Lottery Tickets, Made in China

12/09/2010 8:09 am EST

Focus: GLOBAL

Igor Greenwald

Chief Investment Strategist, MLP Profits

Investors in New York are so worried about the impending slowdown in China, they’ve just better than doubled the value of Youku.com (Nasdaq: YOKU) on its first day of public trading.

Youku is billed as China’s Youtube, and in common with that division of Google (Nasdaq: GOOG), it doesn’t make much—or in its case, any—money. Youku took in $35 million in the first nine months of this year but, a bit more impressively, spent $60 million. Even more impressively, it’s now trading at 40 times projected annual sales.

And then there was Wednesday’s other Chinese rocket, E-Commerce China Dangdang (Nasdaq: DANG), peddled as China’s Amazon.com (Nasdaq: AMZN). Except that a market that turns up its collective nose at US megacaps selling for 10 times earnings had no trouble paying more than 100 times earnings for Dangdang. Amazon fetches a comparatively pedestrian 39 times earnings.

Manhattan natives haven’t been this excited since Peter Minuit supposedly spilled his beads.

Wall Street’s trading tribe must have its reasons for the warm welcome, but it’s not because the last lot have been so hot. After initial gains almost as heady as Youku’s and Dangdang’s, Chinese real estate portal SouFun (Nasdaq: SFUN) is down 19% since Nov. 11. Country Style Cooking (Nasdaq: CCSC) topped out on Oct. 25 at twice the share price of its initial public offering and has lost 38% since. Several Chinese listings in New York have been rocked by questions about their accounting and business practices, though the damage seems to have been confined to the particular companies.

Consider the Alternative
So what’s propelling Dangdang and Youku, besides comparisons to US Internet success stories? Just one thing: growth. Dangdang’s sales are up 56% year over year, and its market in terms of Chinese online spending is likely to boom for years to come. Youku’s visitor count is up 53% from last year. The momentum crowd aims for home runs instead of singles. People are paying up to see what these companies might become a decade from now, in the hope that they’ve found the next Tencent (Hong Kong: 0700) or Baidu (Nasdaq: BIDU).

Contrast the promise of such crazy upside with what the world’s least popular securities now offer. That would, of course, be the sovereign bonds of the most economically wounded European states. Not only are their economies not growing, they’re doomed to shrink if governments comply with the austerity conditions Germany and the rest of the European Union have set in exchange for their costly “aid.”

Dances With Wolves
To buy this debt alongside the European Central Bank (ECB) you’d have to believe that Germany, which spent the past week enthusiastically saying Nein to every proposal made by its needy allies, will suddenly and inexplicably capitulate and sacrifice its good credit on the altar of unity. There’s a better chance of Angela Merkel doing a flamenco with Brian Cowen.   

The yawning gulf between what Europe needs and what Germany will approve is currently being bridged by the ECB, which is buying Irish and Portuguese bonds in increasing and temporarily sufficient quantities. Still, Germany has decreed that the ECB shall not conjure money out of thin air in the manner of the sinful Anglo-Saxons and the luckless Japanese. It’s just not clear on how else the austerity-stricken, growth-challenged debtor states are supposed to borrow what they need to get by.

Eyes on the Prize: Cash Flow
Perhaps the view is different from Berlin and from the boardrooms of the overleveraged German banks. But bond buyers clearly can’t stomach Irish and Iberian debt stripped of long-term European guarantees and further impaired by these states’ reliance on the overpriced euro and Germany’s insistence on collecting its banks’ debts at face value.

Bond buyers by and large don’t care how naughty the issuers have been in the past—witness Russia and Argentina. They want to know about future cash flows that will ensure repayment to them. In the case of Ireland and Portugal, those cash flows are currently estimated at whatever austerity won’t choke off and earlier creditors will not extract. Put like that, Dangdang starts sounding like a bargain.

The truth may well lie somewhere between Tom Slee’s relatively optimistic eyewitness report and Michael Shulman’s much more sobering analysis.

In the same vein, the investing sweet spot—that optimal trade-off between risk and reward—probably resides somewhere between Irish bonds and Chinese IPOs. It may well live near the junior Canadian oil and gas producer recommended by Roger Conrad, which is paying an ample dividend while also investing heavily in future cash flows. Or perhaps it’s with the UK trades publisher flagged by Deborah Owen, which is trading at less than 11 times next year’s earnings. Odds are, it’s got a more credible business plan than either Youku or Ireland.

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