When a new stock jumps 71% in its first hours of trading, it tells you that someone has blundered. Either the investment banks doing the float have got the valuation wrong, or the buyers are getting carried away. The problem is knowing which it is.
That’s what we saw with Renren, a new Chinese IPO in New York yesterday. It priced at the top of the offer range at $14, soared to $24, before closing on $18. At that price, the firm – still loss-making – is valued on 92 times last year’s sales.
Is this just a case of China mania? Or the second coming of the dotcom bubble? Perhaps both. Renren is a social media site along the lines of Facebook. And with Facebook not yet public, this looks like the next best thing to tech investors, as well as luring those bullish on China.
But does it make sense to buy a stock like this? No. In fact, I typically avoid Chinese stocks listed in the US anyway. Here’s why.
Is Chinese tech in a bubble?
Renren is not the only Chinese tech stock trading on a steep-looking valuation. A number of other major firms have gone public in the US or Hong Kong in recent years.
They include Baidu, which is the dominant search engine on the mainland, far ahead of Google. Alibaba is a business-to-business trading platform (the parent company also owns eBay- and Paypal-like businesses, but these aren’t part of the listed company).
Sohu, Sina and Tencent are internet portals, offering search and news and services such as online gaming, blogging and instant messaging. Ctrip is an online travel agent.
More recent arrivals on the market include Dangdang, an online retailer in the Amazon model; Qihoo, which offers ad-supported browsing and security products; and Youku, a video sharing website.
The issue with most of these companies is that they trade at reasonably punchy multiples, as the table below suggests. So do they offer any value or is this another tech bubble?
Selected major Chinese internet stocks and US peers
| P/E | Est P/E | Price/sales | |
|---|---|---|---|
| Alibaba | 39.2 | 29.2 | 10.4 |
| Baidu | 76.6 | 51.7 | 34.7 |
| Ctrip | 44.7 | 30.7 | 15.3 |
| Dangdang | 7,383 | 260 | 5.1 |
| Qihoo | 557 | n/a | 56.7 |
| Renren | loss | loss | 92.4 |
| Sina | 140 | 69 | 18.1 |
| Sohu | 23.7 | 18.5 | 5.4 |
| Tencent | 39.9 | 29.3 | 16.4 |
| Youku | loss | loss | 100 |
| Amazon | 86.6 | 59.6 | 2.4 |
| Expedia | 16.8 | 13.3 | 2 |
| 16.9 | 15.8 | 5.5 | |
| Yahoo | 23.9 | 22.4 | 4.1 |
Source: Bloomberg
For me, valuing tech companies is very difficult. Why? Because the successful ones can scale up very quickly in a way that makes their initial price look stupidly cheap.
Let’s take Google. When it listed in 2004, I knew it was a good business, but I thought it was too expensive. But in retrospect, buying in even when it hit a price to earnings (p/e) ratio of 85 a few days after listing would have turned out to be a good deal, delivering an annualised return of around 25% to date.
The other great US success is Amazon, where you could have bought in at almost any point and still made a profit (eventually). It recently passed its dotcom era peak. The fact that it’s currently on a trailing p/e of 87 suggests to me that there may be some irrational exuberance creeping back in – but I may well be proved wrong again.
But for every success like this, there are many more that flamed out. A few, such as Yahoo, are still kicking around and still making money – but have never justified the price tag put on them initially (see chart below). Most are gone completely.
And that’s the problem. The winners win big. The losers fail miserably. And for a non-specialist like me, it’s hard to judge who will come out on top. In fact, it seems to be pretty hard even for those immersed in the tech industry.
Picking the winners is a tough job
There’s no doubt that there is huge potential growth in the Chinese internet market. And government policy is helping Chinese firms take the lead in most niches. The desire to censor means that they want homegrown players who are compliant when needed.
Renren only exists because Facebook is banned in China. Baidu has been helped by Google’s disputes with the authorities.
Some of the big Chinese names have already done very well for shareholders, despite high valuations. Baidu was on a p/e of over 100 in 2007 – but justified it with earnings that have risen fivefold since then.
Other stocks such as Sina, Ctrip and Tencent have also shown outstanding growth. Tencent listed in 2004 on a p/e of around 15 and has proved a phenomenal investment, returning an annualised 75% to date.
Undoubtedly some of these firms will be long-term winners. However, at the same time, there is the risk that many of today’s hot stocks may not be the big players in five years.
Technology advances: Google blew away other search engines such as Yahoo, Lycos and Excite. So do user patterns: internet portals such as AOL were the hot thing during the bubble, but few users bother with this one-stop-shop approach to browsing today.
In addition, while I think there is a good chance that firms such as Baidu, Ctrip and Tencent will endure, I’m less convinced by the newer ones. They seem chancier to me, with many still not profitable. And on the kind of prices that they’re trading at, I’m not sure you’re being rewarded for the risks.
100 times sales for Youku makes no sense to me. Closest peer Youtube is still losing money for Google.
As for Renren – well, like Facebook, gaining critical mass would give it a huge advantage. People want to be where their friends are, and, absent a giant misstep, it’s hard for another site to gain traction.
However, Renren is still competing for users with other sites such as Kaixin001, 51.com and the Tencent-owned Qzone. It’s not the dominant force in the way Facebook is, although it is considered the best-managed of its peers.
In any case, these social networking sites have yet to show how profitable they can become. Until I understand how that will play out, I’ll pass on these kinds of firms. And I know by doing so I might miss out on a huge hit – but I hope I’ll be missing out on even more enormous failures.
The growing problem with Chinese frauds
That said, one good thing about most of these China internet IPOs is that it’s fairly clear they are a real business. I wouldn’t necessarily be sure that all is above board with some of them, but investors are probably more likely to be ripped off by the valuation than by the management.
The same can’t be said of many other Chinese stocks in the US, where there are plenty of instances of outright fraud. Indeed, Renren was indirectly caught up in one, when an independent director quit just prior to the IPO over allegations of accounting fraud at another company called Longtop Financial Technologies where he is chief financial officer.
I haven’t looked at Longtop in any detail and don’t have a view on whether it’s legitimate. Some of the criticisms look as if they might be explained by the firm’s business model. But there are certainly some issues that I would want to look into very closely before investing.
The wider problem is that it’s just the latest example of a rather unsavoury business that should make all investors cautious about buying US-listed Chinese stocks, however cheap they may look.
The background is that a substantial number of small Chinese firms have come to market in the US through a reverse takeover. In this, an active business merges with a dormant listed shell company, so getting a listing without going through a full IPO. This is cheaper, and so attractive to some legitimate small firms. But it also involves much less scrutiny and due diligence than an IPO, and so is popular with fraudsters.
In fact, Longtop did not do this. It went through an IPO in late 2007. So in theory it should be more likely to be above board. And it may well be – but so far, the affair is playing out along the same lines as its less reputable peers.
By now, there is absolutely no doubt that there is a significant number of very dubious companies and outright scams coming to market in this way. The most recent is China MediaExpress, which puts advertising on buses. After a number of allegations that it may have been inflating its figures, the CFO and auditor quit – which strongly suggests that there was some truth in the rumours. Some fairly significant investors – notably former AIG chief executive Hank Greenberg – seemed to have been fooled by this one.
But dubious ethics are not confined to the management of these firms. Some advisers helping smaller Chinese listings market themselves to investors seem to be unconcerned about whether what they’re involved with is above board or not. More than one manager has told me about one fairly active broker in this area trying to sell him firms that didn’t pass muster on even a cursory inspection.
And there’s an equally unsavoury counterpoint to this: a cottage industry in publishing research alleging accounting frauds in smaller Chinese firms. That would be fine – except that the researchers publishing it often have short positions themselves in the stock (as seems to be the case with Longtop). The potential for conflicts of interest and market abuse are pretty obvious.
Chinese firms shouldn’t list in the US
There’s good cause for the Securities and Exchange Commission to look into what’s going on with both sides of this story. But for any legitimate businesses caught in the crossfire, there’s an even better solution. Don’t list in the US.
It’s very understandable that Chinese entrepreneurs want to list their companies overseas. Apart from anything else, by selling shares in a non-mainland market they instantly shift a substantial proportion of their wealth into foreign currency and can keep it offshore. China’s currency controls mean that they couldn’t simply convert renminbi out into dollars in the same way.
It’s also beneficial for foreign investors. There are tight limits on investing in the mainland ‘A’ share market, restricted to just a few qualified foreign institutional investors. Chinese companies listed abroad give the rest of us a chance to buy in.
And in a couple of industries – notably tech, like the Renren IPO – there’s a good argument that the market is better developed in the US. That means you’ll be rewarded with a better valuation: that’s not so good for new investors, but perfectly fair as far as the existing owners are concerned.
But there’s also a less salubrious reason. If you take your Chinese business to the US, the number of investors who will understand your market, be familiar with your product and read Chinese will be limited. So it will be much easier to get away with anything from overstating the strength of your position to promoting a factory that only exists on paper.
So when I see a Chinese business listed in the US, I ask myself why they didn’t list in Hong Kong instead, where local investors are better equipped to understand the underlying business. And in many cases, I suspect it’s that they are trying to pull a fast one.
The same is even true of Singapore, where investors have advantages that most Americans don’t. The exchange made a major effort to attract Chinese stocks (known as ‘S chips’) in recent years. To do so, it lowered its standards too much – and has been rewarded with an endless stream of scandals, some of which have been mentioned here before.
But in Singapore, there are good Chinese businesses amid a lot that aren’t. And because Singaporean stocks usually trade on lower valuations than Hong Kong, a diligent investor can find some good prospects there.
It looks like the situation in the US may be even worse. To the casual investor, it must look like a bunch of frauds on a p/e of 4 and some tech stocks on a p/e of 40. I’m sure there are a few bargains in the sector how – but I’d be much more willing to look at them if they starting talking about moving to Hong Kong.