Chinese Small Caps With Large Potential

By Sham Gad | June 25, 2009 AAA

I've always felt that the next great future growth story is overseas. Countries like China, Brazil and India have billions of citizens that are just now starting to move up in the world and will want better housing, food and social lifestyles. While there are a lot of U.S.-based companies that have substantial operations overseas, it's good to keep an eye out for companies that are actually based overseas. Warren Buffett did so several years ago and saw tremendous value in Korean stocks when many were trading for low single-digit price to earnings (P/E) ratios.
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Don't Ignore China
As globalization continues to define our economies, many businesses that were once thought of as speculative and operating in closed market economies are now passing the test. The most obvious area is China, as the country is still under communist rule but continues to adopt free market principles with respect to its businesses.

Bet on Chinese Education
An interesting small cap is China Education Alliance (OTC:CEUA), a leading educational service company that offers online educational services like test preps, study guides and certificate training. During the most recent quarter revenues grew by 100% and net income grew by over 65%. Shares are trading at $3.25 and value the company at $75 million, up significantly from its lows in January, with a P/E that is still 7.

The company has no debt and about $1 in cash per share. With a quality balance sheet and a very low-cost business model, China Education Alliance is a quality bet on the future educational growth in China. It's not the screaming bargain it was a few months ago, but it's not expensive either.

ChinaEdu Corporation (Nasdaq:CEDU) is another online provider of education in China, but its gross margins and growth rates are fractions of CEUA. Even Chinacast Education Corporation (Nasdaq:CAST), a $216 million company, is going for 25 times earnings, and "only" boasts operating margins of 36% against CEUA's 41% margins.

China Has to Feed Itself
With a population of 1.3 billion, China has to figure out a way to feed itself as no other country can realistically feed itself plus another 20% of the population. So agriculture in China is looked upon favorably by the government, as food security is right up there with national security.

Investors should pay special attention to China Green Agriculture (NYSE:CGA), a $130 million, debt-free, Chinese fertilizer manufacturer. Net margins are 35% and return on equity is over 50%. In addition, AgFeed Industries (Nasdaq: FEED) sells animal feed, primarily hog feed and recently began buying up hog farms to breed and sell for meat production. China consumes six times as much pork as the next biggest consumer, the U.S. China will only grow and eat more pork and AgFeed is a certain beneficiary. With a market cap of $216 million, no net debt, and being in the business of feeding people, FEED may be a wonderful growth story at only 10 times earnings today. The company earned 56 cents a share last year, up over 200%. If the company delivers $1 in EPS in 2011, assuming no meaningful share dilution, shares will trade at $10, nearly double from today's price.

Bottom Line
These nimble Chinese businesses sport tech-boom-like growth rates, but with utility-like valuations. Such continued growth performance coupled with today's prices make value the catalyst for the long-term investors. As many of these share prices have jumped multifold from the lows earlier this year, the easy gains are likely off the table, but that doesn't mean that patience won't be rewarded in the future. (For additional reading, see Investing In China.)

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