Lessons from China Paper 1 comments

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The curtain has not, of course, fallen completely on China Paper as shown in the steadiness in its share price on Friday, following a collapse on Thursday. It is a fact, however, that confidence in this stock/company has been shaken badly by the substantial shareholder bailout, a process that had been taking place over the last few months but finally brought into focus by the CEO/Chairman's selling of a huge 12% stake in the company on the open market in early April. My personal opinion is that the stock will in the medium term go the way of United Food and China Flexible Packaging, both the paragons of value investing but the dramatic decline in their earnings presaged by massive sellouts by their substantial shareholders/key management (used interchangeably because they are usually one and the same).

The episode has shown that there is some truth in what some investors say, that one cannot buy and hold China stocks for the long-term, but instead should look to take profits at an appropriate time. This is especially true of IPOs, for they are launched in a year when profit margins peak. But even for other China stocks, the tendency is for investors to focus on the phenomenal demand base and forget about the corresponding growth in supply. It has been shown in the past that China undergoes massive cycles of capacity overinvestment which leads to margin collapses (there is a saying that profit margins are the most reliable recurring series in finance), a legacy of its central planning policies. That is on the business perspective. On the management side, the perceptions of lack of proper corporate governance and a management ready to take advantage of minority shareholders still persist, sometimes justifiably: what happens is that the China theme can inflate markets but can easily pop its confidence with a single corporate scandal that exposes investors to the flip side of the theme. In 2004-05 investors/traders were throwing the baby out with the bathwater in the case of China-themed stocks; in early 2006 they are viewing them through rose-tinted lenses; when will the cycle repeat itself?

The way that the stock has risen and fallen has also been instructive in the influence of broker coverage, and increasingly the Internet(!). Talk on the online forums of this stock has been hot since late 2005, with forumers repeatedly and aggressively pushing the undervaluation of China Paper. That was in the days when the stock was still trading at sub-30 cents. As the China theme captured the market's imagination in early 2006, the China Paper threads on the forums became longer, with some running to tens of pages (just look at the Channelnewsasia MarketTalk forum). The stock did start to rise, but range-traded between the 30-40 cent region for quite a while. All the retail attention has been built up by the endless talk online (one of my bugbears with the growing power of the Internet in marketing stocks --- that is what it is --- is that it is not the quality of the postings that matter, but the quantity and the frequency of them); what was lacking was corroboration from the institutions. They got it in the form of a Kim Eng coverage of China Paper setting a price target of >60 cents (Kim Eng, in my view, is the most influential local broker). And so the stock had a meteoric rise from ~36 cents to >50 cents in a matter of days. The Internet talk had concentrated the attention and pent-up demand on this stock, the final catalyst from the broker coverage had lit the fire. Some might observe this Internet phenomenon with other China stocks currently, such as CG Tech, China Milk and Asia Dekor. Sometimes I use these as a stock screening for my HotStocksNot blog.

And this combo has worked in reverse for China Paper these last two days. Market talk surrounding the sale of >10% of China Paper's equity by substantial shareholders announced on Wednesday dominated online talk that evening, and the subsequent downgrade by the same broker Kim Eng from Buy to Sell set about the selling panic that sent China Paper down by 17-18% on Thursday. Given that in the existing scheme of things brokers need licences in order to be qualified to give advice and issue analyst reports, the day is not far away where systematic regulations will be set in place to deter manipulative or deliberately false Internet postings designed to create a market for a stock, in order to engender a culture of responsible speech in a medium which is destined to grow more influential in the stock market in the coming years. One might note that a Shareinvestor forummer has already been charged for spreading online rumours about Datacraft in 2004.