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I have been very bullish on China's online video game companies for quite a while. In February, I wrote an article (here) recommending buying Perfect World Co., Ltd (NASDAQ:PWRD). Then in April, I wrote another article (here) about Shanda Games Limited (NASDAQ:GAME), a Chinese video game pioneer, when it hit a 52- week low of $2.68.

I've put my money where my mouth was and invested heavily into these two companies. In addition, I also bought NetEase, Inc (NASDAQ:NTES), Changyou.com Limited (NASDAQ:CYOU) and Giant Interactive Group, Inc. (NYSE:GA) during recent pullbacks. After everything was said and done, 75% of my personal stock funds were invested in China's online video game sector.

In order to take advantage of this tremendous opportunity, I had to sell all my positions in Xunyuan Real Estate Co. (NYSE:XIN) at about $5 and SoFun Holding Limited (NYSE:SFUN) at about $26.

Cheap Cheap Cheap

Even after the recent run up, the valuation of China's online video game companies is still extremely attractive. This low valuation offers investors with a wide safety margin. The following table highlights some valuation metrics I used to pick attractive stocks in this sector:

Ticker

Market Cap

2013 Earnings

P/E Ratio

Liquidation Value

Adjusted P/E Ratio

GAME

1,076

150

7

880

1.3

PWRD

910

100

9

760

1.5

CYOU

1,696

300

6

520

3.9

Unit: Million USD

The adjusted P/E ratio is calculated by taking the liquidation value out of the market cap and then dividing by the estimated 2013 earnings. You can see how under valued all three stocks are, especially GAME and PWRD. That's why GAME and PWRD are my No.1 and No.2 positions in my personal stock portfolio, followed by CYOU, NTES and GA.

Catalysts

Because the valuation of China's video game companies was so depressed, even a small piece of good news can send their stock prices soaring. That's exactly what happened to PWRD and GAME. PWRD went from $11 to $19 simply because the testing result of one of its new MMO games "Swordsman Online" was much better than expected. I think the stock will go even higher once investors fully realize the potential of "Dota 2", another new game PWRD will launch later this year.

Similarly, GAME soared from $2.68 to $4.1 in just two months, thanks to the strong performance of its mobile games. In Q1 2013, GAME successfully launched its flagship mobile game "Million Arthur" in Korea and now revenue contribution from mobile games is close to 10% of the company's total revenue. GAME is planning to launch "Million Arthur" in China later this month and this launch will further boost its mobile game revenues.

Government Support

We all know that in China, the government is extremely powerful. Its attitude toward a certain business can make or break that entire sector. In the U.S., we have "Don't fight the Fed" and in China we have "Don't fight the government."

The Chinese economy is undergoing a structural change from an investment driven economy to a more knowledge and innovation driven economy. The Chinese government realized that the online video game business could be used as a platform to achieve such a goal. Its attitude toward the business has made a 180° turn from suppression to encouragement.

Recently, the government has undertaken several favorable actions to facilitate growth in this business. For example, it streamlined the governing bodies of the industry to eliminate regulatory ambiguity; it also offers financial subsidies to incentivize companies to produce original video games based on popular Chinese literature. In the last several quarters, many video game companies have received financial subsidies from the government. In addition, news and media have become favorable to the business. PWRD's ex-CEO was put on China's Central TV to tout the merits and potential of the online video game business.

Safe Haven

Recently the news out of China on the economic front is not that encouraging. This week's news about China's imports and exports confirmed that China's economy is struggling. This is not surprising at all when an economy is undergoing a substantial structural change. I believe that in the near future China's economy may remain in the doghouse.

But, this will not affect the online video game companies much because the business is somewhat recession-proof. Its main customers are young people aged 18 to 24 and with incomes less than $480 per month. This group of people is not that sensitive to the economy's ups and downs. In addition, online video games are the cheapest form of entertainment in China. Right now 90% of games adopt a free-to-play model and only charge for in-game items. Thus, the majority of players can play for free. For the small portion of players who do pay, their monthly expense is only about $15 on average.

Some people even argue that poor economic conditions may in fact help the industry. As more people become jobless, they will have more time to kill. And as their income declines, they may have to ditch more expensive forms of entertainment and take up the very affordable video game.

In summary, for investors with high-risk tolerance, I recommend they take a look at China's online video game companies. With the government's blessing, the industry will continue to grow regardless of China's economic conditions. Attractive valuation can provide investors with a wide safety margin.

Source: China's Online Video Game Companies: Safe Haven In Stormy Times