Having just finished about five radio interviews in a row, Addison looked up and gave me the “make it quick” look. So I dove right in…

“I ran a stock screen to find potential candidates to feature in Penny Stock Fortunes. I wanted the names of all the small-cap companies trading for $10 or less on the major exchanges with a market cap of $1.5 billion or less, sales growth of at least 10% year over year and quarter over quarter, earnings growth of at least 10% year over year and net profit margins of 10% or more. Also, the stocks had to be liquid — trading at least 100,000 shares a day. What I found was kind of weird.”

“I ranked the companies by net profit margin first — to see which ones had the most profitable business models. The top four companies (of the 23 that showed up on my screen) were…

1. China Finance Online Co. (JRJC:NASDAQ), net profit margin of 70.7%
2. Ninetowns Digital World Trade Holdings (NINE:NASDAQ), net profit margin of 67%
3. VAALCO Energy, Inc. (EGY:AMEX), net profit margin of 33.8%
4. Hurray! Holding Co. Ltd. (HRAY:NASDAQ), net profit margin of 31.9%.

“Notice anything weird about that short list of companies?”

Before Addison could answer, I told him…

“Three of them are Chinese. And if you look at the other companies that popped up on this screen (that didn’t make the top four), a lot of those are Chinese as well.”

I boldly stated (knowing that almost every Chinese stock is down 50% or more from its 2004 highs), “I think it is time to buy China again. For instance, look at Ninetowns (the second-ranked company on my screen). It boasts a net profit margin of 67%. Its sales and earnings are up more than 30%. It’s liquid. The stock is down 51% from its high in 2004. And with a market cap of $190 million, it has over $100 million in CASH!!

“The numbers look spectacular.”

Addison replied in a skeptical voice, “I don’t know. This is China we’re talking about. Something seems fishy to me. But who knows? Find out and let me know. You could be onto something.”

So I went to work…

I read Ninetowns’ latest annual report and a presentation it put together for investors in November. I was blown away.

Ninetowns is a software company that helps clients streamline the import/export process in China. Talk about a much-needed business.

If you are a logistics manager trying to sell your company’s products in China, the declaration process is a long and potentially painful one. You have to fill out lots and lots of paperwork. Then, you have to physically take those forms down to a branch office, stand in line to pre-register and then stand in another line to have your work inspected. After standing for hours, it’s not uncommon for the inspections officer to find mistakes in your forms and ask you to fill them out again and come back later.

Doing business in China is like dealing with our Motor Vehicle Association — times 1,000. It’s frustrating, time-consuming, inconvenient, error prone and costly.

That’s where Ninetowns comes into play – or so I thought.

It’s flagship software product, iDeclare, is like TurboTax for the Chinese import/export business. Instead of filling out all the paperwork (blindly) and dealing with the lines and the inspections officers, you simply install iDeclare on your PC. It automatically updates you about new laws, rules and regulations that may affect your business. It checks for errors on your declaration statement. And when you are all done, you simply send your completed forms to the correct government office — electronically. With in an hour, you get a note back telling you about errors you need to correct…or that your form has been accepted and you can now do business in China.

Ninetowns makes doing business in China easier. And with a 90% share of this niche market, a powerhouse customer base that includes Sanyo, Honda, Ericsson, Pfizer, Gillette, DuPont, Energizer, Kimberly-Clark, Kodak and others…and a balance sheet that is cleaner looking than a germophobe in the shower, this is exactly the kind of small-cap company you want to invest in — right?

So why isn’t everyone buying this under-$6 stock? Why is it down over 50% since it IPO’d in late 2004?

I kept digging around and quickly found my answer buried in a past earnings announcement.

Ninetowns’ business model was SO good the Chinese government couldn’t resist getting into the action. In Ninetowns’ second-quarter earnings announcement (titled, “Company Lowers Full Year 2005 Guidance”) it stated…

“On July 29, 2005, the company received an invitation as part of an open bid process from the State Administration for Quality Supervision and Inspection and Quarantine of the People’s Republic of China to submit a proposal for development of software products that have basic functionalities similar to those of the company’s existing software products — iDeclare and iProcess. As a result, the company believes that software products with functionalities similar to those of iDeclare and iProcess, developed at the request of the PRC Inspections Administration by the company or another software developer, will likely enter the marketplace in the near future and be competitive with iDeclare and iProcess. Further, the company believes the PRC Inspections Administration may distribute the software products…free of charge to end users.”

Classic. The Chinese government just cold-cocked NINE like it was a drunk guy hitting his wife. Not only did the government ask the company to submit a proposal to develop software it could use to speed up the import/export process for companies wanting to do business in China, it then implied it would take that software and give it away for free!

WHAM! HULK! SMASH! CRASH!

There goes Ninetowns’ business model. There goes its moat. And there goes its stock price.

On that news, shares of NINE fell 33%. And despite all the cash in the world, Ninetowns’ solid-looking balance sheet and its past growth numbers, I wouldn’t invest in this company with my worst enemy’s money. If it can’t change the way it does business, the company won’t be in business much longer. The stock could easily go to $0.

So why I am I telling you this story?

Investing is tough. Sometimes things aren’t as they appear. On the surface, NINE was about as intriguing as it gets. This tiny company has $100 million in cash, tremendous growth numbers and a 90% share of what looked to be a great niche market.

I’m sure a lot of people bought this stock over the past 12 months based on the numbers alone. I mean, when I first saw them, I was beside myself — so much that I made Addison stop what he was doing and listen to my so-called great find.

But only fools invest on numbers alone. To really understand a business, you have to do a lot of digging. You have to read boring annual reports, quarterly reports and earnings statements. You have to pore through Web sites, product lines, analyst reports, balance sheets and income statements. You have to look for the information that isn’t obvious.

In NINE’s case, I had to do a lot of back work to find one tiny paragraph that told the entire story. In this case, the Chinese government ripped off NINE’s business model for its own. And in the process, it ripped off what could have been a great opportunity for my small-cap investors.

Oh, well. I was reminded of a very useful lesson…

If something seems too good to be true — it is. And my goal as the editor of Penny Stock Fortunes and Penny Sleuth is to filter out the companies that are fluff and feature the ones that have legitimate growth potential.

NINE turned out to be fluff. But that’s OK. I am working on another idea now.

I found an American company that has a 50% stake in a growing market. It also has a great looking balance sheet. And so far, I haven’t found any reason not to believe it will rise a lot higher in the months and years to come.

Stay tuned…

Best regards,

James Boric
March 2, 2006

China’s Government Hulk Smashes This Small-Cap Contender was originally featured in the Penny Sleuth.