Beware of These Cheap Stocks

Not too long ago, one of our Motley Fool Global Gains subscribers emailed me and asked me to take a look at a company called Orient Paper (OPAI.OB). Though the stock was Chinese, small, and traded over the counter, it had piqued his interest because it looked so darn cheap.

As I began my own research, I quickly confirmed that yes, this stock looked darn cheap. At $0.55 per share (its price at that point), it had a $25 million market cap and was trading for less than 1 times sales and 2 times EBITDA.

The story does not end there
After studying Orient Paper's SEC filings, however, I came away with five troubling questions:

First, until just last month, the company had a 25-year-old CFO who had worked in that position since she was 23 or so. That seems like an awfully young and inexperienced C-level officer for a publicly traded company. Given that so many small public Chinese companies struggle with internal controls even after they've hired qualified CFOs and auditors, one has to wonder if Orient Paper has the same issues.

Second, the company keeps extraordinarily low levels of inventory (just 2% of sales) while larger peers such as International Paper (NYSE: IP) and Boise (NYSE: BZ) keep 9% to 13% of sales in inventory. How can Orient Paper maintain such small inventories and produce such significant sales growth, and what does that mean for the sustainability of the growth story here?

Third, the company has a volatile customer list (with major customers appearing and then disappearing from one year to the next), yet has no advertising expenses and extremely low SG&A expenses. If the company is not keeping customers and not spending to promote itself to new customers, how is it getting business? The 10-K tells us that the company relies on its CEO for his "personal and business contacts." But while contacts are a very good thing to have in China, you don't ever want to be part-owner of a company that relies entirely on the relationships of one key individual.

Fourth, the company seems content to use its shares as currency, despite its seemingly low valuation. For evidence of that, note the 5 million shares the company issued to pay a $500,000 consulting bill in 2008. What does this mean for how it will treat outside shareholders going forward?

Finally, multiple insiders have loaned money to the company at charitably low rates to fund working capital. If this company is financially strong, why can't it source bank debt or, better, self-fund?

Nor does it end there
After posting these questions on my blog, I received a response from Orient Paper's new CFO, Winston Yen. While you can read his full response for yourself, he confirmed that the company is very good at managing its inventories, turning pulp into finished customer orders within days. He also noted that the company used the proceeds from its related-party loans to add a production line and that the company would not have been able to do so otherwise. And he asserted that the company's consistently low levels of accounts receivable show an operation that is legitimate and efficient.

On the other hand, we have to take his word that the financial compliance in place at the company is solid, he had no explanation for why the company can't get bank debt to fund growth, and he had "no comment" on the bizarre share issuance to former consultants.

The point of this story
Now, if you find Mr. Yen's answers to be satisfactory, then buy Orient Paper because, yes, it does look cheap. I, however, will be watching and waiting for at least a little while longer to try and verify the quality of the business.

See, high-quality businesses don't normally sell for dirt-cheap valuations -- note Google's (Nasdaq: GOOG) enterprise value-to-EBITDA ratio of 13. That's particularly true of high-quality businesses in a fast-growing economy like China's -- Baidu.com (Nasdaq: BIDU) trades for 46 times EBITDA. But it's also not impossible. Thanks to the recent market downturn, there are more than 100 Chinese companies trading on the U.S. exchanges today for less than 5 times EBITDA.

Are they all bargains? Of course not. But at Global Gains, we think there will be significant long-term rewards for investors who are willing to be patient and carefully study the likes of Orient Paper, SORL Auto Parts (Nasdaq: SORL), Noah Education (NYSE: NED), and Linktone (Nasdaq: LTON) among others.

The key, though, is that you don't just want to find a cheap stock. You want to find a cheap stock that aligns you with a high-quality, scalable business whose management team you trust to allocate capital effectively.

More on that last point
This is why we travel to China every year at Global Gains to investigate and meet a collection of promising companies and management teams. And while some scare us away, others make us that much more confident. In fact, during each of our past two trips, we uncovered a stock that's since more than doubled. (Read more about that here.)