Seeking Alpha
Recommended for you:
Profile| Send Message|
( followers)  

This column originally appeared in Forbes

For a decade critics have derided me as a China bull for arguing that China's economy would continue to see robust growth. And for years Chinese consumers and China Inc. have proven me right. Retail sales have grown 16% to 18% a year over the past five years while gross domestic product has grown 8% to 12% a year.

Companies from Apple (NASDAQ:AAPL) to IBM (NYSE:IBM) to Louis Vuitton make serious money in the country. Paul Otellini, the chief executive officer of Intel, recently said, "Thank God for China. They buoyed, certainly, our company through the depths."

China's economic structure has changed from being heavily export-oriented to a healthier balance with domestic consumption and services. Leverage is being squeezed out of real estate by increased bank reserve ratio requirements (which are almost double those of banks like Citigroup and Bank of America) and by limits on mortgages. All these changes are salutary, and they make me as bullish as ever on China's overall economy.

However, a mania about China has gripped too many investors. Anything with China in its name gets hot in the way dot-com got people's blood pulsing in the 1990s. Many of America's biggest-gaining initial public offerings this year have been of Chinese firms. Many of those companies deserve high valuations, but not all of them.

Soon two Chinese online video companies, Tudou and Youku, will be going public. Both are run by intelligent, savvy and aggressive management teams that have raised more than $100 million in private equity money. I have friends involved with both companies who will probably be very angry at me for writing this, so I do not say it lightly, but investors need to be very cautious about investing in these companies and understand the risks.

Why? Take Youku. Bloomberg reports that it will value itself at $1.1 billion despite having lost $25.2 million through the first three quarters of this year, according to its filings with the Securities and Exchange Commission. Its competitor Tudou similarly lost $12.6 million in the same period.

At some point, sanity and hardcore analysis need to prevail. Whenever stock analysts mention these two companies, all I hear is that China has 420 million Internet users, mostly young people who have lots of disposable income, and that nearly 800 million people have mobile phones and will want to watch videos on their phones.

Who cares? What is the business model for generating profits? That's what is important. I am dubious about online video sites' business models. Even Google's YouTube doesn't seem to turn much of a profit, if any at all. That will be harder for standalone video sites.

Searching for profits, both Tudou and Youku have moved into generating more content rather than relying on user-generated content, and they have clamped down on pirated shows. A Hulu-style site might make money more easily than one with user-created content, but the cost of creating content is huge. Tudou and Youku are not television stations; Hulu's backers, like Newscorp and ABC, can simply broadcast their television content online. Creating content and developing a cool website take totally different management skills. Content, like the movie business, is a risky bet, because it is dependent on one-hit wonders.

Aside from dubious business models, there are two more reasons why I fear a dangerous bubble is emerging in Chinese online video.

First, the reality is that most big Chinese companies' digital marketing budgets remain at only 3% to 5%, far below the standard 8% to 12% in the U.S. That won't change much anytime soon. Yet at the same time, more and more digital marketing efforts, from online game sites to Groupon-like buying sites, are emerging. In other words, there is increased competition for fairly small marketing outlays.

Second, since digital marketing budgets are relatively small, most big companies outsource most of their buying decisions to media buyers. The dirty little secret of media buying is that those buyers often don't look to where their clients can reach their target markets best; they look for where they can get the best rebates. That is highly risky if they take their entire client base away from one medium.

The good news about Tudou and Youku is that my firm's research suggests that consumers do love their services and do recall ads the ads they show fairly well.

My guess is that both Tudou and Youku's stock price will soar in the short term, because of the mania surrounding China and because they are both well-run companies. Both have compelling stories that investors will be drawn to. However, my advice to investors: There is undoubtedly a bubble emerging in some of the stock prices of Chinese companies, so be really cautious about where you place your bets in the coming months.

Personally, I wouldn't put money into any public company that hasn't proven able to turn a profit.

Disclosure: No positions

Source: A Dangerous Bubble Is Emerging in China