP Morgan are not yet as of today. Instead of taking over BoA and Citi, which risks causing panic for Wells Fargo and JP Morgan, why not delay the decision and hope the economy turns around in the meantime? I actually hope this assessment is more accurate than the more cynical conclusion that the Treasury and Fed are protecting the interests of the big banks at any cost to the taxpayer. I find it ironic that Obama’s speech last night warned if we did not act boldly today that the U.S. could enter a “lost decade” similar to Japan in the 1990’s and the very next day his Treasury Secretary announces a plan that keeps our insolvent banks in business which was one of the major criticisms of Japan during their lost decade. To be more optimistic, at least the groundwork is being laid for the inevitable.

This doesn’t fundamentally change any of my views and I still will wait on the sidelines for better prices in the marketplace. Unfortunately for me, so far, this strategy has not materialized yet as the stocks I am following are almost all up even after today’s fall. Regardless, between the tepid stimulus package and the Treasury plan, I see no reason to expect a strong rebound in the global economy anytime soon and thus see no major catalysts for the U.S. equity markets.

Companies Under Consideration

The following are stocks that I believe fit into the criteria I discussed in the previous blog entry. With the exception of Gulf Resources, I currently do not own any of the following stocks, but will look to purchase the rest at periods of particular weakness throughout 2009.

Gulf Resources (GFRE.OB)
Summary:
This is one stock I currently own. Gulf Resources is China’s largest producer of bromine and also sells crude salt and chemical products. In China, a net importer of bromine, Gulf Resources is the market leader with over 20% market share and the Chinese government is not licensing for any further domestic competition. The stock currently trades at a P/E of close to one, attributed to a sell-off of a larger shareholder who received the shares as compensation for helping take the company public. This has offered a compelling buy at current prices as downside risk is limited.

The Market:
Global production bromine capacity is approximately 720,000 metric tons and dominated by three international players: ICL, Chemtura, and Albemarle. With about 33,000 metric tons capacity, Gulf Resources provides roughly 5% of the global capacity but currently sells only in China. It is estimated that China demand is 190,000 metric tons per year but the country can only supply 160,000 tons per year.

Competitive Advantages:
Government regulation provides high barriers to entry for Gulf Resources. Gulf Resources is one of only six license holders permitted to extract bromine in China. The government issued a decree that they would not grant any more licenses in the future. Gulf Resources has grown significantly by buying up unlicensed producers who are legally not permitted to produce bromine. The company is certainly not immune to a global slowdown but Gulf Resources should be one of the first to emerge from it since it supplies many industries that should recover including energy and waste water treatment.

Business Model:
Gulf Resources generates sales with cash in advance from customers they have long-standing relationships with, which generates solid cash flow.

Valuation:
Gulf Resources will earn $0.20-$0.23 per share in 2008. This provides a compelling valuation of 1x earnings for a company with high barriers to entry, strong cash flow generation, and products that should have strong demand once the world economy recovers. Debt load is minimal so the company should survive any sustained downturn and emerge from it in a position of strength. This company should trade again at least an 8x earnings multiple once the investment climate stabilizes suggesting significant appreciation potential.

ChinaCast Education Corporation (CAST)
Summary:
ChinaCast Education Corporation uses its brick-and-mortar schools and a satellite broadband network to serve the growing Chinese post-secondary and e-learning education market, similar to Devry, Strayer or Phoenix University in the United States. Flying under the radar, this company is quietly building up an impressive infrastructure and cash reserve to take advantage of a huge untapped market.

The Market:
The education market in China is expected to be one of the biggest growth markets in China for the foreseeable future with the post-seconday market particularly appealing due to its value proposition. Despite recent annual growth of 23% over the last five years, only 5% of the population possesses college degrees and there is a clear value proposition for pursuing a degree since the average wage increases are over 200% for post-secondary degree. Distance learning will also continue to fulfill a glaring need for the Chinese Education market. According to China’s Ministry of Education in 2007, there were over 100 million higher education students, while universities had sufficient physical space to accommodate only about 15% of the students qualified to attend.

Competitive Advantages:
The company is still establishing its moat but does enjoy some competitive advantages. The company possesses two important operating licenses including one from the Ministry of Education for its accredited degree programs and the other from the Ministry of Information Industry for its nationwide satellite broadband internet license which it hopes to build a nationwide network of campuses and an e-learning network throughout China. The company believes the satellite license gives them a first-mover advantage for their e-learning segment over competitors using terrestrial networks and they have the cash to make strategic acquisitions to expand its national coverage.

Business Model:
This business model generates lots of free cash with stable, recurring revenue streams and low CAPEX. This is a cash business right now compared to the United States, loans are not really existent so the company collects the cash up front or the student does not go to school.

Valuation:
ChinaCast has an Enterprise Value of approximately $19M and has generated free cash flow of $19.6M in the first nine months of 2008. With $2.00 in Net Cash and roughly $0.30EPS, the company is basically selling for nothing right now. It may take time for the company to prove itself to the investment community and justify a higher premium, but in the meantime the company will continue spitting out significant free cash flow and building its moat in this attractive market.

China Medical (CMED)
Summary:
With the recent sale of one of its main subsidiaries, China Medical is now focused on the attractive advanced (in-vitro) diagnostic market selling highly recurring reagent kits, probes, and chips in China used to detect various diseases. Investor sentiment in the stock is low right now partly due to the dubious nature of the sale of its subsidiary to a major shareholder, but the sale frees the company to focus on the in-vitro market that offers appealing long-term potential with a business model that ensures significant cash flow.

The Market:
The company serves the Chinese in-vitro market, estimated at around $1.5B today with strong continued growth expected, using ECLIA, FISH, and SPR technologies to detect diseases. In the interest of brevity, ECLIA is a test that detects diseases based on a reaction of the patient’s bodily fluid, such as blood, with a reagent to create a light emission and the analyzer measures this light to detect a specific disease. FISH probes are used commonly for prenatal and postnatal diagnosis and certain types of cancers while SPR is used primarily for cervical cancer. ECLIA products have been targeted to small-medium hospitals while FISH and SPR have been targeted at large hospitals.

Business Model:
The company is now focused on the highly recurring, high margin sales of reagent kits and probes. In order to build its established base to sell these kits and probes, the company has recently made it easier for hospitals to install their systems by either renting it out for free or reducing prices. The company hopes the familiarity of use and high costs to replace their system with an international competitor will be enough to generate substantial long-term revenue streams.

Competitive Advantages:
This company’s competitors include international giants such as Johnson & Johnson and Beckman Coulter. Despite this, the company can price significantly lower than these competitors and is establishing positions in the small-medium hospitals vice the large hospitals targeted by its larger competitors. As the company wisely builds up its installed base by selling their systems at reduced prices, high switching costs will keep sales of its reagent kits, probes, and chips recurring in the long-term.

Valuation:
The company has an estimated $167M in cash and $150M in convertible debt. Estimating what earnings are today excluding the sale of its recent subsidiary is about $1.20-$1.50 per share, placing the stock at multiple of 10-12.5x earnings. For a company with highly recurring sales and strong cash flows with a growing installed base, this makes a good entry point.

Heckmann Corporation (HEK)
Summary:
China is facing a potential water crisis. The statistics are sobering, with 90% of cities’ groundwater and 75% of rivers and lakes causing 700 million people to drink contaminated water per day. Northern China faces an even more severe water shortage, as more than 63% of the country possesses less than 20% of the water supply. Heckmann Corporation has established an entry point into the market with the purchase of China Water, the fifth-largest bottled water company in China, and has $380M remaining in cash with negligible debt to consolidate what is presently a highly fragmented industry. Chairman and CEO is Richard Heckman has a proven track-record, executing a comparable strategy in the US by buying US Filter for $1.6M in 1990 and selling it to Vivendi in 1999 for approximately $10B. The attractiveness of this investment is based primarily on the potential due to such high sustainable demand for water in China, but at today’s prices you don’t have to pay for the speculation.

The Market:
The bottled water market in China is estimated at $4.6B and is growing at about 17.5% per year for the last five years. It is still an industry in its infancy as China is only starting to embrace bottled water in comparison to the rest of the world. As a comparison, China has 4x the population of the United States but only consumes 40% the amount of bottled water. China will desperately need to establish industrial wastewater treatment which offers another compelling opportunity.

Competitive Advantages:
The company is the key supplier of bottled water to Coca Cola in China since 1996. It currently has six facilities located throughout China and is in process of expanding to nine in the near future. The company plans to use its superior cash reserve to purchase companies in this down market and expand its facilities.

Business Model:
The company is still in the initial stages of defining itself but the new acquisition is reported to generate cash from operations equal to 38.1% of revenues.

Valuation:
Heckmann has $330M in cash and potentially about 165.7 million shares outstanding which is roughly $2 per share in net cash. The China Water acquisition is expected to earn over $0.38 per share in 2008. This equates to under 10x earnings net of cash. This valuation does not even take into consideration the cash the company would raise if warrants were exercised. The company is actively buying back warrants given the depressed market value which should be a good use of cash for existing shareholders to prevent dilution.

Potash Corporation (POT)
Summary:
The economic downturn did not spare the agriculture industry as everyone conserved cash, including farmers. This may have affected potash demand, especially in North America, but it does not change the long-term strengths of the fertilizer industry. The three main fertilizer nutrients are nitrogen, phosphate, and potash. Nitrogen and phosphate are competitive industries with low margins, but the potash industry is an oligopoly which can better control supply and thus margins. Since populations and meat consumption are increasing (it takes approx. 7 pounds of grain to produce 1 pound of beef) while available farming land per person decreases, the need for higher yields becomes imperative which provides continued strong demand for fertilizers. Potash Corporation will see continued strong demand with high barriers to entry for many years while farmers work to address a severe global grain shortage.

The Market:
Potash Corp has capacity for 10M tones per year with planned expansion to 18M by 2012. The potash market is currently underserved in major developing countries such as India and China. In countries such as the U.S., the mixture of the three nutrients in fertilizer is typically 0.4 units each of Potassium (Potash is Potassium Chloride) and Phosphate for one unit of nitrogen. India and China use far less Potassium, in fact China would need to double their potash application to meet this ratio.

Competitive Advantages:
Potash sells nitrogen, phosphate, and potash but it is potash that is the obvious crown jewel for the company. Potash is known as the quality nutrient since it is credited with improving the crop’s disease resistance and nutrient value. Usually a commodity producer will find it impossible to possess a strong competitive advantage, but a lack of economically viable deposits, high production costs, and long lead times make this an industry with high barriers to entry. Potash will be supply challenged over the next five years and Potash Corp will supply over half of increased supply in that time. “Greenfield projects” (developing brand-new supply) costs roughly $3B and takes about a decade to show investment returns so the costs to enter this space, especially in current credit conditions, are steep.

Valuation:
Any near-term weakness in earnings is already factored into the stock so this represents a good opportunity to invest in a company with dominant position in an attractive long-term market. The company forecasts $10-12 per share in earnings for 2009, which equates to a 6-8 Forward P/E. The company also has long-term investments that are far in excess of debt. Potash was a hot stock in 2008 that came crashing down, but it is more than hype and will come back strong.

Intuitive Surgical (ISRG)
Summary:
Intuitive Surgical provides their proprietary “da Vinci Surgical System” to hospitals, which they believe is a next generation surgery technique that will replace minimally invasive surgery. The da Vinci Surgical System consists of a surgeon’s console, a patient-side cart, a high performance vision system and proprietary “wristed” instruments. By placing computer-enhanced technology between the surgeon and patient, the system translates the surgeon’s natural hand movements on instrument controls at a console into corresponding micro-movements of instruments positioned inside the patient through small puncture incisions, or ports. This robotic surgery results in faster patient recovery times and thus less lengthy hospital stays. The penetration rates for this system are still very low but the barriers to entry are high as adoption increases. While still in its infant stages, this technology is being used effectively today, with 136,000 operations last year representing a 60% increase from prior year. The sales cycle for selling a new system is long due to the high capital expenditure required by the hospital. This has caused growth investors to flee this stock given the current economic climate and is providing an attractive valuation for long-term investors.

The Market:
The da Vinci system is cleared by the FDA to perform urologic, gynecologic, cardiothoracic, and general surgery. The company has sold about 1,111 units to date and believes the total market is about 6,000 worldwide.

Competitive Advantages:
The company believes this system has significant advantages over the Minimally Invasive Surgery and Open Surgery techniques used predominantly today to provide a solid return on investment for hospitals. Due to the lengthy FDA approval process and IP protection, it will take time for direct competition in robotic surgery and currently the biggest competition is status quo with current surgical techniques.

Business Model:
The business model is essentially a "razor/razor blade" model. The company sells and installs the da Vinci Surgical System for about $1M at their customer sites (hospitals) and then generates recurring revenue as the system is used to perform surgery and, in the process, necessitates buying and consuming new EndoWrist instrument and accessory products. The recurring revenue comes in the form of about $100K service contracts and $2K replacement parts for each surgery. Recurring revenues currently accounts for close to 50% of the company’s sales.

Valuation:
With no debt, the company has about $22 per share of net cash. With earnings of about $5.30 per share, this represents a P/E below 14 for a company establishing an impressive recurring revenue stream.

PowerShares DB Crude Oil Dble Long ETN (DXO)
Summary:
Despite the reduced demand for oil due to the global recession, there are two main reasons to be long oil in the long-term. The most commonly cited reason is that oil supplies are declining with some suggesting we are past peak oil. The other reason to be long oil is as an inflation hedge against the U.S. Dollar.

Based on research developed by Paul Van Eeden which tracks the price of oil in nominal terms and inflation adjusted in relation to US dollars and ounces of gold, the average price of oil since 1931 in these inflation-adjusted terms is approximately $87 per barrel. While the collapse of global demand has crushed oil prices to lows many thought we would never see again, this low price is actually a disincentive for companies to spend capital for new exploration and will only exacerbate the fundamental supply problem once global demand returns.

The exact time to go long on oil is another question entirely. There are indications OPEC is not able to cut production as quickly is it wants to, as evidenced by a new forecast by tanker-tracker PetroLogistics which pins January OPEC output at 26.15 million barrels a day, which is 5.4% lower than the firm's December figures, but well below its target of 24.8 million barrels a day in production. U.S. crude inventories have risen by 14 million barrels in just the last three weeks (January, 2009), according to the Department of Energy's Energy Information Administration. With increasing supply and decreasing demand, oil is likely going to go down in the near future from its current price of $47 per barrel and test the low $30’s. This would be an attractive entry point.

An ETN is a simple way to invest in oil. The PowerShares DB Crude Oil Double Long ETN (DXO) is a senior unsecured obligation issued by Deutsche Bank AG, London Branch that is linked to a total return version of a Deutsche Bank crude oil index designed to offer two times leveraged exposure to the monthly performance of the DB optimum yield crude oil index plus the monthly TBill Index return, subject to an investor fee. One thing to keep in mind in this investment is volatility may not be good for performance. As an example assume a $100 investment in the ETN, if oil goes down 5% one day, then the ETN will go down 10%; if oil rises 5%, then the ETN will go up 10%. However, the fund is still down $1 since the value of the investment went from $100->$90->$99.

Oil prices have potential for further drop as the recession deepens, but long-term fundamentals are still there and expect oil to be one of the first assets to rebound from the global recession.

UltraShort Lehman 20+ Trsy ProShares (TBT)
Summary:
Investors trying to avoid the bloodshed of collapsing assets prices in 2008 flooded to the U.S. Treasury Market. The interest rate on a 30-year Treasury Bonds stands today at approximately 3% and offers investors liquidity and safety they are not finding anywhere else. Treasuries may continue to show strength in the near-term as the Fed works to keep interest rates low to stimulate the economy and investors stay on the sideline until there are more visible signs of a recovery. However, one of the easiest investments today for someone with a long-term horizon is to short U.S. Treasuries. Interest rates on long-term U.S. government debt will rise substantially in the future as inflation sets in on a depreciating currency for a government with a massive amount of debt and less tax revenues from a retiring workforce.

The US government has massive obligation coming due in the not-so-distant future with Social Security and Medicare programs while it fights today fears of a deflationary spiral due mainly to a deleveraging process and credit crisis in the banking system. The current government programs such as the first $350M installment of the TARP program is expected to be just the beginning and it could take well over a trillion dollars of investment before banks start to become adequately recapitalized. This does not include all the other stimulus and bail-outs that may be implemented. The government will run trillion dollar budget deficits and spend as much money as necessary until the nominal economy is growing and inflation is rising (which would be evidence that deflation is not occurring).

This is another investment where it is not a question of if, but when. The current yield on long-term Treasuries is much too low to compensate for the inflation risk and investors will eventually demand a higher return to hold these investments once panic subsides in the market. An opportunity to enter this investment should occur in the near future as economic data and failing institutions spook investors back to U.S. Treasuries in the near-term.

Investment Thesis

I am looking for advantaged companies with excellent long-term prospects trading at an attractive price. Doesn’t everyone? I believe there are certain assets with “excellent long-term prospects”, despite the feeling in the market today. I am expecting the current global slowdown to go well into 2010, but the opportunities will open themselves before the turnaround. Private industry is in a period of mass-deleveraging which is driving down the prices of almost all asset classes. This deleveraging period will cause a deep recession in the United States throughout 2009 (at least) and the Fed will leverage up their own balance sheet and dump massive amounts of money into the system to try to get banks lending and businesses/consumers spending again. But the deleveraging process will take a long time to work itself out. Investors fearing a sustained period of deflation have flocked to US Treasuries in what is being characterized as a “flight to safety” causing a rally in the USD. This reflation and fear in the markets has made the US Treasuries the next investment bubble. Expect the US and other trade deficit countries in Europe to impose some type of trade restrictions in 2009 to increase the price of imports and devalue their currency to increase their exports. The trade relationship between China and the US make these two countries intimately linked and the severe recession in the United States may cause a full depression in China. China has a problem of over-capacity by producing greater than domestic demand and exporting the rest out of the country. If Chinese consumption does not expand, then production contraction will have to make up for the entire shortfall which will wreak havoc in China soon. The age of the US consumer driving the global economy is dead, and the next engine of consumption will eventually be the rising middle class of emerging economies, in particular China, but this will be a long transition that will play out over decades. In the short-term this global contraction will hurt China more than the United States. However, currency debasing and trade protectionism will hurt the United States in the long-term. It will be a painful transition, but expect China to come out of this contraction better than the United States with a stronger currency and an expanding middle-class. At some point, money will stop flooding into the United States government and Treasuries will be the next bubble to burst. The Fed and Treasury policy to reflate our way out of this problem will be too excessive which will result in inflation once the velocity of money returns to more historical levels. Instead of trying to time this perfectly by buying dollars, I will look to buy assets attractively priced in the long-term. I expect commodities such as oil and fertilizer to benefit once the deleveraging process slows. I will therefore look for opportunities in the near future to be long on oil and fertilizer, and short on US Treasuries.

Advantaged companies possess competitive advantages that are not easily replicated. Ideally I look for a large (potential) installed customer base in which the company sells a recurring, rapidly depleted product/service leading to significant free cash flow while competitors can't enter due either to high customer switching costs, (geographical) monopoly, government regulations, patents, or superior brand image. The more protected this advantage is for the company, obviously more appealing the company will be viewed.

An attractive priced company will determined based on multiple factors including conservative capital structure, high returns on capital, and earnings power to arrive at an intrinsic value for the company. If this intrinsic value is estimated to be significantly higher than the current share price (at least 2x), then the stock will be considered attactively priced.

This blog will seek to find these offerings and will focus on the underfollowed and generally distrusted Over-The Counter market, to find the opportunities no one is looking at right now or just too afraid to go near in today's market conditions.

Is Gulf Resources Really Undervalued?

It seems a fair question, probably one that is being asked by every shareholder in the company during the midst of its current steep decline in share price. Gulf Resources (GFRE.OB), the largest bromine producer in China and fourth largest in the world, is expected to earn $0.20-$0.23 per share this year despite a temporary 3Q disruption in demand due to the Olympics. The company just announced that 4Q revenue demand is strong as customers have renewed orders following the restriction of certain industrial activities during the Olympics. Despite no obvious impairments to its future earning capabilities specific to the company, the current price of the stock is still just $0.23. Is it just the fact that Chinese companies are currently out-of-favor, especially over-the-counter stocks with low liquidity, coupled with the drop in commodity prices which is causing this stock to trade at slightly over 1x 2008 earnings? Despite the pessimism in the marketplace and the de-leveraging of the investment community, this seems like an extremely depressed price even at today’s standards. What is the investment community seeing? First, here are some questions for consideration.

Does the company have any competitive advantages?
Yes, it has gained 20% market share in Chinese bromine industry as one of only six companies in the country with a bromine exploration license. China has stated they will no longer issue any future licenses and are shutting down unlicensed production facilities giving Gulf Resources a significant barrier to entry. Gulf Resources is taking advantage of this opportunity by investigating potential acquisitions of unlicensed bromine production facilities to expand its market share. The company also has a profitable subsidiary specializing in chemical products to the oil & gas industry and paper making industry offering some growth potential.

Is bromine an element that is in demand?
Yes, China is a net importer of bromine as only 160,000 tons were produced within the PRC to meet the country’s demand of 190,000 tons.

Does the company have a sustainable source of bromine?
Yes, the company maintains 50-year mineral rights with reserves of approximately 2 million tons and annual production of just over 30,000 tons per year, giving it over 60 years worth of production potential.

Is the company in financial trouble?
The company currently has about $6.3M in cash and $21M in debt. The first installment of the $21M debt is due May, 2009. This $3M payment is interest-free and can be covered with existing cash. The other $18.2M is due no earlier than December, 2009. The company generated about $20M in cash flow from operations in the trailing twelve months and should be able to service this debt with cash flow from operations.

So why is it selling so low?
In June of this year, the price per share of Gulf Resources was over $2 per share. The main reason for the recent free-fall in share price cited by the company is a sell-off by a large stakeholder, presumably China Finance which owns 3.3M shares as of 6/30/2008. These shares were received as payment for surety guarantee services provided by China Finance for Gulf Resources’ 2006 merger and it is largely speculated (largely being a relative term since only a few people seem to follow this stock) that China Finance is selling its 3.3M shares now that the shares are qualified for sale. It is now anyone’s guess if the sell-off is being caused by a large shareholder and when the sell-off will be done.

Latest statistics show China has slowed to 9% growth. While many people are focused on a slowdown in the global economy, this is one stock that seems to have been battered down way too much. This company possesses clear barriers to entry, generates solid cash flow from operations, and has appealing growth potential in a domestic marketplace that has greater demand than supply. Trading at 1x 2008 earnings and 0.60 P/BV, there is enough margin of safety at this price to counter the risks in this micro-cap.

Industry Review (continued.......)

Metal Fabricating: Insteel Industries (IIIN)
This industry supplies to the construction, automotive, and manufacturing sectors. Thanks to the strength of manufacturing, companies in this industry have posted solid gains of late. Some companies are using creative ways to stay profitable, such as The Timken Co. restructuring its automotive segment to convert some of this capacity to serve the growing energy segment. Companies in this industry are obviously dependent on the health of the customer’s they serve so results will vary across the industry.

One example of a profitable company not getting positive results recently is Insteel Industries (IIIN). The stock has dropped from its 52-week high in August of above $23 per share to its current price today of $10.92. Insteel makes steel-wire reinforcing products for concrete construction. It recently reported its net income fell by 49 percent to $5.2 million, or 28 cents per share, from $10.1 million, or 55 cents per share, a year earlier. The company has no long-term debt and should survive this housing market downturn, but 2008 will probably not be anymore fun for this company than 2007.

Heathcare Information Services: National Research Corp (NRCI)
This industry seems to have solid long-term potential due to the ability of companies in this industry to provide solutions to the healthcare industry that streamlines operations and reduces errors. However, evidence that these products provide savings and increase efficiency is still mostly subjective. This is still an emerging field and time will tell if healthcare organizations will spend the money required to implement these systems. However, it looks promising which should produce some profitable companies in this industry.

National Research Corporation provides ongoing survey-based performance measurement, analysis, tracking, and improvement services to the healthcare industry in the United States and Canada. It addresses healthcare organizations' need to track their performance at the enterprise-wide, departmental, and physician/caregiver levels. The company develops tools that enable healthcare organizations to obtain performance measurement information necessary to improve their business practices. The company reported record revenues and net income in its latest quarter but was disappointed its growth wasn’t better. The stock is trading near its 52 week high but its success makes it a company to keep an eye on for the future.

Specialty Chemicals: Terra Nitrogen (TNH)
For reasons gone over already ad nausea, companies in this industry are better served offering products to a diversified base of customers since the downturns in the housing market are effecting sales of chemicals used for home construction. One segment within this industry doing well is electronic chemicals as demand from China is strong for manufacturing electronic products. Companies in this industry are facing rising input costs but have been able to pass this on to customers so far but increased competition could threaten that in the future.

Terra Nitrogen (TNH) engages in the production and distribution of nitrogen fertilizer products for use in agricultural and industrial markets. The company has benefited recently from continued strong U.S. nitrogen demand for corn and wheat plantings. The stock price has reflected this strong growth. It traded a year ago at around $28 per share and traded as high as $140 per share in August before trading today at $106 per share. The money seems to have been made for this stock but what a nice run it was.

Power: VeraSun Energy (VSE)
Alternative energy companies are looking for solutions for a non-petroleum-based world and are spending significant amounts of research and development to find it. There is little put forth so far in the way of commercial products for today’s market. It will be interesting to see if these companies can continue to find external financing to pay for this R&D if liquidity dries up further. Merchant power generation companies typically have large amounts of debts and thus face risks of meeting its obligations. This industry is very volatile and the inherent risks need to be understood before investing in one of these companies.

VeraSun Energy (VSE) is the nation's second-largest ethanol producer. Ethanol is primarily used as a blend component in the gasoline fuel market. The company's ethanol co-products include wet and dry distillers grains with solubles, which are used as animal feed; and Corn oil, which is used as an animal feed, as well as to produce biodiesel, a clean burning alternative fuel. In addition, it offers ethanol-blended VE85 fuel to gas distributors and retailers. The company is increasing its capital expenditures to increase its production and has tripled its long-term debt in the last year to over $650 million. Investors seem unimpressed as the stock has dropped from over $26 per share early in the year to just under $13 a share today.