Wednesday, September 16, 2009

Explaining The Market Inefficiency

There are many reasons why a particular stock's price might differ from its value, not the least of which is a motivated seller. A motivated seller will drop the price of any asset (e.g. real-estate, vehicles etc.) and stocks are no exception - particularly small-caps, where a lack of liquidity can result in dramatic price drops.

Consider Orsus Xelent (ORS), a stock we have previously discussed as a potential value play. The former CEO and a former director of the company owned about 30% of the outstanding shares of this company just a few months ago; but in the last several months, they have started to unload their shares.

Former director Wang Zhibin has unloaded some 6 million shares between April and September alone, representing 20% of the company's outstanding shares. Over the course of that period, that represents almost 40% of the company's trading volume (though many of the transactions took place off-market). Similarly, since Wang Xin resigned as CEO in March, he has been unloading his 3 million shares at a frantic pace. Compare his daily market transactions to Orsus' average daily trading volume; he has clearly had a large effect on the stock price.

Do these sellers know something we don't? It's entirely possible. But at the current stock price, a lot would have to go wrong for the investor to lose his principal. It's also important to remember that these are not insiders - they began to liquidate their stock only after they left their posts. As such, it's entirely possible they are selling their shares for personal reasons, or because they can no longer influence the company.

Many financial experts regard stock prices as fully reflecting the values of the underlying businesses. This assertion must be thrown in doubt, however, in cases such as this one, where shareholders controlling large blocks of shares are dumping their stock over very short periods of time.

Disclosure: Author has a long position in shares of ORS


Ryan S. said...

If you like reading about EMH and such, check out Andrew Lo's papers, especially "The Adaptive Market Hypthesis."

Anonymous said...

I took a look at ORS. Red flags to me by looking at the difference between OpCF and Net Income. Since Jan. 1, 2004 the company has reported Net Income of $44.3 USD but reported Operating Income of -9.2m for a staggering average annual difference of roughly $9-10m (on a company that has averaged revenue of 80-90m, or roughly 10-12% of revenue). This is the sort of discrepancy in a foreign (especially Chinese) company that doesn't even leave me any reason to investigate further.

exMBB said...

I think there is psychology in play here too.

Most Chinese businessman are nouveau riche. They are not seasoned westerners with a golden nest egg. Their decision to sell is not whether they should wait for their investment to appreciate another 50%. Rather, they are thinking about "gee, if I sell now, I am guaranteed to be a millionaire, and I can retire for the rest of my life".

Having $5M in China will afford you a lifestyle that is not much different than $10M.

Additionally, with the abundant entrepreneurship in China, the opportunity cost of not selling might be greater; at least psychologically.

Saj Karsan said...

Hi Anon,

You are right that there are risks here, one of them being the large receivables account (which is the reason for the difference between income and operating cash flow that you note).

But it's important to realize that by stopping there, you are ignoring the company's price. For example, if the entire company was for sale for $1, would you still not be interested?

Unknown said...

I bet quite heavily on this company too. I'm glad to see that they stopped trying to make an plant acquisition and they seem to be pretty consistent in earnings.
The concerns that I have are
1) their accountants resigned in 2008 Mazur(sp?) stated that is wasn't because they'd have produced a qualified opinion but I wonder..auditor shopping?

2) the sales by the former chairman make sense however the resignation of Howard Barth who was on the audit committee is also worrying

3) The insurance on receivables is for RMB300million or roughly $43 million. Receivables as we know are $82 million

4) Their 2008 10K states that they have receivables over 120days past due and the plan to reduce their exposure to this particular client to 20% of total.

Warning signs or no? If they were to collect only the 43 million insured, then our margin of safety is not too big.

Like I said, heavily invested in them, just trying to invert always invert :-)

Unknown said...

Oops one last thing I found funny. Turns out they have a great poison pill, management has the right to issue 100million preferred shares. Talk about poison pill

Anonymous said...

As I was reading through the Q this afternoon, I noticed the issue that Prince raised about the $43M insurance policy against the $82M in receivables. How are you thinking about that?

Secondly, how do you think about sizing a situation like this in your fund? I'm curious.


Anonymous said...

$1, yes. $1/share, no. If it goes to zero, I'd lose $1 vs. $29m ;).

Between the NI / CF discrepancy, resignation, China-based, AR issues (as a Net-Net, it's a zero at the insured level of AR), I'd stay away from this one.

I do think there is probably a "pony in there somewhere" and the margin of safety is probably sizable but it just doesn't have the level of margin of safety with which I prefer to invest.

On that note, I do enjoy your site thoroughly!

Saj Karsan said...

Hi guys,

I agree with all those risks pointed out above. Furthermore, the guarantee for the receivables is only as good as the company guaranteeing it.

However, the receivable from the one customer has started to come down, as collections from this customer were $8 million higher than revenue from this customer last quarter, so things are going in the right direction.

To answer your question Anon#2, this position would be part of a well-diversified portfolio. But I am very confident that if one could find 50 situations like this, in the end one would make a lot of money in the long term, but some would of course be failures.

Anonymous said...

On another company note.... Does anyone know why the company web site is no longer operational?

optionsnut said...

"But I am very confident that if one could find 50 situations like this, in the end one would make a lot of money in the long term, but some would of course be failures."

Can this one be put in the failures pile Saj?

Saj Karsan said...

Hi optionsnut,

I would lean towards yes right now. When there is some finality to the situation, I'll do a post-mortem.