There�s an intriguing growth story in China right now that you need to be following � particularly one specific play that could help you take advantage of a powerful new trend before it catches fire. This growth market is so compelling, in fact, that it�s making me rethink my long-standing prohibition on Chinese ADRs.
But before I get into the details, let me explain why I�ve been so reluctant to take a serious look at any Chinese stock, even those trading on major U.S. exchanges…
For almost a year, I�ve honored a self-imposed ban on the purchase of any Chinese stocks. I haven�t touched a single Chinese ADR since my ban � and I haven�t recommended a single one to my readers.
The saga began last year with a small Chinese travel stock called Universal Travel Group (NYSE:UTA). Back in September 2010, I recommended shares of the small-cap Chinese travel company to my readers, pinning hopes on a dirt-cheap valuation and breakneck growth in the Chinese travel industry. But the morning after I sent out the recommendation, a short seller published a report detailing why UTA was a fraud and why he was actively betting against shares. The stock opened for trading down 30%, and we quickly sent out an alert for readers to sit tight before buying while we investigated the claims.
After some digging, I felt the claims boiled down to a misunderstanding of the company�s business. Every argument for UTA being a fraud looked incorrect. Luckily, we were able to take advantage of the situation, re-issue the buy recommendation � and even ended up booking gains on the investment.
Even though we did well on the UTA investment, we were concerned about the power that unknown short sellers could have over Chinese ADRs. While there had been some rumblings about the abundance of fraud in China, UTA was one of the first major short attacks on a Chinese stock.
Then the floodgates opened. Fraud allegations appeared left and right. And short sellers eventually targeted another one of my recommendations, Advanced Battery Technologies (PINK:ABAT).
ABAT was a Chinese battery stock I recommended back in March 2010. It was up as much as 21% early last year � but that was before another short attack shoved shares more than 40% lower in a single trading day. I ended up closing the position for a loss � but was spared the 90% drop that eventually crushed the stock.
That�s when my ban went into effect. Even if Chinese fraud wasn�t truly widespread, the risks of a short attack were just too real to justify buying any of these ADRs � no matter how rosy the growth picture may have been at the time. Investors were eating up every fraud report that hit the web. There was no telling what stock would be the next target �or if the claims of fraud would even be legitimate…
But now, something has changed. I�ve found this new growth market in China that could have the potential to deliver early investors significant gains. It has the potential to be so powerful, in fact, that it could easily repel short attacks just like the ones I�ve experienced firsthand…
I�m talking about the Chinese pharmaceutical market. It�s growing faster than any other drug market on the planet right now, with some projections expecting it to balloon to $115 billion in the next three years.
Here�s the kicker: Because the Chinese government requires local testing of medicines � and because the cost for conducting the animal research to perform these tests is about half what it is in the U.S., domestic companies are beating down the doors of these Chinese drug research firms. They want to get their foot in the door so they can grab some of the profits of this red-hot growth market.
Because these Chinese-based firms are now buyout targets for major U.S. Pharmaceutical firms, we now have an extra margin of safety while exploring the sector for potential investments. If Big Pharma has sent its best people to China to investigate these businesses and their growth claims, I sincerely doubt a short-selling raid would hold up to the scrutiny.
That�s why the small-cap ADR WuXi PharmaTech Inc. (NYSE:WX) has caught my eye. Not only does WuXi grab 70% of its revenue from research for U.S. companies, it also was involved in a �near miss� $1.6 billion takeover attempt from U.S.-based Charles River Labs, according to Bloomberg. The only reason the deal went sour is because Charles River shareholders voted it down because they felt the premium was too high.
In my view, this was a huge mistake made by short-sighted Charles River shareholders…
A precedent was set by the offer � which represents a premium of more than 60% above WuXi�s market value right now. Analysts don�t see the company accepting anything less. Frankly, neither do I. WuXi is simply making too much money � and monopolizing too much U.S. business � to humor a lowball offer. According to data compiled by Bloomberg, WuXi�s profit margins are 5 times that of its U.S. counterparts. WuXi is eating their lunch, and they know it.
A buyout offer is not a matter of �if� but �when� at this point. Someone will come along with a massive offer for WuXi � or even one if its competitors in the research sector. An event like this should trigger a ton of activity in the sector. And anyone with the foresight to see the big buyout on the horizon stands to capitalize on the action.
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