Unfortunately, there's not much good to report out of China and the China small cap sector this week. This is not unexpected, and I'm fully prepared to experience more downside as I don't believe we have yet achieved the point of "Maximum Pessimism" in the sector.
We'll be at the point of Maximum Pessimism when there isn't one single investor- either fund manager or individual, who believes there's any chance a China based small cap stock can go up. As I've written in the past, based on my long experience in these matters, the bottom is likely to be made sometime in the mid July to mid August time frame -but there's no telling for certain.
The Macro Picture
The macro- or "Big" picture in China continued to worsen this week as US markets put in their 6th down week in a row, and China followed suit with the Shanghai "A" shares trading down to their lowest level in 9 months.
This is a weekly chart showing this index was last at this level last September. That's was quite a while ago.
It's also worth noting, the last time this index was this low, it traded sideways for two months, then rocketed.
Dropping below the 2800 was not a positive sign, and with inflation still coming in at a difficult 5.5%, the market is perceiving "China Slowdown" in big, bold print.
The Good and the Downright Ugly
The China small cap sector was hammered again this week as more allegations of fraud surfaced .
On the good side, Morgan Stanley, after what the firm described as "Extensive Due Diligence", closed its $50 million investment in fertilizer producer Yongye International Inc. (NASDAQ: YONG, Stock Forum). This transaction is clearly an implied endorsement of the company, as the convertible preferred structure demonstrates investors believe in much higher levels for this stock. The $50 million is convertible at levels starting at $8, and the stock is at $5. The investors are content with a small coupon for the time being, but only have really significant upside if the stock trades above $8. YONG, in my view, is now a stock you can safely own, but I can't say when it will trade up significantly with all the negative noise in the sector.
On the negative side, there were three highly damaging revelations in small cap stocks. Harbin Electric Inc. (NASDAQ: HRBN, Stock Forum) is a company whose CEO has been making a lot of noise about taking the company private at $24 per share.
Citron Research claimed to have found evidence the CEO was involved in some very shady dealings in the past, and the stock cratered from, $16 to $6, then bounced to $8. This one might be intriguing for a trade as the allegations did not extend to activities at Harbin- so who knows. Morgan Stanley has been involved in organizing the buy out to take the company private, but the market has never believed the transaction will take place.
Then, there was more fraud alleged at Yuhe International Inc. (NASDAQ: YUII, Stock Forum)- this is a company that hatches baby chickens and sells them to poultry farmers.
The company claimed to have acquired a competitor- Dajiang. When the negotiations fell apart, the CEO admits to have taken the deposit money, put it in a private account, and used to to buy 11 other properties without disclosing his move to anyone including the CFO. I was interested in this story up until last week because I'm interested in anything food related. YUII is now halted for trading.
China Biotics Inc. (NASDAQ: CHBT, Stock Forum) became another casualty of this week's mess. The company was unable to get auditor BDO to sign off, and announced due to some inconsistencies could not file its audited numbers in time. Halted for trading.
Between these three incidents, coupled with the large Interactive Broker Network no longer allowing margin on China stocks, and we've got a piling on effect that seems to have no bottom.
These things are like freeway wrecks to me- I'm now morbidly drawn to the drama as I drive by. I'm now just waiting for the accidents to clear and traffic to pick up again.
John Paulson- The Greatest Trade Ever
Billionaire fund manager John Paulson has been getting a lot of ink lately. I'm a big fan of this highly successful contrarian, but his performance of late has been rough.
Paulson was a well respected manager of a merger arbitrage fund in the 90's and into the 2000's. In the mid 2000's he went short the super frothy housing market by accumulating credit default swaps that were trading for next to nothing. These were the instruments crooks like AIG invented as semi fake "insurance" against the demise of sub prime debt.
When the world fell apart in 2008, Paulson made $15 billion with a one year return of 590%. He personally netted $3.7 billion.
Money came pouring in, and his assets under management reached $40 billion. He made billions more going long large financial institutions like Bank of America Corp. (NYSE: BAC, Stock Forum) and Citigroup Inc. (NYSE: C, Stock Forum) in early 2009.
Of late, Paulson's fund has been doing poorly- having lost what might be $500 million on Sino Forest Corp. (TSX: T.TRE, Stock Forum). The financials he still holds have been very weak of late as well.
I've admired this guy as a great contrarian investor. When the world thought the US real estate market could continue going up forever, he was shorting. It took two years to really pay off.
When the world thought our financial institutions were going to close their doors, he went long.
Perhaps his fund has now become too large to take advantage of these emotional and irrational markets.
Lesson learned: when the bubble bursts, there's a lot of money to be made, and bubbles can form both on the positive and negative side.
There's an irrationally pesimistic bubble forming in China Small cap, but we're not at the bottom yet.
There will be a bottom and when it happens, there will be far fewer stocks to choose from, and they will be far better companies. There will also be rocket fuel to the upside in the form of short positions that need to be covered.
We're not there yet, but we will be. Watch the carnage from the sidelines for now. The long side will come back when every last buyer gives up. That's what I'm waiting for.