Monday, September 03, 2007

Investment Mistakes Part 7 – No consideration for industry characteristics

This mistake is one mistake which many investors frequently make, and it is admittedly one of the more difficult mistakes to analyze, predict and rectify. Being value investors, one is always supposed to analyze the company’s maco-environment including the industry and country where it provides its services or products (e.g. China market, local market or international market). Early on in my investing career, I had frequently failed to adequately consider these factors in my analysis, resulting in “shocks” and lost money.

I had purchased a company called C&O Pharmaceutical on February 28, 2006 at a price of S$0.405 per share. This was a China-based pharmaceutical company and at the time, they had just acquired another company called Shenzhen Liancheng in order to boost their distribution network and bolster their pipeline of available drugs to sell to the market. Their market was predominantly China and the pharmaceutical industry (at the time) was loosely regulated, meaning suppliers of drugs did not have to pass their drugs through intense scrutiny and draconian checks in order to be commercially saleable. Also, loose regulations meant that prices for drugs could also be “fixed” and many companies freely bumped up the prices of their drugs in order to secure a large gross margin. In short, the lack of regulation meant that a lot of drugs were being pushes to the market irregardless of their safety (or even intended) effects, and that prices were wildly out of proportion with international standards (even if the drugs were supposed to have the same effects).

The company in question was doing well at the time; the purchase of Shenzhen Liancheng meant that they would increase their pipeline of ready-to-market drugs and also enable “better control and greater effectiveness” in the distribution of third-party and C&O branded drugs. To be honest, I also did not do an in-depth research of the company or its industry and I based most of my purchase decision on this one piece of news (another mistake !).

In June 2006, after a series of drug scandals in China, the Chinese government announced a clampdown and tightening of the entire industry by imposing price ceilings for various drugs and also subjecting new drugs to greater scrutiny. This had the unexpected effect of compressing margins for all Chinese pharmaceutical players and overnight, many local-listed China pharmaceutical stocks (e.g. Landwind Medical, Reyoung pharmaceutical, C&O and Asiapharm) suffered. Looking back, I should have been able to anticipate such moves by the government as there was already rampant and uncontrolled drug distribution and pricing by unscrupulous drug companies. It was only a matter of time before such stringent regulations came into effect, as China wished to preserve its reputation in light of the upcoming 2008 Beijing Olympic Games.

Thus, on November 9, 2006, I sold out at a 36% loss (at S$0.255) after C&O gave a profit warning (amid a flimsy excuse of lower profits due to the “consolidation of inventories”). It is currently trading at S$0.48 today (only a slight 20% profit from my old purchase price after nearly 1.5 years) due to the continued challenging environment for Chinese pharmaceutical companies.

Note: The current scandals in the papers involving Chinese products should alert the intelligent investor to possible repercussions from the Chinese government, and one should stay alert of such developments as it may affect your investments in China companies, especially those which produce goods for the domestic market in China like shoes (e.g. Hongguo, China Hongxing), frozen foods (e.g. Youcan, Synear) and consumer goods.

10 comments:

Snapper said...

Hi Musicwhiz,

Couldn't agree more with your take on the Chinese pharma business after authorities excercised tighter controls.Longer term, more established players like Asiapharm should benefit.Bought this stock for 0.58 about 2 years back, saw it reached a high of 0.98 before selling it at 0.66 after news of the clampdown.Suppose holding on would mean "opportunity costs"

I don't consider Pac Andes as a liability cos their products are wild catch from the ocean and fishmeal is for farming.Haven't got an idea who their major competitors are. Do you consider CFG's rights to fish in Russian and Peruvian waters as high barriers to entry in this industry? Have held Pac Andes shares since June 2003.Thanks!

cccd said...

I read a lot of your articles about financial and stock knowledge. I found them very interesting and saluted your achievements. I just wonder how you chose the stocks you own now from so many stocks listed @ SGX. What's your criteria?

According to some broker house research reports, it's a good opportunity to take up some China stocks such as Synear. The reason is as a series of branded productor, Synear will benefit from the recent reconstruction of Chinese products. What's your opinion?

musicwhiz said...

Hi snapper,

Yes, I had the same experience with Asiapharm as well, except that I bought it at a high of 94 cents and lived to regret it ! Haha.

PAH competitors would include Copeinca (not sure of the spelling) but they are one of the largest fishmeal companies also operating in Peruvian waters. I think you can do a search under fishmeal to look them up. I think PAH definitely has a competitive advantage but I hope CFG can scale up their biz further through more acquisitions in future. IN that way, they can literally grow their vessel hold capacity and thus increase their catch.

musicwhiz said...

Hello cccd,

Thanks for visiting my blog regularly and glad you enjoy the articles ! I choose my companies mainly from corporate announcements on SGXNet, after which I will commence research on the company proper. For my criteria, please click on the category "Research Series" to see what I look out for in a company.

The way I think of China stocks is as such: yes, there is definitely a large market for China goods, but one must be selective to pick out the gems from the mediocre companies. After all, China has 1.5 billion people and probably has hundreds of thousands of brands and companies; so one must be very careful of which company one chooses as most will tout themselves to be "the dominant player". Proper research is necessary before putting your money into a China company, as corporate governance issues may arise due to the difficulty in monitoring an oversea company (it's a China company after all).

For Synear, note that they are reliant on prok for most of their food products like dumplings; thus the recent incidence of blue ear disease in China would push up prices of pork, which would affect their gross margins. I would be cautious and adopt a wait-and-see attitude before deciding to buy into the company.

regards, musicwhiz

fishman said...

Hi cccd and musicwhiz,

Would like to add in on the topic of selection criteria. For me I first of all choose the sectors or types of businesses which I'm interested/comfortable with. For example, healthcare, real estate etc. From there I choose the company that I would like to invest in.

On hindsight, this might also helps to avoid the kind of problem that musicwhiz you encountered?

to musicwhiz: thanks for your interest in my blog! Past few weeks totally burnt out by work. Totally no time to do another things! Will be posting soon though! :)

musicwhiz said...

Hi fishman,

Take things easy man, work can be tiring I know !

I think you made a good point to look out for industries which are growing first, then zooming in on the company.

Good luck in your investing journey as well ! :)

ThinkNotLeft said...

Hi,

Interestingly, I started to collect C&O Pharm at around 0.28 sometime in Nov 2006. And from Dec 2006 to Mar 2007, I am thinking that C&O is probably the best stock to own, since its inventory problem is likely to be just a temporary event. The price should recover when the inventory problem blows over. Turns out that the equity investment by a venture fund help the price to rocket and I sold it off at around then.

I am not trying to show off. But just trying to state an alternative line of thought to C&O and to investing approaches. There are many roads to Rome,especially in investing after all.

musicwhiz said...

Hi thinknotleft,

It turns out that the price I paid for C&O at a time when they were "reorganizing" their inventory turned out to be too high, which was probably one of the reasons I lost out: No Margin of Safety.

You mentioned that the inventory problem was a temporary event, but I was thinking more of the maco aspect of C&O's operating environment (i.e. its industry) rather than strictly focusing on the inventory problem. I would now only invest in companies which show good growth over a number of years, and C&O did not give me that kind of confidence as it was "just another player" with no world-beating drugs or products; thus it has no sustainable competitive advantage.

Thanks for sharing your thoughts too, but I think your horizon was much shorter than mine when it came to C&O, as you stated that you "sold it off around then" when the venture fund bought into C&O. I sold at a loss as I had a longer-term horizon and I was not convinced it was going to show the kind of growth which I had expected when I first invested in it.

Cheers....musicwhiz

ThinkNotLeft said...

I can understand why you sell C&O. This is done with reference to your investing reason and style.

To further explain my selling decision on C&O. A factor that push me to sell C&O then is that its 3QFY07 results is not as good as I expect. And by then, the value gap caused by the inventory re-organization seems to have closed. Thus, there is not much reason for me to hold to C&O.

Yes, my investing horizon would be on average shorter then yours. This is due to my impatient character.

musicwhiz said...

Hi thinknotleft,

Thanks for your additional explanation. All the best for your other investments ! :)