Last Thursday, a company by the name of China Shen Zhou Mining & Resources (AMEX: SHZ ) watched its shares plunge 22%.
There's a good chance that you don't give a hoot about China Shen Zhou. It's a $137 million, Amex-listed, Chinese reverse-merger company that's burned through nearly $14 million in free cash flow over the past three years. The company's primary claim to fame appears to be that it gets lumped in with the red-hot shares of rare-earth companies like Molycorp (NYSE: MCP ) and Rare Element Resources (AMEX: REE ) , despite the fact that it doesn't actually produce rare-earth elements.
However, even if you don't care about China Shen Zhou, keep reading. The story behind the big drop in China Shen Zhou's stock contains a very important lesson that every investor should pay attention to.
A big concern
On the morning of April 19, China Shen Zhou issued a press release that said the following:
[The company] today announced that its audited financial statements in the Company's Form 10-K for the fiscal year ended December 31, 2010 filed on March 29, 2011, received a going concern qualification from Sherb & Co. LLC, the Company's independent registered public accounting firm.
By itself, that certainly sounds like big news, right? And heck, the headline of the press release alone sounds pretty scary: "China Shen Zhou Receives a Going Concern Qualification for the 2010 Year."
But reading on, the press release also said:
This announcement is required by NYSE Amex's rules and does not represent any change or amendment to the Company's financial statements or to its Form 10-K for the fiscal year ended December 31, 2010.
Now this is significant because while the press release singling out that the "going concern qualification" was issued on April 19, as noted in the text above, the company filed its form 10-K (the annual report) on March 29. In the 10-K, there are three separate sections that talk about the going concern qualification.
More to the story
But that's not all. A going concern qualification is focused on a company's ability to fund itself. This was exactly the case for China Shen Zhou, as stated in the auditor's letter in the 10-K:
The Company has incurred operating losses, negative cash flows from operations and has a working capital deficit as more fully described in Note 2. These issues raise substantial doubt about the Company's ability to continue as a going concern.
Of course, the opinion of the auditor is focused specifically on the story told by the 2010 numbers. On January 19 of this year, the company announced that it had sold $20 million in new shares. Considering the company's historical cash burn, this should make sure that the company stays funded through at least 2011. And in case investors had forgotten about this, the company reminded them in the April 19 press release.
So what all of this amounts to is that the April 19 press release disclosed something that had already been in the public domain for three weeks and the specific concern that was highlighted has been addressed.
What else is going on?
Searching through the news, I wasn't able to find anything else that could account for such heavy selling. So I turned to the Yahoo! Finance message boards.
As a quick disclaimer, I try to stay off these message boards. For the most part, the "discussions" tend to resemble some cross between The Athens Lunatic Asylum and a middle-school lunch room. However, I do find that on occasion the boards' chatter can be revealing.
In this case, I found many posts similar to the following:
- "Not another one of these China Scams, is it????"
- "We all knew this company was bogus!"
- "If this gets HALTED permanently, blame only urself"
For those not tapped into the world of Chinese small caps, these comments refer to the startling number of apparently fraudulent companies in the sector -- and an even greater number of fraud accusations. In March, for instance, facing tough questions and auditor issues, the stocks of both China MediaExpress (Nasdaq: CCME ) and China Agritech (Nasdaq: CAGC ) were halted. They haven't traded since.
But of course, a going concern warning has nothing to do with fraud -- it's standard auditor speak for "Your company may run out of money."
Putting the pieces together
Taking this all into account, I think there are a few conclusions that we can draw from the 22% sell-off in China Shen Zhou's stock:
- Investors do not appear to have read the 10-K and were therefore unaware that its auditor had issued a going concern qualification;
- It does not appear that the investors understand what a going concern qualification is and what it means for the company; and
- This may be moot considering No. 2, but it's unclear that investors were aware the company had addressed its funding issue.
To be clear, wacky sell-off or not, I don't think China Shen Zhou is a good investment. Rather, I think the details around its sell-off are fascinating and bring us to...
The big finale: China Shen Zhou, Mr. Market, and you
Now I promised at the outset of this article that the story of China Shen Zhou's ugly day would hold a lesson that every investors needs to keep in mind. Since you've stuck with me this far, I'd hate to disappoint, so here it is:
Mr. Market is an idiot. Good enough?
OK, I'll elaborate. There are still many investors who are stuck with the assumption that the stock market is some sort of magic machine that is able to properly find and digest all news and accurately price that news into individual stocks. This would be a difficult pill for stock pickers to swallow since it means that there wouldn't be opportunities to find mispriced stocks. A bitter pill, that is, if it were true.
The China Shen Zhou story above is one of the best examples I've seen in a while of the market acting in a totally absurd fashion. And while there may be more room for absurdity like this among smaller, less followed stocks, I think that investors often give the market too much credit, assuming that stocks are priced the way they are for good reason.
Right now, for instance, Microsoft (Nasdaq: MSFT ) trades at less than 10 times expected forward earnings, while Abbott Labs (NYSE: ABT ) has a forward P/E of 11. And, in fact, many other quality blue-chip companies carry similarly low multiples. Is there good reason for such low valuations? Perhaps. Or perhaps Mr. Market has gotten it completely and utterly wrong.
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