Orca Strategy

 

In the darkest days of the dotcom crash of 2000, when even mighty Amazon hit the skids following a bearish Lehman Brothers report, it was next to impossible to find interest in internet stocks. Investors retreated to bricks and mortar, and the sector went from favourite child to leper. 135 dotcom stocks went bankrupt in 2000 as funding stopped.

 

The best strategy for companies after the crash was to change names and avoid the post-boom hangover. In a scholarly peer reviewed paper, Cooper et al (Purdue University) determined that in 1999, listed companies adopting internet related “dot com” names had a sustained 32% return. After the crash, the authors revisited their study and found that removing internet related dotcom names had a sustained 64% return.

 

Jump ahead 10 years –we have the crash of the Chinese stock sector, when among other scandals, Sino Forest collapsed following a sensational Muddy Waters report. Dozens of Chinese RTO’s and IPO’s fell under investigation by the SEC and other regulatory bodies. Investors headed for the exits on Chinese stocks. 

 

In a paper by Vijay Mahan et al. (The University of Texas, Austin), reasons identified for the dotcom collapse included investor over-enthusiasm for internet technology, a lack of coherent business models, lack of methodologies for assessing the market value of the dotcom firms, and lack of management expertise and experience in dotcom management teams.

 

Did the Chinese sector deserve to be taken to the woodshed by investors? Probably. Many problems in the dotcom sector have parallels in the Chinese sector. Add in concerns about contractual rights, transparency, ownership structures, and audit reliability and investors should indeed put a premium on due diligence.  

 

However, investors have instead lurched from “anything China” to “nothing China.” This has become more pronounced by the activities of short sellers and other China bears.  Although instrumental in pointing out the cases where the emperor indeed has no clothes, some short sellers have exploited investor wariness and casted dispersions on companies simply because they are Chinese. Over-enthusiasm has been replaced by guilt by association, not by careful investing.

 

Contrarian investors now see the parallel with the dotcom experience, where expansion and collapse are necessary elements of a sector’s ultimate growth. Certainly, China’s economy will continue to grow. In their December 31, 2011 edition, The Economist analyzed 21 economic indicators and found that China had surpassed the United States on over half, with the others in sight, even as China’s growth rate slows. Just as out of the dotcom ashes emerged Groupon, with a market cap of $13 billion, and Google at over $200 billion, investors couldn’t ignore the internet forever.

 

And they shouldn’t ignore China.  While no one could have predicted the growth in individual companies during the malaise following the dotcom crash, it is possible to identify now companies whose outlooks are by no means reflected in their current capitalization, thanks to the China discount. 

 

GLG Life Sciences (GLG) is the world’s leading provider of high grade sweetener stevia and has launched aggressively into the bottled beverage market in China. Silvercorp Metals Inc.(SVM) is China’s largest primary silver producer. Both are under attack by short sellers not because of their business models, but because of their Chinese-ness. Both would have considerably higher valuations if they were operating elsewhere.

 

Overall, standards of corporate governance, transparency and reporting are improving for China sector companies. Very expensive lessons have been learned, by investors, auditors, underwriters and regulators.  Meanwhile, Lehman Brothers, who originally pulled the pin on Amazon, filed for bankruptcy on September 15, 2008, ultimately a victim of (albeit highly leveraged) ‘bricks and mortar’ while Amazon is ticking along quite nicely. Muddy Waters et al are bound to unearth the occasional irregularity, but investors should look beyond the negative rhetoric.