A Fear-Busting China Growth Story

12/05/2011 9:45 am EST

Focus: GLOBAL

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

This Internet winner has been held down by the usual qualms over Chinese stocks, fears that are mostly unfounded in this case, writes Paul Goodwin of Cabot China & Emerging Markets Report.

My stock pick for today is a Chinese Red Chip stock that has all the hallmarks of a big winner, but whose chart says a little more patience is necessary.

The company is NetEase.com (NTES) a Chinese Web portal that offers a standard menu of Yahoo-like services, including news, blogs, search, matchmaking, social-gathering spaces, and so on. But what sets NetEase apart from other Chinese Web giants like Sina.com (SINA) and Baidu (BIDU) is that it derives 85% of its revenue from online gaming operations.

The hot items among the company’s massively multiplayer online role-playing games are Fantasy Westward Journey, Westward Journey Online II and III, Heroes of Tang Dynasty, and Datang, plus World of Warcraft and StarCraft II, which it operates under license from Blizzard Entertainment. Game revenue comes from playing-time fees and from the sale of in-game items.

The company’s revenue growth hit 49% in 2010, and averaged 40% for the first three quarters of 2011, while earnings growth for the period averaged nearly 61%. After-tax profit margins have topped 40% for the last six quarters.

The company has no long-term debt, and the stock is liquid (trading over a million shares a day) and sports a laughably low P/E ratio of 13.

So why isn’t this a screaming buy right now? NetEase has the power to move big, but is now trading at about the same level it attained in September 2009. The culprits are the usual suspects: general market weakness, fear that the Chinese government might initiate another one of its occasional crackdowns on playing time (just like parents in the US!), and a general distrust in the reliability of Chinese reporting.

So when should you buy NTES? NTES looks like a high-quality bargain, but the chart counsels caution, probably in the form of a tight sell stop.

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