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I just bought Perfect World Co., Ltd. (NASDAQ:PWRD) at $10.27. The reasons are somewhat similar to what drove me to buy Changyou.com Limited (NASDAQ:CYOU) about 10 days ago. Let's go over them.

Trust

The main issue with buying any small or medium capitalization Chinese stock is trust. There are an incredible number of frauds out there, where the numbers the companies present are fake down to the cash on the balance sheet. If you can't trust the numbers, then saying the companies are cheap is meaningless.

So before being able to buy any small/medium Chinese stock, one needs to have some kind of trust that it isn't a fraud. In the case of Perfect World, I got the needed trust from reading a fellow author's article, Omar Altay's "Perfect World - A Perfect Buying Opportunity".

In the article and comments, Omar leaves several arguments that lead me to believe the company is for real, from having tested the games, to the auditor, to having bought advertising in the company's proprieties. Also, Perfect World has already paid a generous cash dividend and bought out a foreign company (Cryptic Studios) - these are actions that lend credibility to Perfect World's cash hoard existing.

In short, there are good reasons to trust Perfect World as being legit. This allows us to concentrate on the company's merits and valuation. If such trust was not present, then we couldn't justify buying the shares at any price.

Valuation

Due to the large amount of fraud in Chinese equities, many companies got slaughtered to levels unthinkable in the West, given published fundamentals. Perfect World was one of them.

Presently, PWRD trades with a TTM P/E of 3.5 and a price/book value of 0.9, while carrying a 25% ROE. PWRD has a market capitalization of $488 million, while carrying cash and investments of around $400 million in its balance sheet as of March 31 2012 (net of debt).

Growth

There are two main risks affecting PWRD. One is that China might be slowing down. As I explained in the Changyou article, I believe this risk is somewhat overblown in that China's slowdown is also a transition from an investment-led economy to one that's somewhat more focused on consumption. Gaming is consumption, not investment, so stands to benefit from the transition.

The other risk is the obvious high level of competition that's hitting the Chinese online gaming market due to its attractiveness. This has stomped on growth (PWRD is presently stagnated in terms of revenues, though it continues to be very profitable). Still, PWRD is working towards launching new titles and the gaming marketplace does have some network effects, which means that players that control a large gaming population, such as PWRD, are more likely to continue controlling that population and even growing.

Conclusion

I believe buying PWRD is a decent opportunity to buy into a deeply undervalued, profitable, and cash-rich company that, due mostly to temporary factors, is trading at these attractive levels.

Source: Why I Bought Perfect World