China Medical System (HKEX:0867) or CMS in short, is a major medical distributor in China.
We first spotted this stock in early 2019 as the share price crashed 50%, from HK$19 to HK$8.
The stock appeared in our proprietary stock screener and had a set of attractive metrics based on our GPAD strategy (read more here).
It was G5D5 and it simply meant that it was a highly profitable asset-light business and it was trading at an attractive price. The stock beat the other 80% in the listed companies in terms of profitability and dividend yield.
We did a write-up on the stock to our graduates on 21 Mar 2019 so that they are aware of a new stock passing our stock screening criteria.
We explained that the reason for the huge dive in the share price was due to the change in the government policy. The drug distribution chain had a lot of middlemen and each would layer on the cost of medicine to the patient. The Chinese government wants to lower this cost by imposing a maximum of two players in any one distribution chain or so-called the two-invoice system.
CMS is a major distributor and would be less affected compared to the smaller players. The drug distribution industry will consolidate with either the small players exiting the market or being acquired by the larger one.
CMS calculated the impact of the two-invoice policy and it would lower the gross profit by about 8%, which wouldn’t be significant, or at least not warranting a 50% drop in share price.
We invested in CMS at HK$7.91 and the price quickly rallied to as high as HK$12.
We intend to hold the stock for the long run as we see it having great growth potential due to an aging population needing more drugs in China.
However, our intention was challenged on 6 Feb 2020 when Blue Orca, a short seller, issued a damning report on CMS accusing the company was inflating revenue and claiming tax savings from a shell company in Malaysia.
We immediately informed our graduates in case they didn’t follow the short seller.
We wouldn’t be able to tell who is saying the truth but we believe it was more prudent to get out before it was too late. So we sold it on the same day the report was out at HK$9.89 and inclusive of dividends collected, we realised a 34% gain.
The trading of CMS shares was halted shortly after we have sold and only reopened on the following Monday. There was worry that the share price could dive when they reopen. But it didn’t. The share price went above HK$10 and subsequently to HK$11 on Tuesday.
We believe that it could be the management supporting the share price as there were announcements of share buybacks by CMS.
But given that Blue Orca’s track record of 82% accuracy rate in previous attacks, we believe it was better to err on the safe side and assume CMS wasn’t clean with the numbers.
The share price is still holding up well till now and it was trading at HK$9.50 at the time of writing. Only time will tell and we will continue to monitor the development as it would be a good case study.
Many investors would shun Chinese stocks for the fear of fake accounting and poor corporate governance. We do observe that the Chinese companies tend to have a higher fraudulent rate than the other companies. That said, every country has her rouge counterparts and Singapore managers were not short of examples.
Hence we should not be deterred to invest in Chinese stocks since, China is poised to be the next superpower and would create the MNCs of the future.
We just need to be extra careful when we analyse them and do more checks to verify the legitimacy of the figures. One of which is to only buy those that distributes dividends, using essentially a ‘show me the money’ heuristic. But in some cases it could still fail. Hence we also follow short sellers closely to help us identify potential frauds.
If you are interested to invest in the growth of China, you can check out our China-focused newsletter.