Chinese internet stocks have been the hot investing topic in 2011, but it is just this type of hype that gets many investors into trouble. The thought of making a quick profit in a hot sector often leads to investing in over priced, over hyped stocks while ignoring the tried and true precepts of investing.
I have been bullish on this sector for a while now and have profited from the rising prices, but in recent months the hype has gotten out of hand, and I think a high level of caution is now necessary.
In May we saw this bubble begin to burst with some of the big names such as Baidu (BIDU), Youku (YOKU) and Sina (SINA) falling from their blow-off top highs. The RenRen IPO (RENN) was met with a lot of skepticism and showered a dose of reality onto the party. It could be an indication that the rampant speculation that was driving prices higher is now turning into a more cautious stance. The question now is: How should investors position themselves between the potential bubble bursting and the potential for continued long term profits in this space?
As a long term investor, the things that matter most to me are the earnings/revenue numbers and the quality of management. I'm not big on speculation and "what ifs". For example, if we look at two stocks, Baidu and Youku, we see vastly different stories. With Baidu we get real profits, explosive revenue growth, true market leadership and a commanding position in the most lucrative sub-sector within the Chinese internet sector.
The company also seems to be in good hands under CEO Yanhong Li and the rest of the management team, who have avoided many of the missteps that have plagued other Chinese stocks. Baidu has not had accounting irregularities or PR nightmares like many other Chinese firms and the company seems to be very focused on accessing new markets (Japan) and delivering new products (Qiyi and an upcoming mobile operating system and web browser). This is just the type of forward thinking that investors should be looking for.
With Youku, there is mostly speculation. The company is losing money, trades at nearly 70 times sales and faces stiff competition in the online video space. At the height of the insanity, Youku was valued as a $6.5 billion company (currently valued at about $5 billion), both of which are insane. Revenues have been growing quickly, but costs have been growing as well and it could be a long time before YOKU reaches an operating profit.
Another comparison is Sina (often called the Twitter of China) which is trading at 17 times sales with a market cap of about $7.5 billion. Sina seems to be more of a Baidu than a Youku since it is the clear leader in an important (although highly censored) position as 'the Twitter of China'. Since it is not yet posting profits, it falls into a gray area between the real money makers and the castles in the sky, but Sina looks poised to reach profitability soon and should continue to grow revenues at a nice clip. It has a powerful first mover advantage and the market opportunity is potentially huge.
There is added risk investing in this space due to the unpredictable behavior of the Chinese authorities and the wide spread censorship of the web in China, but for some of the high quality companies like SINA and BIDU, these risks are balanced out by the vast market opportunity.
Yes, even these quality companies are richly valued, but I would argue that they deserve their premium valuation. Baidu has traded for over 100 times trailing earnings for much of the past 3 years, during which time the stock was up over 1,000%. As the company grows, saturates the market and the law of large numbers begins to take effect, a more reasonable multiple is to be expected but it will likely be a few years before we see Baidu trading at a P/E below 30.
There is still a ton of growth in the fledgling Chinese internet space and Baidu is the company in the best position to profit from this growth. The company is also looking to expand abroad, diversify their product offerings and continue to refine their market leading search engine and advertising platform. There have also been rumors of a partnership with Facebook as both companies look to put a dent in Google's (GOOG) commanding lead in search.
The Chinese internet space has been red hot for the past year and many investors will get burned by coming late to the party, but there are still good profits to be had for patient investors who avoid the castles in the sky and invest in companies with firm foundations and real profits.
There has been a lot of hype and some bubblicious valuations, but the fundamental story remains intact: China is the world's largest internet market by number of users with many exciting new companies. At a time when the hype and speculation have reached a fevered pitch, investors would be smart to take a very cautious approach. But for those who are able to stomach the risk and volatility, I would recommend buying BIDU at $130 or lower and keeping a close eye on SINA. Any major pullback in these names could be a good buying opportunity.
Investing in the stock market is like walking a fine line; it's a balancing act between optimism and pessimism, between profits and potential. It's easy to get excited by the promise of huge profits and stock market gains, but many of these new and exciting companies will come crashing back to reality. In these cases, the words "new and exciting" could be replaced with "speculative and over-valued". Only buy into the names with real profits and firm foundations. Some of the speculative names may end up doing very well, but it is better to miss a stock than to gamble on "what ifs".