Saturday, October 29, 2011

Smallcap Stock Screen - Investment Ideas

Although I don't recommend most people invest in individual stocks, I do keep a (very) small portion of my investable funds in an account I actively manage. My results have been decent. I have a few stocks I track regularly and have been in and out of them a few times over the years. I've also done some experimenting with options (failure), shorting (great success), and various other securities. At the moment, I'm about 50% cash in the account and have kept my eyes open for potential ideas.

(Note: almost everything (except for a long term holding or 2) in this account and every company mentioned below falls into the category of speculation, not investment. An investment, upon thorough analysis, promises security safety of principal and a satisfactory return.)

Though I try to stay away from the smaller end of the spectrum due to the higher risk I associate with tiny companies, I figured I might run a screen on the small end of the market to see what popped up. To that end, I did a screen of microcap stocks with market caps below $20 million, P/Es below 12x, 5 year average ROEs above 15%, trailing 12 months EPS above zero, and 5 year revenue growth above 10%.

The result was a list of 24 stocks for further investigation.

One thing that immediately stood out to me on the list was the pharmaceuticals. There were four of them on the list with similar sounding names: Huifeng Bio-Pharm (HFGB), Jiangbo Pharma (JGBO), Lotus Pharma (LTUS), and Skystar Bio-Pharm (SKBI). They all had P/E ratios of 1.13 or below and also made me immediately skeptical.

Starting at the beginning, I pulled up a yahoo finance quote on Skystar. The stock trades for $2.15 per share and had a 52 week high/low of $1.39 and $10.58, respectively. All else equal, I'd rather buy a stock at its high than its low, so this was a positive sign. I did a quick calculation and if I bought this stock today at $2.15 a share, then sold it for $10.58, I would make a 392% return. (conversely, the people who bought it at $10.58 and sold it today are looking at an 80% loss).

I also noticed it traded only 580 shares last friday, or about $1,200 of total volume, showing that the stock is very illiquid. If I owned shares of this company and needed to sell for any reason, the lack of potential buyers in the market could mean I would have to take a discount on the prevailing market price to sell them. Though this is a risk, you can also see this as a positive. If a lot of people aren't buying the stock, chances are very few people follow the company and you might notice something others have missed. If the stock ends up being a true winner, people will eventually come around to realize the value of the company

I have no idea what the company does, so I decided to pull up its most recent 10-K. They might as well paint a bird on this thing and fly it above Busch Stadium because it looks like one giant red flag to me. The first page was enough to turn me off, and this rarely happens to me:

"We were incorporated in Nevada on September 24, 1998. We are a holding company that, through our wholly owned subsidiaries in China, Skystar Bio Technology Co.(Skystar Jingzhou) and variable interest entity (“VIE”), Xi’an Tianxing Bio-Pharmaceutical Co., Ltd. (“Xi’an Tianxing”), researches, develops, manufactures, and distributes veterinary health care and medical care products in the People’s Republic of China (“PRC”).

All of our operations are carried out by our subsidiaries in China and Xi’an Tianxing, which the Company controls through contractual arrangements between Xi’an Tianxing and Sida Biotechnology (Xi’an) Co., Ltd. (“Sida”), the wholly owned subsidiary of Fortunate Time International Limited, the wholly-owned subsidiary of Skystar Bio-Pharmaceutical (Cayman) Holdings Co., Ltd. (“Skystar Cayman”), which became our wholly owned subsidiary in 2005.

Such contractual arrangements are necessary to comply with PRC laws limiting foreign ownership of certain companies.

Through these contractual arrangements, we have the ability to substantially influence Xi’an Tianxing’s daily operations and financial affairs, appoint its senior executives, and approve all matters requiring shareholder approval. As a result of these contractual arrangements, which enable us to control Xi’an Tianxing, we are considered the primary beneficiary of Xi’an Tianxing.

On August 21, 2007, Xi’an Tianxing invested $68,550 (RMB 500,000) to establish Shanghai Siqiang Biotechnological Company Limited (‘Shanghai Siqiang’). Xi’an Tianxing is the 100% shareholder. Shanghai Siqiang serves as a research and development center for Xi’an Tianxing to engage in research, development, production and sales of feed additives and veterinary disease diagnosis equipments."

In addition to Xi’an Tianxing, Skystar Jingzhou also manufactures and distributes veterinary medicines including aquaculture medicines in China."

So Skystar is an Arizona-based holding company that set up a complicated ownership structure to comply with (ie, get around) Chinese restrictions on foreign ownership of companies. The company's main line of business is selling veterinary health care and medical care products in China.
As a general rule, anything involving a Special Purpose Vehicle (SPV) or a Variable Interest Entity (VIE) makes me nervous. VIEs, as Bloomberg puts it, are a "post-Enron version of Special Purpose Vehicles." The fact that Xi'an is a VIE means that Skystar stands to benefit the most from the company, but it does not own more than 50% of the company. Only being able to "substantially influence" rather than "completely control" the company's main subsidiary is a huge red flag for me.

The page also referenced a Cayman Islands based corporation used as part of the ownership scheme.

All of this shit might be on the up-and-up, but the number of huge risks on page 1 of the 10-k are enough to make my head spin, and I haven't even gotten into the specific kinds of products the company sells yet. There's the risk of being tiny, the risk of doing business in China, the risk of not controlling your main source of income, etc. etc. After doing a little further research on the internet, I came across a publication about "Investing and Operating in Restricted Industries in China" It looks like this type of ownership structure has been put in place a number of times and as far as I can tell, it looks like a way for Chinese firms to raise capital from American and other investors.

A few other great tidbits from the 10-k: The company leases a building in China that the chairman owns for about $24,000 a year. The company also had accounting issues: "On December 17, 2010, the Company filed an 8K with the SEC disclosing the termination of Frazer Frost, LLP (“Frazer Frost”) as our independent auditors effective as of December 13, 2010." They replaced their auditors. They identified material weaknesses in their accounting and internal audit functions and finally, they disclosed this:

"Conflicts of interests between the duties of our officers and directors who are also management members of Xi’an Tianxing to our company and  Xi’an Tianxing may arise. As our directors and/or executive officer (in the case of Mr. Lu), they have a duty of loyalty and care to us under U.S.and Cayman Islands law when there are any potential conflicts of interests between our company and Xi’an Tianxing. We cannot assure you, however, that when conflicts of interest arise, these individuals will act completely in our interests or that conflicts of interests will be resolved in our favor. In addition, they could violate their legal duties by diverting business opportunities from us to others. If we cannot resolve any conflicts of interest between us and them, we would have to rely on legal proceedings, which could result in the disruption of our business."

I work at least 11 hours a day, 5 days a week. There is no way I am risking my hard earned money on an equity ownership interest in a setup like this. Even if the China operation does make enough money to one day pay some back to shareholders in the US, who knows if they will ever even be able to get the funds out of China without the government intervening? I'm passing on this one. Though the stock quote might go higher in the next few years, to me the risk is not worth the potential reward.

One thing I definitely do give the company credit for being straightforward and disclosing risks in its filing.

I think I've had enough smallcap action for one day. I assume the other pharma companies on this list are similar to Skystar and plan to report back any findings when I get the chance to look into them. Hopefully this gives you a sense for the kinds of things I look for in an investment/speculation. There will be many other pitches to swing at, so I dont mind letting this one go by. In this case, the ownership structure was so risky in my opinion that it didn't even matter what the financials looked like.

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