Wuhan General (WUHN) manufactures industrial blowers, turbines and other industrial machinery. While the company trades for just over $50 million, it has a tangible book value north of $80 million and has earned a combined operating income of about $15 million in its last four quarters. While the company looks cheap on this basis, two completely separate but important factors reduce the attractiveness of this company.

The first problem is the company’s limited operating history. While the company has seen strong growth rates over the last three years, value investors prefer companies that have consistently demonstrated an ability to withstand the competition. The company underwent major changes in 2004, but only recently has it demonstrated decent returns on capital. Were these returns simply due to an overheated economy or can they be sustained? Unfortunately, without a stable and consistent operating history, it’s difficult for the investor to tell. For further discussion on this topic, see Chapter 37 of Security Analysis.
The second major problem with this investment is its share structure. Large blocks of preferred shares not only rank ahead of the common shareholder, but are convertible into common shares on a one-to-one basis. For the investor, this means not only will any upside will be shared, but downside risk is increased, because of the junior ranking of common shares. Furthermore, the magnitude of this impact is huge: if all shares were converted today, the number of shares outstanding would double, effectively halving the investor’s share of the company.
While investments can look cheap on the surface, investors must dig deeper. For example, Google Finance does not show the preferred shares (let alone their convertibility) for this company. To avoid overpaying for stocks, investors much ensure they take the time and effort to do their homework, and not simply rely on what looks cheap at first glance.
Disclosure: None