China and the Internet: Bubble or Opportunity?

08/28/2014 10:00 am EST

Focus: STOCKS

James Oberweis

President, Oberweis Asset Management, Inc.

Fifteen years since the peak of the dotcom bubble, investors are asking if this is just a dangerous new bubble or an opportunity to jump on the growth of tomorrow’s titans, questions Jim Oberweis, money manager and editor of The Oberweis Report.

To get to the answer, it is worth comparing today’s environment to the last “bubble” of 1999. In the last 15 years, the number of global Internet users has exploded. Today, there are 2.9 billion global Internet users versus just 300 million in 1999.

China has twice as many Internet users as America, and 80% of China’s users access the Internet via smartphones. Mobile traffic globally, which comprised only 15% of Internet traffic in 2012, now represents over 25% and it should eclipse 35% in 2015.

The developed world is already online, emerging countries are catching up quickly, and mobile Internet is gaining traction at a staggering pace. In short, the market potential for many Internet businesses is exponentially larger than in 1999.

The light bulb went on a couple of months ago when we were meeting with the management of a Chinese company called Tarena International (TEDU). Tarena is the leading provider of IT professional education in China.

Their business model is fairly straightforward: Hire the best teachers, have them lecture from Beijing to Tarena students around the country, and augment the lectures with localized teaching assistants. With this type of business model, courses such as Tarena’s C++ class can be taught with only one lecturer.

For massively distributed content, theoretically, the best lecturer should get paid a ton and everybody else should get fired. In 1999, this model wouldn’t have worked because the population wasn’t online.

With today’s super cheap, fast, and widely available distribution capabilities for online content, new industries will be disrupted in ways that weren’t plausible then. Obviously, the economics of education change dramatically if the cost of instructors becomes immaterial as a percentage of education revenue.

The second difference is scale. More than ever, the market leader wins. For Tarena, the strongest brand attracts the top lecturers, who attract the top students. More students help to spread the fixed lecture costs over a larger base, driving up operating margins.

VipShop Holdings (VIPS) sees the same network effect for online discount retail in China—customers want brands and the brands want as many customers as possible. It’s the same for Google, Alibaba, Baidu, Tencent, and Amazon.

Scale and market leadership have always been key for Internet stocks. But with three billion Internet users instead of 300 million, the reward for a winning concept with market leadership is far greater (and so, the appropriate price for that lotto ticket should also be higher).

By all metrics, today’s Internet valuations remain a pittance compared to those of 1999. Even if there are pockets of what appears to be froth, a premium short-run P/E may be a low price to pay for exceptional Internet scale and a keen focus on franchise monetization.

Niche companies—even hybrid technology firms like VipShop and Tarena—seem well-positioned. China’s sheer size and far faster growth rate justifies a premium, as do businesses that are well-situated to adapt to mobile.

It’s easy to dismiss the premium valuations of Internet and social media; in fact, we are often the biggest of skeptics. Still, for the market leaders and the profitable niche leaders that surround them, you just may get what you pay for and maybe a lot more.

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