To OTC Journal Members: 
 

Same Movie, Different Ending- The Market Correction

In case you haven't noticed in the past week everything China from the mid to microcaps has been getting hammered. In my view, we're in a corrective phase right now which was inevitable after about 5 months where they pretty much went straight up.

It's not just limited to the OTC Journal ideas- it's China situations across the board. Look at superstar Rino International (NASDAQ: RINO)- from $27 to $19 in about the last 12 trading days. ChinaCast Education (NASDAQ: CAST) is another I've been watching- $8.50 to $6.50 in the last 5 days.

OTC Journal followings CREG, NFEC, CEU, and XSEL have all taken it on the chin in the past week. If you look back historically, these stocks have made some gigantic moves off their absurdly oversold lows post '08 crash, and all we're entitled to enter a corrective phase of some sort. 

This was inevitable, and I'll provide some thoughts at the end with regard to how we can profit best from the situation. For those of you with a longer term perspective- here's something to think about.
 

Same Movie- But Different Ending For Different People

Forget about the short term trading issues in these China situations for a moment, and let's look at a bigger and far more interesting issue. Here's some reasonable EPS estimates for several of our China based companies- CREG- $.25 to $.30 EPS in '09; NFEC- $.47 to $.60 in EPS in '09; UTA- $1.20 in EPS in '09; CEU- $.60 to $.75 in EPS in '09. 

What do all this companies have in common? Strong top line growth, great margins, no debt, and very low valuations. Valuing companies in order to predict what the market might be willing to say they are worth down the road is tricky business. 

There's a couple of old rules of thumb one can go buy. PE Ratio (Price to Earnings) as a measure of value has been used for years, and every analyst uses this measure as one component of their research. The mature behemoths of the DOW tend to trade at a PE multiple of 10 to 12- another words, the stock trades at 10 to 12 times EPS. Growth companies tend to trade at much higher multiples- 20 to 100 times EPS. Here's a rule for long term investors that has worked for years- A stock will eventually trade at a PE equivalent to 1/2 its growth rate.

So, let's take CEU as an example. The company has reported about 80% growth so far this year. This suggests the stock will eventually trade about a PE of about 1/2 it's growth rate- 40. Based on the first half of '09, the company will earn at least $.60 this year. 40x.$.60 = $24. Yet the stock is only trading at $5. How can this be?

Here's a case where there's a lot of people watching the same movie, but drawing different conclusions. The answer can be found in the general skepticism that pervades everything China. 

The movie I'm watching is about a country exploding with commerce, boasting the largest emerging consumer class in history, and a government committed to infrastructure, green technologies, education, health care, and the general well being of its citizens.

Here's an anecdotal story for you. This past Monday night I had dinner with a hedge fund manager who had just returned from 3 weeks in China. Over the course of that 3 weeks, this guy visited 26 different companies. He told me the level of commerce and activity was through the roof, and management was willing to meet in the evenings, weekends- anytime. 

He told me it was an eye opening experience, and likened it to visiting Silicon Valley in the early to mid 90's- and we all know how that turned out.

But, there's investors and media who the ending of the China movie in a different way. Here's an examples:
 

Recent articles I have also call into question the "quality" of earnings companies are reporting. For example, LDK Solar (NYSE: LDK) and Yingli Green Energy (NYSE: YGE) had the quality of their earnings questioned by some analysts. 

There have been numerous allegations Chinese companies have poor corporate governance and "shady dealings" going on behind the scenes.

Then, there's the issue of the "C" word- Communist- many point out China is a communist country to this day, and hence can't be trusted. I would suggest the opposite is true as it relates to growth and a business friendly environment.

It's true- the Communist Party rules China. If we're going to liken investing in China to investing in the US in the '50's times 28, then we have to compare business friendly governments.

The Chinese government is still communist, but it's as capitalistic as it gets. I would suggest China offers a better business environment than the 50's version of the US.

In China, when the government decides to do something, they do it the next day. There's no bureaucracy. A watered down version of a stimulus bill doesn't take 8 months to go through Congress where it comes out laden with special interest pork. Just the opposite is true. In China, a stimulus package is decided and acted on in a nano second. 

The Chinese government is moving rapidly to clear up these "misconceptions" about what's going on in China. They are moving even more rapidly to clean up their highly polluted air, and move their economy from export driven to internally driven growth.

What's the ending in your version of the movie? Do you believe as I do in two years we'll be looking back and wondering why we didn't back up the truck on some of these valuations. Surely, as time goes by, and these companies become more attractive to Western capital, the valuations will find their way to more typical US type multiples.

Or, are you a skeptic? Are you having a hard time believing the numbers are this good? If so, you might want to seek growth elsewhere, but you won't find it as easily in the US.

I believe the market's skepticism is our opportunity, and I'll need 1 to 2 years to be proven right.
 

What Now? A Strategy

We're in the middle of a correction. It's not as evident in the large cap world yet, but it will be shortly. Smaller stocks are getting beaten down on light volumes.

It's not time to panic. It's time to get excited. I believe this correction will have run its course by Thanksgiving. It's time to look at your investable capital, and set some aside to scoop up bargain basement opportunities in November. This is a chess game, so let's start thinking a few moves ahead.

We are right in the teeth of tax selling and profit taking. The January effect will happen in December this year. 

Next week earnings season for small stocks gets rolling. About 75% of companies reporting Q3 numbers delivered far better than the analysts expected. 

If you wait until the second or third week of November to do your bargain shopping, we'll have the benefit of having had the chance to review Q3 earnings reports.

I would set some cash aside, put a shopping list together for post Q3 numbers, and get ready to pounce on some bargains. I predict strong numbers from CREG, CEU, TPI, and NFEC. We'll see when they hit.

Those with the courage to jump in on this pullback will be smiling as we roll past the first of the year and into January and February.

The Earth is estimated to be 4.7 billion years old. Man has been on earth about 2 million years. You and I represent a tiny blip in that period of time, and the next 30 days of our existence are not that meaningful in the big picture.

I know we all want to trade in and out today, and scalp a quick profit. However, the kind of growth we're investing in here can take a year or two to be fully recognized by the markets. Patience is a good thought for now.

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