Frank Voisin is a value investor and independent analyst whose site, Frankly Speaking, contains Frank’s investment theses as well as educational material to help investors avoid value traps. Subscribe to Frank’s feed here.

Sutor Technology Group Ltd. (NASDAQ:SUTR) is a manufacturer of steel products. It trades for just $80m despite having NCAV of $104m and positive earnings (the company trades at just 5.6x P/E).

Looking more closely however, see see that $98.5m of current assets is “Advances to Suppliers, Related Parties.” From the company’s disclosures, its largest supplier (61%) is Shanghai Huaye (“Huaye”), a privately owned company, wholly owned by SUTR’s CEO, Lifang Chen. Since Huaye is privately held, it does not release its financial information to the public. As such, there is no way to evaluate the creditworthiness of Huaye or the potential for these advances to be repaid. Without any assurance as to whether its largest current asset will be repaid, it is impossible for a value investor to make an assessment of whether there is a margin of safety, in that the intrinsic value of the company’s assets may actually be much lower than reported. We have seen several high profile cases of fraud involving Chinese companies, and while it isn’t right to paint them all with the same brush, it is important to be vigilant while assessing them.

Beyond SUTR’s reliance on Huaye for supplies, it also relies on them for revenues, as Huaye accounts for 61% of SUTR’s sales. A picture begins to form of SUTR being a quasi-subsidiary of Huaye, and the analyst’s job is made more difficult by the fact that the subsidiary’s very existence is completely reliant on the parent and the parent is opaque.

When analyzing a company, it is important to consider the risks associated with the companies relationships. Dependence on a small number of other institutions is always a red flag that should result in the value investor requiring a greater margin of safety than otherwise. Additionally, always be sure to investigate the nature of the company’s assets to determine how closely their actual economic value relates to the company’s stated carrying value. Sometimes the difference can surprise you!

Author Disclosure: No position.