These Stocks Are Dangerous

No matter what anyone else tells you, low-risk/high-reward opportunities in the stock market are an endangered species these days. That's because there are too many analysts combing over stocks, too many media outlets reporting news in real time, and too many computers and high-frequency traders arbitraging away inefficiencies. So if you want to earn outsized returns in the stock market, the fact is you have to take some risk.

That said, there is such a thing as too much risk.

And here is just such a thing
China Northeast Petroleum (AMEX: NEP  ) , for example, was once a promising story of a company with a plum deal with PetroChina (NYSE: PTR  ) and the opportunity to profit from China's insatiable demand for fossil fuels. Now, however, that story looks to be ending in delisting and disaster for investors.

The company revealed in an April 20 filing with the SEC that its financial statements should no longer be considered reliable, that it had been massively misstating net income and the value of its oil reserves, and that it had material weaknesses in internal controls. It's been subsequently alleged that senior officers at the company were embezzling funds.

This, obviously, is unacceptable, and the belief that corrupt and/or incompetent practices such as these are widespread among small Chinese companies is one reason this segment of the market trades so cheaply relative to its market opportunities and growth rate.

The best lies are believable
There are, however, good reasons so many investors wanted to believe in China Northeast Petroleum's story. Above all, the stock looked extraordinarily cheap. This time last year investors saw a company trading for just 2 times EBITDA versus 10 times for PetroChina, 6 for CNOOC (NYSE: CEO  ) , and 11 for Sinopec (NYSE: SNP  ) , even though all of these companies ostensibly stood to profit from the same oil-demand trends in China.

What's more, the broader thesis has turned out to be spot on. PetroChina, CNOOC, and Sinopec are all up over the past year, with CNOOC up nearly 50%. What's more, China's energy fundamentals remain intact, making these larger plays all continue to look attractive. China Northeast, on the other hand, has done nothing but disappoint.

When our Global Gainsteam looked at China Northeast last year, we found a far less intriguing story beneath the surface. My colleague Nathan Parmelee was not only concerned the company was depleting its reserves, but also that its disclosures about its reserves -- the lifeblood for any exploration and production company -- were far inferior to industry comparables.

It wasn't clear exactly what the company was hiding, but it appeared as if it was hiding something. We know now there were significant behind-the-scenes problems.

Issues are everywhere
Yet while we steered clear of China Northeast Petroleum at Global Gains, we have not steered clear of China altogether. In fact, we've recommended that every investor buy a handful of Chinese stocks.

Does that sound crazy? Perhaps it is. Of the five China plays we told investors to buy last July, one has been attacked by short sellers as a fraud and three have made or plan to make seemingly dubious or expensive acquisitions.

Given those facts, you might expect that we've lost a lot of money in China. The truth is just the opposite. Our basket of 5 Chinese plays is up more than 40%, besting the S&P 500 by more than 30 percentage points and the China 25 index by more than 45 percentage points.

Results matter
As you can surmise, the secret to our success has not been to avoid controversy altogether. Rather, we've embraced controversy as an opportunity to pick up shares in a company that we like for cheap. Instead, our tack has been to broadly diversify across companies and market caps in order to limit our exposure to any single name and instead benefit as China's rising economic tide lifts a larger number of (hopefully seaworthy) boats.

Thus, we've paired Yongye International (Nasdaq: YONG  ) , a small fertilizer manufacturer that we consider a compelling value but that is also one of the companies that recently announced acquisition plans, up with Coca-Cola (NYSE: KO  ) , a tried-and-true blue chip that is growing sales in China and has a history of rewarding shareholders through dividends and share repurchases.

While both companies will benefit from China's growing economy and strengthening currency, Yongye obviously has greater growth potential because of its size and focus exclusively on China. It also has the potential to be dangerous.

Coca-Cola, on the other hand, should prove to be far more stable and help us handle the volatility we expect in Yongye's share price. This is how we achieve outsized returns in China without, we believe, assuming outsized risk, and it's the strategy every investor should use to add sometimes dangerous China exposure to his or her portfolio.

Going back for more
It's in order to replicate last year's success that we're heading back to China in July in search of other promising names to add to our China basket. You can join us and get all of our notes from the field simply by entering your email in the box below. To get you ready for the trip, we'll also send a full report on all of last year's picks -- all of which continue to trade at compelling valuations.

Tim Hanson is co-advisor of Motley Fool Global Gains and looks forward to spending another few weeks in China. He owns shares of Yongye, which is a Global Gains recommendation. CNOOC is also a Global Gains pick. Coca-Cola is an Inside Value and Income Investor pick. The Motley Fool owns shares of Yongye and Coke. The Fool's disclosure policy looks forward to having the team buy it a souvenir.


Read/Post Comments (15) | Recommend This Article (73)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 28, 2010, at 5:48 PM, justatitanfan wrote:

    yeah, and you guys here definitely live up you your "fool" moniker by constantly pumping up this stock. nice. you guys were also bullish on CHNG when it was in the low teens, and look where it is now...$8.50. again, nice. you wanna-be analysts need to improve your game.

  • Report this Comment On June 28, 2010, at 7:45 PM, HawaiiTrader wrote:

    1. massively misstating net income and its value of its reserves? Proof!!

    2.alleged that senior officers at the company were

    embezzling funds? By whom?

    If unable to answer,you may need to contact your

    attorney.

  • Report this Comment On June 29, 2010, at 4:14 AM, exseries7 wrote:

    Tim, that is good advice because a quick check of Google Finance reveals multiple shareholder lawsuits against NEP.

    Don't let the 50 Centers (Wu Mao Dang) get you down. they infest virtuyally every forum and distort facts.

    I have been living in China for several years and have had to deal with both corruption, and with the 50 centers, as first revealed by BBC: http://news.bbc.co.uk/2/hi/7783640.stm

  • Report this Comment On June 29, 2010, at 1:10 PM, mikecart1 wrote:

    Worst article ever? Survey says: YES!

  • Report this Comment On June 29, 2010, at 8:57 PM, mountain8 wrote:

    no

  • Report this Comment On June 30, 2010, at 5:04 PM, efalco wrote:

    Wow, where was this article 6 months ago?

  • Report this Comment On June 30, 2010, at 5:43 PM, chincompanalyst wrote:

    hey tim, it's chinesecompanyanalyst.

    that's a fair article. your mistakes are in the past. going forward, make sure the auditors are top-5, that the return on capital and growth numbers are reasonable, and that guerrilla capital didn't lead their reverse merger by investing $10m at a 2x PE with a large amount of warrants. if an RTO sounds too good to be true, it probably is.

  • Report this Comment On July 02, 2010, at 2:11 PM, michaelbinCA wrote:

    2 + 2 = 4.

    Where was this article 6 months ago?

    Get on your Marx. Get set. Stop.

  • Report this Comment On July 11, 2010, at 2:36 AM, tkell31 wrote:

    Congratulations on pointing out NEP is too risky after trading was already halted on the stock. Very impressive. Stay tuned for my article on who will win the world cup...think I'm going to write it sometime in August.

  • Report this Comment On July 19, 2012, at 9:41 PM, OceanJackson wrote:

    One stock not getting much recent coverage here at the Fool is Nintendo (ntdoy.pk). The Stock has taken a beating recently. And yet - Nintendo is just 3 months away or so from releasing their next generation Console - Wii U, the successor to the best selling console in history: the Wii. They are at the edge of the cycle starting over. About at this time in 2006 - Nintendo stock was rocked hard but skyrocketed off of the Wii's success. I wonder why no one's discussing whether or not we'll see a similar rise this time. Sure the Console market's declined, but this is Nintendo we're talking about here...

  • Report this Comment On August 17, 2012, at 8:43 PM, walid1947 wrote:

    who knows what about Nokia

    Once a giant winner , now a big loser.

    does it have a chance?

    The recent downturn shows it might.

    walid addas

  • Report this Comment On August 17, 2012, at 9:41 PM, Mega wrote:

    Before this article, has Global Gains ever publicly mentioned the Chinese companies they found questionable, including NEP?

    I have the impression you guys are leading from the extreme rear, only warning people after tons of money has already been lost.

    In addition, Global Gains performance is not included on the Fool front page. Yet you tout part of your performance in this article?

    I am sure you are smart analysts, but I question the overall GG approach.

  • Report this Comment On October 20, 2012, at 11:45 PM, NickD wrote:

    I'm sure David and Tom are laughing fools? Yea we are Fool's for paying for this service.Just a heads up

  • Report this Comment On March 09, 2013, at 7:12 PM, Steven261 wrote:

    I have been reading a lot of negative comments about Chinese stocks. To give them credit, many of them turned out to be poor. However, to say that ALL Chinese stocks are bad or a fraud is to commit a logical fallacy.

    To maximize profits, one needs to be open-minded on where the next strike will be.

  • Report this Comment On November 08, 2013, at 11:25 PM, RyanPeckyno wrote:

    China is a very tough market -- both to purchase Chinese stocks and for large U.S. companies to compete. Many large companies such as YUM, INTC, SBUX, and many others, are lured by the number of consumers. Yet investors don't realize how questionable many of the companies are and large companies looking to grow don't realize how difficult it is to do business in China. I don't really understand the author's comment regarding pairing YONG with KO. Relative to other large companies, Coke has not performed that well over the past few years. I feel that the best way to play China is through other emerging markets.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1219944, ~/Articles/ArticleHandler.aspx, 11/28/2014 3:32:15 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement