Tianyin Pharmaceutical Co., Inc. (TPI)

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The Chinese Small Cap Sector - The Other Side of the Rain

Many of us in our posts here are comparing the miniscule market capitalization of many of the Chinese small cap companies to the otherwise much higher valuations warranted by the strong past performance and the strong growth forecasted into the future and then express frustration, suspicions and despair due to the huge dichotomy between these two values.

I find it screamingly obvious that the relationship between market values and fundamentals across this sector is broken according to any common norms or benchmarks. Please note that I am referring here mostly to Chinese companies that are focused on and operative within the Chinese domestic markets and have no export activity.

As an indicative example, please consider the price chart and the declining P/E Ratio of CNIT (China Information Technology, Inc.) throughout this crisis, beginning at its preceding top in October 2007:
During the period between October 2007 and February 2011 the EPS for the years 2007 until 2010 grew 2.2 fold from $0.33 to$0.73, a blistering compound annual growth rate of 30.3%, yet the share price declined by 56% from $10.5 to $4.6 and the P/E Ratio declined by 81% from 32.8 to 6.3, drawing better than words how the ascribed risk shoot up and the sentiment fell off a cliff to the bottom of the barrel. To date, there is no indication that CNIT's growth may weaken going forward.
In particular, the declining price pattern that started for CNIT in October 2009 and continued until end of February 2011 ($8.0 to $4.6) is highly typical across this entire sector's price behavior during the past year. Even more so if we consider the fact that during this later period the broad market continued to rally additional 22%.

Having made this broad observation, I find it reasonable to assert that the companies themselves are not to blame. The answer must lie elsewhere.

And if we understand that the crowd behavior and its sentiment drivers are where to look - given the recent dark wave of allegations with respect to the entire Chinese small cap sector as being systematically fraudulent - we get our answer.

Clearly, the worst financial crisis in recent history and the collapse it caused has impacted investor psyche in a big way. In these post-crisis times, having stared at the abyss not too long ago, we are still carrying post-traumatic types of emotional weaknesses that influence abnormally our investment mindset and practices.

As we human beings are being threatened and hurt, our rational and enlightened mind recedes into our emotional tribal mind, which recedes into our instinctive survival mind, all depending on the level of threat and despair. The effect on our common crowd behavior is as if our elevated cultural evolution receded to darker periods in our history. For in-depth understanding of our crowd behavior as investors I recommend reading the book "The Psychology of Technical Analysis" by Tony Plummer.

As simple examples to consider, we may develop distrust and animosity towards different and remote people and cultures (they become the enemy), and conspiracy theories are easy to develop and get a hold (all Reverse Mergers done by Chinese are suspects of fraud as part of a pervasive scheme).

We are all essentially subject to a natural law which organizes individual behavior through the influence of group activity. And fear is likely to drive most of us straight into the arms of the crowd. And as top traders know, the crowd always loses in the end.

In this unregulated online exchange of information and opinions we are all taking a part, any stranger can cast doubt and spread fear by making allegations without stating conflicts of interest or having tangible evidence. It is common knowledge that the Chinese belong to historically separate and unfamiliar culture and different behavior patterns and therefore could be easily misinterpreted and abandoned if indeed dark and primitive emotions emerge and govern the scene. So under such extreme distrust and licentious environment, who would risk investing in a Chinese small company that might very well turn the next day to be accused of fraud? During the past year it seemed to be as dangerous as walking in a minefield. The encounters between ruthless short traders who smelled the fear in the air and their sheep-like insecure pray culminated in a blood bath that has racked up devastating losses for many shareholders.

Yet those of us who are able to regain their rational and independent mind from the oppressive direction of the crowd, may very well assert firmly that the correct and wise broad perspective is that China is a phenomenal growth story that is based on nationwide systematic innovation and investments, flexible adaptation and fast learning, and efficient and tireless execution of the central government growth programs, and many of these able entrepreneurs who reached out to the Mecca of the capitalistic free world for the best of reasons, overcoming great obstacles, will grow their companies in unprecedented rates with almost zero debts in still highly lucrative and unsaturated huge domestic markets. And in contrast, the US economy still needs to reach the stage where it can stand on its own following the FED's $2 trillion money-printing program, and the necessity to reduce the astronomical deficits and escalating debt levels is a very tall order. For an enlightening reading about the Chinese civilization I recommend reading a series of articles http://www.historians.org/projects/giroundtable/Chinese/Chinese3.htm.

It should be acknowledged that by the end of 2011 the majority of these companies will be trading on Wall Street and reporting to the SEC for their fifth consecutive year, a sufficiently distanced time from the early days following their typical Reverse Merger debut.

This Reverse Merger debut (reverse IPO) is the single most highlighted indicator to pinpoint a fraudulent Chinese company according to the governing fraud conspiracy rhetoric. Yet many of these companies have already engaged top tier accountant and law firms and have substantially improved their transparency and timely reporting as well as having been qualified for up listing to senior exchanges. I find it absolutely absurd to conclude at this point in time that these companies came to Wall Street in droves just to cheat for five consecutive years and counting, manipulating top professionals and paying hundreds of thousands of dollars as fees each year just for keeping this grand scheme alive. And correct me if I'm wrong, none of the accused firms (e.g., HRBN, YONG, CBEH, CEU, CCME, CHBT, ONP, CGA, CAGC, CSKI, CHNG, altogether I believe no more than one or two dozen) were delisted or legally proven as fraudulent to date.

As a final remark with respect to the Chinese entrepreneurs who are ill treated almost to the level of scoundrels by the all too many bashers of late: It is worthwhile appreciating their deep cultural heritage as there is a very real advantage of being part of the oldest living civilization. The values of culture and of being civilized have existed in China so long that they have soaked right through the whole people. Even a poor Chinese with no education is likely to have the instincts and bearing of an educated man. It is in their nature to set great store by such things as personal dignity, self-respect, and respect for others. And they have tremendous hunger and aptitude for education, which is one of the reasons why the future progress of China is likely to be amazingly rapid.

So as the problem lies in the crowd psychology domain, so does the solution. The distortion in the crowd behavior will be mended as this historic crisis continues to heal over the next several years and broad senses of normalcy and confidence are gradually restored. Time reveals truth and justice, and in this particular case the systematic and robust growth of the large majority of these companies will be depicted by the credibly audited financial statements. And the wave of fraud allegations will lose most of its hot air as there is a certain limit to how many times few can cry 'wolves' and they never really come.

A realistic and sound investment horizon that perhaps must be considered in order to benefit from the market capitalization recovery of this sector may be five years from today. I believe it is conservative to assume that many of these companies will grow their EPS by 15% to 20% per year and gradually be granted a P/E Ratio of 20 to 25. This implies that the Chinese small cap sector in all likelihood is a ten-bagger. We all can do our own calculus with respect to our chosen investment candidates based on our best analytical scrutiny. The key point here is that there will come the time when these Chinese companies will regain their credibility and be evaluated in full according to their consistent and dependable performance. It is my solemn observation that the dire sentiment has reached its nadir and it is only a question of time and an invisible match to fire it all up. Perhaps the time will be ripe later this year as 2010 10-Ks will be reported and 2011 estimates will be released and the first half results will be supportive of these estimates.

Good luck to all who are of the same line of independent thinking. It may very well spell an investment opportunity of a life time.