“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett
Chinese ADRs have been punished over the past several weeks due to a possible Greek default, Chinese government regulation on VIEs, Department of Justice’s (DOJ) investigation on US-listed Chinese issuers for accounting irregularities, and a possible hard landing of the Chinese economy.
While it is possible that Greece might enter an “orderly default,” the fear over VIE regulation, DOJ investigation, and China’s hard landing is greatly exaggerated. In a recent media report, listed Chinese companies, including Baidu (BIDU), Sina (SINA), and Sohu (SOHU), are likely to be exempted from VIE regulation. According to an anonymous source inside China Security Regulatory Commission (CSRC), top leaders in China would likely apply “old rules to old companies, and new rules to new companies.” Many overseas-listed Chinese firms use the VIE structure and the combined market capitalization of all Chinese firms in the US is estimated to be over $900 billion. By banning VIE, Chinese government would harm companies worth billions in foreign markets, and would be under strong international criticism as it tries to win global recognition by launching the international board later this year or early next year. Unless China wants join North Korea to become a Hermit Kingdom, it is unlikely that the Chinese government will “crack down” on the current overseas-listed companies.
In regards to DOJ’s investigation of the U.S.-listed Chinese issuers, it is likely that DOJ is targeting companies that are listed on the U.S. exchanges through Reverse Takeover, or RTOs, because they account for a majority of delisted Chinese companies. The quality Chinese companies that were listed via IPO and have a well-defined business model, strong brand credibility, and recognized auditors are unlikely to be under DOJ investigation
Finally, many fear that China will experience a hard landing. The recent Chinese PMI indicates otherwise, as service industry rose 59.3 from 57.6 in August. Also, many investors fail to recognize that China is a politically-driven economy rather than market-driven economy. In order to create a stable labor market, the Chinese economy must grow at least 8% annually. Failure to do so would result in high unemployment rates that would spur social unrest among the estimated 150 million migrant workers. Social unrest is the Chinese government’s biggest concern, because throughout history we have witnessed social unrest topple governments around the world (The French Revolution of 1789, the October Revolution of 1917, the fall of Soviet Union, and the current revolution in Libya, just to name a few).
Simply stated, the Chinese Communist Government will to whatever it can to achieve a GDP growth of 8% to avoid social unrest in order to stay in power. Based on the efficiency and decisiveness that the Chinese Communist Government has shown in response to the Financial Crisis of 2008, it is likely that China will not experience a hard landing in the foreseeable future.
The recent fear in the market has pushed many companies near their 52-week lows as the stocks are priced for the worst case scenario. However, it is unlikely that such a scenario can occur, thus the current valuations of the following seven companies offer a compelling attractive entry point.
Sohu (SOHU)’s lack of leadership in the web portal, online gaming, online video, and online search has weighed on the stock price over the past several years. Many investors do no appreciate Sohu’s strategy of building network externalities, such as Sogou Browser and Sogou Pinyin Input, that generate no revenue. However, in my opinion, Sohu is in the midst of a brand reinvention, and the company is building products and services that will expand its presence in online advertising. I would like investors to note that Sogou Search’s capability is gradually becoming on par to Baidu's (BIDU), and has the additional offerings of a larger music library, a wider selection of online videos, and a leading web portal. Eventually, internet users are likely to appreciate and adopt the Sogou Browser, which will drive search traffic on Sogou Search, web traffic on Sohu.com, and viewer traffic on Sohu TV. The company currently has a market cap of $1.9 billion and trades at 12x earnings. The company also boasts a strong balance sheet of $811 million in cash and no debt.
Ctrip International (CTRP) currently trades at 28x earnings and has a market cap of $4.7 billion. The company is the leader in China’s online travel agency (OTA) market. In my earlier article on Ctrip, I pointed out that the company is underappreciated by the North American investors due to their lack of familiarity with Ctrip’s product offering and its customer service. Ctrip’s focus on delivering quality customer service has allowed the firm to build a large base of loyal users, and the introduction of value added services such as Lvping.com (similar to TripAdvisor) and group deals will likely generate greater brand loyalty that will expand Ctrip’s industry standing in China’s OTA market.
Even though I questioned Renren’s (RENN) acquisition of 56.com, I am positive on the company’s secular growth and its leadership position in China’s real-name SNS. The 56.com acquisition did not significantly impact Renren’s balance sheet, as the company still has over $1 billion in cash (more than 50% of the market cap), and no debt. According to the result from last quarter, Renren has done exceptionally well in returning to profitability and the company’s initiative in social gaming and advertising sales will likely drive solid top-line growth going forward.
Focus Media (FMCN) is a forgotten leader in China’s advertising industry. The company has a market cap of $2.8 billion and trades at 13x earnings. The company is the largest digital advertising company with approximately 170,000 flat-panel displays in about 95,000 buildings located in 90 cities across China. Its customers include GM, Coca Cola (KO), Citibank (C), P&G (G), Hennessy, and Sony (SNE). The company recently announced that it would increase its share buyback program by $200 million to $650 million by the end of 2013. Since February 2010, Focus Media has bought back $315 million worth of shares.
E-Commerce Dangdang (DANG) is known as “China’s Amazon.” The company has a market cap of $368 million and has no earnings. Dangdang is a leader in China’s books and media distribution business, with over half of all China’s online book sales. In addition, the company is continuously expanding its product mix by adding general merchandise and improving user experience by establishing more distribution centers to cut shipping time. In the near term, Dangdang’s margin will likely face headwinds, but could improve in the long term as better product mix and increasing sales are likely to cause incremental margin expansion.
New Oriental Education and Technology (EDU) is China’s largest private school that specializes in language training and exam preparation. The company has a market cap of $3.6 billion and trades at 35x earnings. New Oriental's competitive advantage lies in its brand equity, broad network, and solid management. Currently, New Oriental has over 1.6 million students enrolled in its 456 schools nationwide. The company has established a strong brand in English training and is now looking to expand its elementary school programs and overseas education consulting services.
TAL Education Group (XRS) is another leading education player that is often overlooked by many investors. Unlike New Oriental which caters to the masses, TAL Education Group is extremely selective in its student enrollment and provides high-end academic after school tutoring services. The company has a market cap of $750 million and trades at 26x earnings, and will report second quarter FY2012 on October 25th.