China's dotcoms: handle with care

These days everyone seems to love China and everyone loves the internet. So it's no surprise that the City's analysts are recommending China's internet sector. In the last few months, as Joe Leahy points out in the FT, market leaders such as Yahoo, Ebay, Amazon and Google have been adding fuel to the fire by pouring into the sector (Yahoo bought 40% of Alibaba, the country's biggest business-to-business e-commerce site, Ebay has bought online auction house Eachnet and Google has acquired 3% of Baidu, China's most popular search engine). This proves, say the bulls, that not only are Chinese internet businesses growing at almost unimaginable speeds, but Chinese cyberspace is about to be the target of a land-grab' by giant Western companies all desperate for a piece of the action. That means investment portfolios simply have to have a direct China play or two. As Ebay boss Meg Whitman put it: "Whoever wins China will win the world."

Given this level of hyperbole, it somehow seemed inevitable that the cheerleaders of the original dotcom bubble would soon turn up to hype the sector's stocks. And so they have. Morgan Stanley analyst Mary Meeker, a name virtually synonymous with the millennial market mania surrounding internet stocks, last week published a very bullish report on China's internet sector. Her case in a nutshell is that China is the world's fastest-growing economy and the internet is its fastest-growing industry. Put the two together and bingo! you've got the world's biggest growth opportunity. Meeker's favourite area is online gaming, which is showing spectacular growth of 37% a year, with brand advertising and mobile value-added services provided by internet operators not far behind, at 24% and 28% a year, respectively. She also likes online commerce, including travel, instant messaging-related services, and auctions. Her message makes some sense: last year only 7% of China's population used the internet, but given that the number of users is rising by about 18% a year, the potential is obvious.

However, investors must proceed with maximum caution. For one thing, the Chinese internet boom is already reminiscent of the last internet bubble. Take Baidu. The stock may be below its high of $154, but it is still hovering around the $80 mark, three times its $27 initial public offering (IPO) price. Even though Meeker does not cover Baidu, her bubbly report helped push the search engine stock up 16.6% on Monday. Yet in a rare show of an ability to grasp reality, or perhaps just of candour, even the two houses that managed its IPO Goldman Sachs and Piper Jaffray have released reports saying it is overvalued. The numbers may be impressive China has the second-biggest internet community after the US, and Baidu accounts for about 40% of the search market, while Google has a quarter. But with Baidu currently on an estimated p/e of 298 times, it's no surprise that both brokers reckon it is overvalued, and placed sub-$50 price targets on the shares.

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Still, even Mary Meeker reminds her readers that investing in emerging sectors (the internet) in emerging markets (like China) is always "fraught with risks and challenges". Wise investors will take this health warning seriously. While China's fast-developing internet sector clearly offers huge opportunities, it is as ever the individual risk profiles and valuations of companies that matter. Many firms will aim to win in this market, but only a few will ever justify their valuations.

The best shares in the sector

Mary Meekers top picks all new and volatile stocks include Ctrip (CTRP, $62.9) and Tencent (TCEHF, $1.07). Ctrip is one of the biggest beneficiaries of "rising consumption power" and travel in China. Its focused approach makes it a dominant player in the travel industry. The shares trade on a relatively high p/e of just over 40 times, but on a more reasonable sounding price-to-growth ratio (PEG) of 1.24 times. Tencent is the "powerhouse" behind China's rapidly expanding instant-messaging market, with over 60% of user share. It has successfully grown profits in internet value-added services and is driving earnings through online gaming and advertising. On the downside, the shares trade on a p/e of more than 30 times and a PEG of over two.

The Disruptive Investments newsletter suggests Nasdaq-listed Sohu.com (SOHU, $16.60) as a very worthwhile investment. Sohu does not yet have the same high-profile or market share as Baidu, but it does have a "comprehensive matrix" of web properties, including that "magic" search-engine element. The China story is all about future revenues from advertisers looking to promote their brands via general and sponsored search engines. And with an undemanding prospective p/e of under 15, and predators on the prowl, Sohu shares really do look attractive.