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.