Amid controversy over Sino-Forest's financial statements, many China-based stocks have sold off sharply: an index of U.S.-listed China-based companies is down 21 per cent from its peak on April 21. This kind of train wreck naturally draws contrarian investors who hope to find extreme value among the debris.
If you have already decided that the financial statements of these companies are simply not worth the paper they are printed on, then it is probably sensible to avoid the sector. For the more adventurous, though, a return to a classic valuation model invented by the legendary investor Ben Graham may be in order.
Mr. Graham knew that the part of a company's balance sheet most open to misrepresentation is the section dealing with long-term assets – things such as machinery, equipment, intangibles, goodwill, etc.
This is a category where the current value of the assets, their replacement value or even their very existence depends heavily on the judgment of management. In contrast, even a cursory audit should produce fairly reliable numbers for "current" assets such as cash in the bank, accounts receivable and inventory.
So, wouldn't it be helpful to value stocks by focusing primarily on those balance sheet items that are most reliable and attributing no value at all to the potentially vaporous long-term assets? This is exactly what Mr. Graham did.
The father of value investing liked to prospect for promising stocks by looking at what he called "net-net working capital."
The traditional measure of working capital is simply current assets minus current liabilities. Mr. Graham took this one step further by deducting all liabilities – long-term as well as current – from current assets to derive net-net working capital. Divide this by the number of shares outstanding and you have net-net working capital per share.
His goal was to find companies where the share price was below this value. In such cases, you are buying a company for less than its short-term liquidating value and you haven't even begun to look at the long-term fixed assets. If they prove to be worthless, you still aren't out of pocket.
Most of the time, there are very few net-net stocks available in the market. In fact, the number of stocks which pass the screen is also a proxy for the overall valuation of the market. For example, every week I receive a listing of all global stocks trading within 25 per cent of net-net working capital, courtesy of Robotti & Company in New York. At the beginning of the year, there were 305 companies on the list. By the end of August the roll call had more than doubled to 625 companies, so the market is clearly a lot cheaper. More to the point, the number of China-based companies had tripled from 20 to 60. This should be fertile ground for a value investor.
American Lorain caught my attention, and is now in my portfolio. The stock trades close to its net-net value of $1.70 (U.S.), well below its book value of $4.03, and has a market capitalization of $60-million.
The company has annualized revenues over $200-million and sells snack foods in the form of chestnuts (50 per cent), convenience foods such as pre-packed lunch boxes (35 per cent) and frozen foods (15 per cent). Revenues and pretax income are growing in the 20 to 25 per cent-a-year range, although earnings-per-share growth has not kept pace as shares outstanding have also grown in recent years. The company, though, has announced a $5-million share buyback, so this problem may correct itself.
Although the market capitalization is $60-million, the float is only about half of that as the chairman and CEO holds 47 per cent of the shares outstanding. This, in itself, suggests that he is motivated to enhance the share value.
How can we be sure that the chestnuts and lunch boxes really exist? I haven't been there to count them, but I am reassured by the fact that the clients' names are disclosed and include the Beijing Railway Authority, Jusco Guangdong and a local subsidiary of the Japanese company Ito Yokado. American Lorain has in fact been selling to Japanese companies for the past ten years and the customers have very strict standards in terms of quality and food safety. As recently as July 5, the company announced that it had successfully passed a due diligence inspection by two major customers. Presumably they were no less diligent than the typical Bay Street analyst.
My experience with statistically cheap China-based investments has not always been positive. It dates back 20 years or more to the TSX-listed Noble China, which had the Chinese licence for Pabst Blue Ribbon, a particularly tasteless American beer. The whole episode ended in tears for the shareholders. So, I am not about to invest my life savings in American Lorain, but I think that Ben Graham would approve a modest exposure.
Special to the Globe and Mail. Mr. Tattersall is co-founder of the Saxon family of mutual funds and recently retired chief investment officer of MacKenzie Investments.