On Monday, 23 September 2013, “Kingold Jewelry (NASDAQ:KGJI) was downgraded by analysts at Thomson Reuters/Verus from a buy rating to a hold rating”, according to Zolmax News. The shares closed at $1.73 on Thursday 26 September, up 25% on the day, and up 40.6% from Monday’s close of $1.23.
These kinds of anomalies are pretty rare; living proof of the fallacy of instantaneous market efficiency. But as a wise woman once said, contradictions do not truly exist; “Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong” (AR).
Examining some widely held assumptions regarding the relationship between sell-side advice and their clients reveals the following:
- Brokerage houses employing sell-side analysts do not speculate with client money;
- Sell-side analysts and brokerage-houses are looking after their clients’ best interests; advice is unbiased; conflicts of interest are minimal; and,
- There is a wall between investment banking side of the house and the analysts;
If one of these assumptions is erroneous, then the contradiction ceases to exist. It’ll be interesting to see next quarter’s 13-F filings to determine if institutional holdings in KGJI had increased. If so, then this downgrade may be interpreted as a blatant attempt to cheapen the shares, or at least blunt the effect of institutional purchases on an illiquid stock.
KGJI produces gold jewelry and other trinkets by purchasing gold from the open market. It is a Chinese reverse-takeover listing, and therefore much maligned by the investment community. However, if one is to believe their audited financial statements, they are grossly undervalued.
Although KGJI’s margins appear to be paper-thin, the Chinese jewelry market is more akin to a commodity than a consumer discretionary business (as is in many developed nations). Because the Chinese typically buy gold jewelry for weight as opposed to craftsmanship, the sales prices of finished gold pretty closely mirrors the cost of sales. While KGJI can pass normal gold price volatility on to the customer, margins are very sensitive in the direction of rapidly changing gold prices. If gold prices shoot up, margins will follow because they will have bought the gold cheaper than the market value. Recently, however, gold prices have plummeted, thinning already thin margins. This simple business model has both upsides and downsides.
The obvious downside is that requires a huge amount of gold inventory, gobbling up capital and exposing the firm to gold price volatility. Nevertheless, the sheer amount of tangible gold inventory on their books justifies a much higher value for the equity. You could buy the company outright, pay off all outstanding obligations, and still have a bunch of gold leftover.
Here’s how it works:
|In thousands||Per fully diluted share|
|Cost of goods sold (ttm):||$968,911||$15.08|
|Cash & equivalents (ttm):||$5,692||$0.09|
|Total liabilities (mrq):||$11,658||$0.18|
|Shareholder’s equity (mrq):||$192,182||$2.99|
|Market capitalization (current):||$106,660||$1.66 (current price)|
|Fully diluted outstanding shares (mrq):||$64,253|
Simple addition and subtraction shows you can pay $1.66 per share, receive 2.63 in cash and gold, pay off all outstanding obligations, burn the entire rest of the business to the ground, and leave with a profit of $.79 per share. At anything less than $2.45 per share, buying KGJI is kind of like piracy, except it’s more like getting free gold.
Free gold did you say?!?!?! Sell-side analysts be darned! I am long KGJI and intend to hold it for as long as the company remains profitable, the financial statements appear to be legitimate, and the market-cap is below net-asset-value.