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Shanda Games Limited (NASDAQ:GAME) is not doing well lately. Over the last year, its stock price went down from over $5 in May 2012 to the recent 52-week low of $2.68.

This is because GAME's business is struggling. Since Q2 2012, its monthly active user base and average paying accounts have been shrinking. As a result, both its revenue and profits declined three quarters in a row.

However, I believe the stock market overreacted to GAME's poor business performance. At the current price of $2.68, GAME offers a great risk/reward profile for those investors who have the courage to take advantage of this opportunity.

Dirt Cheap

At the current price, GAME carries a P/E ratio of about 4 and P/B ratio of about 1. Its market cap is about $740 million. At the end of 2012, GAME had over $600 million in cash and cash equivalents on its balance sheet. That means if we net out the cash, GAME's market cap is only $140 million.

Last year, GAME's net profit was $177 million. That's more than its market cap, excluding cash. In other word, an investor can recover all his money in less than one year if he buys the stock now. I believe this ridiculously low valuation offers the investor a huge safety margin.

Yes, GAME's business is struggling, but it's still making good money. And, it will continue to do so for quite some time even assuming there will be no hit game in its game pipeline.

Growing Industry

Is the industry that GAME operates in collapsing? Quite the contrary. In 2012, China's total video game sales reached RMB60.3 billion, with a growth rate of 35%. This growth is expected to continue, albeit at a slower rate. Total video game sales are forecast to grow more than 12% per year in the next five years and hit RMB130 billion by 2017.

Revenue Source

Unlike other online gaming companies such as Changyou.com Limited (NASDAQ:CYOU) or Giant Interactive Group, Inc. (NYSE:GA), which rely on only one game or one series of games, GAME's revenue source is more spread out. Currently, its top game Mir II contributed 32% of total revenue, while the other two games, Dragon Nest and Woool, contributed 16% and 15%, respectively. Mobile games and overseas revenues contributed another 10%.

Strong Pipeline

GAME has a solid new game pipeline that may become the catalyst for the stock. Its upcoming title, Rift, has ranked among the top five most anticipated games on several major Chinese game portals. In addition, GAME will launch many other games such as AION 4.0 expansion pack, World Zero, Final Fantasy XIV, and Dungeon Striker in 2013. GAME will launch several mobile games as well.

Strength in Mobile

Compared to other big players in the online gaming industry, GAME is better positioned to compete in the mobile game area. In Q4 2012, its other revenues (mainly mobile revenues) grew more than 60%, thanks to the superb performance of its mobile game called "Million Arthur." In 2013, GAME will launch more mobile games in Taiwan, Hong Kong, and Mainland China to capitalize on its strength and expertise in mobile gaming.

Dividends and Buyback

GAME has been busy buying back company shares. In the past three years, GAME has bought back over 23 million shares of company stock at a total cost of $107 million. This translated into an average cost of $4.65 a share. The share buyback amounted close to 9% of current total shares outstanding. Currently, GAME still has an ongoing stock repurchase program to buy back an additional $60 million worth of shares.

In 2012, GAME issued a massive dividend payout. It paid $290 million or $1.02 per share to investors. This kind of dividend payout may continue in the future since GAME generates a lot of cash year after year.

Portfolio Approach

I believe China's online gaming industry offers a low risk, high reward opportunity for investors who have the courage to step in. The single most important factor is valuation. Some stocks in this industry have been priced so low that investors can enjoy a huge safety margin buying at such a depressed price. Secondly, this industry is somewhat recession proof. People play online games in good times and bad. Some people even argue that people play more games in bad times because of high unemployment and the fact that online gaming is the cheapest form of entertainment in China. Finally, online game companies generate a tremendous cash flow. For example, GAME's cash flow from operating activities was $237 million in 2012, or 32% of its current market cap.

However, it's quite difficult to predict which new game will be a hit and which company will prosper going forward. For example, CYOU's game "Tian Long Ba Bu" turned out to be a huge success, but the game had a very shaky start. Conversely, another game, "Lu Ding Ji," also launched by CYOU, started very strong but ended up as a dud.

So how do you deal with this situation? I believe the best way is to use a portfolio approach. The investor should invest in several different companies within this industry. The key is to buy them "on the cheap."

Right now, I have invested in three online gaming companies. Perfect World Co., Ltd. (NASDAQ:PWRD) is my largest holding, followed by NetEase, Inc. (NASDAQ:NTES). I bought NTES at the end of 2012 when it fell below $40. Recently, I started to accumulate GAME at around $2.70. I will keep an eye on CYOU and GA and will step in should their prices fall.

Source: Now Is The Perfect Time To Play The Shanda Game