A Great Value Play: Lihua International, Inc. (LIWA)

Just took a position in Lihua International (NASDAQ: LIWA) and I usually like to do some sort of writeup so I can remember in the future why I took particular positions. Lihua International is a Chinese reverse-merger company that is in the copper wiring/electrical arena. They're currently trading at about $5.07 per share ($158M market capitalization).

Asset Valuation

First thing that jumped out to me about this company is that while the market is valuing them at $158M, they have $144M in cash equivalents alone in the bank. Ignoring the $854M in revenue in 2012, this at first glance seemed to be a complete misvaluation by the market because if you divided up the cash alone, each share outstanding would receive about $4.80. In fact if you look back to 2011, if all assets were liquidated and debt paid off, net current assets per share alone are worth $11.69, and that was over two years ago:

Lihua's Net Current Asset Value/Share (2011)

(click to enlarge)

Attractive Margins

Another thing worth noting is Lihua's supply chain management. Unlike its competitors, Lihua isn't making its wiring from virgin copper, but instead scrap copper. The benefit of this is that its margins are not compressed like it's competition's because its costs are not as high, so its management of scrap copper suppliers has given it a competitive advantage:

Chinese Copper Suppliers

(click to enlarge)

Product Mix

Besides it's supply chain management, Lihua also has the benefit of focusing on one of its core product innovations, copper-clad aluminum wiring (CCA). Their high-quality pure copper wiring alternative is priced much cheaper than pure copper wiring (almost 1/3) which provides significant cost advantages in larger projects from the lower commodity price of aluminum.

Copper-Clad Aluminum (CCA) Wiring Structure

Why is this important? Because the PRC government just approved $240B to be invested in the development of China's Smart Grid infrastructure over the next five years so all of its citizens are able to receive affordable power. Along with this comes miles and miles of necessary wiring and cable running, and what better use of CCA wiring/cables than for large projects over thousands of miles. Why is Lihua set up best to benefit from this? Because they currently are the only company that has the proper license in place to import scrap copper to China from places like the United States, which makes them the only company currently able to even approach filling such large orders. Besides CCA wiring, its product mix does still include pure copper wiring, in addition to copper anodes, rods, and magnetic wiring.

In addition to China's investment in its infrastructure, China is the number one consumer and importer of copper:

Copper Demand By Region

(click to enlarge)

The trend is in no way slowing down either, current predictions are that given the trend, China's consumption and utilization of copper could soon exceed world supply, which means scrap copper suppliers are going to become vital, and Lihua is already in position to benefit from this. As far as copper commodity fluctuations go, even though copper pricing is expected to remain stable with the growing demand, Lihua's products are all priced on a cost-plus basis, which means any movement of commodity prices would not erode its profit margins.

Risk

So why does this price of $5.07/share seem too good to be true? Well, its China, which means shady business practices, and its a Chinese reverse-merger, which means potentially even shadier accounting practices. However, due to the fate of its fellow reverse-merger companies such as China MediaExpress Holdings (CCME), all Chinese reverse-mergers are being painted with the same brush by institutional investors.

In 2011, Absaroka Capital, who had taken a short position on Lihua, released a study it commissioned on Lihua trashing the company's practices and accounting methods. Among things claimed in the study included doubt regarding Lihua's financial statements, its executives' backgrounds, supplier relations, and its auditor's track record. In response to this allegations, Lihua's CFO directly addressed all claims (seen here) made by Absaroka, which in my opinion rendered them moot. In addition to that, Lihua has made strides over the past year to be as transparent as possible to the market regarding its accounting methods, even going so far as to having forensic accounting firms such as John Lees Associates do a full investigative confirmation of its cash balances. Besides this, its auditor is Crowe Horwath. While technically using Crowe Horwath's Hong Kong division, Crowe Horwath has a reputation here as one of the top ten auditing firms in the US.

Also, since these allegations were made two years ago in 2011, I'd presume Absaroka has already left its short position by now after the stock tumbled 22% from its study. In other words, they made their money, and now with Lihua's transparency of accounting practices, there's little more to gain for Absaroka or any other institution with a short interest.

Conclusion

Taking a long position in LIWA, committed half my capital allocated to this position for now in case of a dip in the price, this will allow me to average down a bit for a bigger return later. My estimated fair value of the stock is about $15, with a hedge of at least $11.69 from a net asset valuation. Expected time for value manifestation is about 2-3 years, with a option for future review of fundamentals at the $12/share mark.

One Year Update on my "Home Depot, Your Next Great Investment" Post

Just wanted to give an update on one of my postings I wrote about a year ago on February 1st, 2010 regarding Home Depot as your next great investment. At the time of the posting, the price was at $28.01, almost a year later the stock is up to $36.02. If you had bought it at the time I recommended it and sold it today, you'd be looking at a 29% annual return on your investment, which is double the average return of the whole S&P 500 (~14%)

Technically, you'd want to wait until February 2nd to sell it, that way you would be taxed at the long term capital gain rate (I think its 10% right now?), rather than short term capital gain which would be taxed at your income bracket (probably 20-33%). 

Now if only we could get a 29% return on every investment, we'd all be millionaires in no time. ;o)

The Stock Market is a Lot Like Baseball

The stock market has always amazed me. It's such an integral part of our economy, our jobs and our financial futures yet the average person has very little knowledge as to how it functions. You would think that such an important aspect of our daily lives would have been taught to us in school, yet we walk away with only basic economic concepts.

The underlying fact is that because so many people know little about it, investing can be a daunting and in the case of Madoff, be a harmful experience. So much relies upon what we have already accumulated, yet we still aren't where we want to be. Understanding the stock market and how it functions can help us make investment decisions with a little more confidence.

The stock market can be compared to the World Series. There are two teams, announcers, an audience and a whole bunch of other components that really tie the two together concepts together in similarities.

In the stock market there are buyers and sellers, these can be likened to the two teams playing. There are two teams playing against each other and only one will win. The fundamental truth here is that in order to buy a stock, someone has to sell it to you. That means that the person selling it to you thinks no more economic value will be extracted from it while you think there is still potential. One of you is wrong.

Another component in the stock market is mutual funds. Mutual funds are the employees who work in the back office for the championship team. They'll get a ring if their team wins, but their bonus is never as big as the players themselves.

The audience can be likened to index funds, they're just there to watch be at the game and win over time just for being there. However, they don't really see any immediate benefit besides exposure to the game.

The announcers are like Wall Street, calling the play by play and reporting on recent happenings. They sway between excitement to lethargy depending on what is happening in the moment. However, as knowledgeable as they may seem, they cannot be relied upon to accurately predict the long term outcome. The only thing they do is broadcast and sometimes point out arbitrary facts.

Now that all the basic components of the stock market have been described, we need to talk about the game itself. Now while a typical World Series game lasts nine innings, the stock market world series is game that doesn't end. So how is a winner determined? The winner is determined depending upon the individual time horizon of the players on each team.

So if you are buying Procter & Gamble for a long term investment and it drops in the short term, you haven't lost the game yet until your time horizon has been reached. This allows there to be multiple winners and losers all simultaneously, making the game a little more fair to the participants involved.

Also, unlike the World Series where only one game is played at a time, there are many games being played all at once in the stock market depending upon what stock you are talking about. Each stock has its own game being played. So there is the Johnson & Johnson game being played along side the Procter & Gamble game and so on and so forth. As an investor, you will find yourself playing in different games on all different teams depending upon the position you've taken in your portfolio. Some you may feel are going to be winners making you a buyer, while some you may feel is going nowhere or down, making you a seller (or even a short).

This sort of competitive play goes on in all the different markets associated with the stock markets (derivatives, CDS's, futures, etc.) and it is up to you as an investor to decide what games you want to be in and what your role is going to be. Are you a player, a back office manager, or an audience member? It depends upon your strengths and comfort level in the games you are a part of.

(This article originally posted on April 19th, 2010 on Technorati. Read the original article here.)

Refining The Capital Asset Pricing Model for Practical Investment Use

The capital asset pricing model is a great display of academic prowess in financial theory. However, it does have its limitations. Mainly, the criticism it receives is that it makes a number of assumptions that do not necessarily hold true in market conditions. The biggest one I feel is is the beta coefficient, or β.

To break it down the capital asset pricing model (CAPM) is a way of determining the cost of equity for a company. This is often also referred to as the investor's expected rate of return for investing in a security. The formula is as follows:

where:

E (Ri) = expected rate of return of investment i
Rf = the risk free rate of return (usually the 10-year bond return)
βi = beta coefficient of investment i (the individual price volatility of the investment relative to the market as a whole).
E(Rm) = expected return of the market as a whole


The biggest concern is with β. The capital asset pricing model as it stands alone assumes that the riskiness of an investment is based upon the past price volatility of the investment. This is HUGE assumption, because future prices cannot be accurately extrapolated from the past prices. Market prices of a security are determined not only by supply and demand from investors, but also the profitability and growth prospects of a security. The beta coefficient is assuming that market prices are efficient and that all information is known to all investors.

However, we know that not all information is known to all investors, and not all information is important to all investors. Also time horizons for investors differ (another huge assumption of the model), therefore even if all information was known, some information may disregarded by short term investors if it does not serve their time horizon. The information that a trader will be looking at may affect his view of the price, while a long term value investor may see information that reflects his view of the price.

In present circumstances, the current market prices are the averages of investor perceptions. Therefore, if most investors are arguably short term oriented, the price of that stock will more favorably reflect short term prospects. For example, if Ford stock has low upwards movement prospects in the short term because Ford is taking non-cash charges (thus reducing current earnings) , the majority of investors may be uninterested in that stock, and the price of the stock will reflect there lack of demand for it.

This is why it is important to have a somewhat longer investment horizon. You want to account for short term prospects and long term prospects. Yeah, Ford may be taking short-term non-cash charges and reducing their earnings, but is a non-cash charge really a reflection of a change in business value, especially if the company is still making adequate capital expenditures to improve the business for the long term?

The market is not perfectly efficient, which gives the individual investor an edge if they are willing to resist the temptation of short term sentiments.

So how do we adapt CAPM for reliably determining the cost of equity? Simplistically, an investor can expect the market to return 11% on average over time. Therefore, it is reasonable to say that an investor should expect no more than an 11% return on average from their portfolio (this is supported by the latest indexing fad).

Even though the expected return may fall short of what an investor's actual return may be, it is fair to say that a prudent and rational investor should expect no more than what the market will return (unless of course the risk free rate were to exceed that, in which case the last thing anybody would be concerned about is their return on investment when the whole market is collapsing!).

With the cost of equity set to be at a value of 11%, the discount rate for a security can thus be figured out by the company's weighted cost of capital, utilizing the borrowing rates of a company after taxes and our constant cost of equity. Thus we have a maximum discount rate for a public company to be no more than 11%* (if the company is 100% equity financed).

This figure to me seems fair, considering Warren Buffet discounts utilizing only the risk free rate.





*This discount rate only can be comfortably applied to non-controlling shares of publicly traded companies of a reasonable size (excluding micro caps) without getting into liquidity discounts, size discounts, and control premiums.