“My No. 1 China stock for 2015”

What's the "last man standing" among China stock newsletters teasing now?

China stocks are back, but China newsletters not so much. That’s a little bit unusual, actually — typically, newsletter publishers are quick to produce new “niche” letters or repurpose faltering letters to take advantage of big swings in the market, and just as quick to shut those newsletters down if that “niche” loses the interest of investors.

Chinese stocks have been on a tear of late, particularly the domestically traded shares as represented by the relatively newly available ETFs like the China A Shares tracker (ASHR) but also the large-cap Hong Kong-traded names like those that dominate the much older FXI ETF. And still, there’s really only one substantial China-focused newsletter from a major publisher. During the China bull market, there were probably a half-dozen pretty large China-focused (or “Asia”) newsletters — but most of them disappeared or got absorbed into other, more general letters, and these days I only ever hear about one, the China & Emerging Markets Report from Paul Goodwin at Cabot. That was one of the “hot” ones back in the 2007ish China bull run, and apparently it’s the only one of the China guys to survive the multiple crashes of Chinese stocks since then and emerge to take advantage of the big run Chinese stocks have had over the past year or two (and the last six months, particularly).

That doesn’t mean other folks haven’t been touting Chinese stocks — we see them teased from time to time, and I know Steve Sjuggerud over at Stansberry was riding that ASHR trend for a while (and may still be, I don’t know) — but China enthusiasm is surprisingly muted when it comes to our daily harvest from the field of teaser ads. Maybe no one wants to bet on stocks that look like they might be about to get altitude sickness, maybe they just don’t trust China after the many scams and collapses we’ve seen over the years, but it’s pretty rare that we see any China mentions beyond the occasional chatter about giants Alibaba (BABA), China Mobile (CHL), or Wynn (WYNN) and Las Vegas Sands (LVS).

So when I saw Paul Goodwin out with a teaser pitch about his “#1 China Stock” I thought, well, why not? Let’s look and see what it is.

(Last time I noticed him teasing his favorite China stock it didn’t work out all that well, by the way — so keep your enthusiasm under control. About a year ago he was pitching 500.com (WBAI), the Chinese sports lottery operator — I assume he’s probably out of that stock now, since Cabot newsletters generally follow some technical trading guidelines and wouldn’t likely hold a collapsing stock, but it’s down about 50% from then (and was much lower a few weeks ago) as earnings growth has failed to materialize through a couple weak quarters. Haven’t checked up on the details, but, as we said at the time, the government can step in and change that business anytime they want to, so perhaps regulatory pressure has hit a bit. Cabot China & Emerging Markets did beat the broad market in 2014, with about a 10% return according to Hulbert… though the ad highlights only the huge winners they’ve had, of course.)

Here’s how the Cabot folks pitch this one:

“Forget what you’re reading in the financial media about China’s great growth machine slowing down.

“Apple just reported a $16.1 billion windfall in China sales in January.

“That windfall gave Apple its biggest quarter in the company’s history—increasing its overall profit to $18 billion on $74 billion in total sales.

“That’s a whopping 70% rise from the same period a year ago—all from sales from a country that pundits are calling ‘dead’ ….

“… the financial media is missing this story by a country mile for two reasons:

“The S&P 500’s new high plays directly into the conventional wisdom that the big money will always be made in U.S. stocks, and

“Making money in China stocks has been Wall Street’s version of ‘The Boy Who Cried Wolf’ since the 2009 sell-off.”

OK, so that’s the big picture idea — that China’s still growing and rewarding investors, but no one believes it yet. What about the stock he likes now? Here are our clues…

“… experts estimate the global gaming market will reach—hold on to your hat—a whopping $109 billion in 2017. The biggest rise is coming in the mobile gaming sector, especially in China where that sector is experiencing an average 35% year-on-year growth rate….

“… our top China gaming stock has jumped 110% over the past 12 months as its revenues have risen by 43%.

“That’s just over the short term. Over the past five years, this company’s stock price has skyrocketed as well—rising 390% and outperforming U.S. gaming juggernauts Activision/Blizzard and Electronic Arts by as much as 250%.”

OK, so it’s a hot gaming stock in China. There are a handful or so of those — which one?

More clues:

“It owns the No. 1 grossing gaming application with 2 million users.

“The company is bringing America’s most profitable gaming to China, through strategic partnerships that will give the company exclusive rights.”

And…

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“… this company is China’s leading player in the online search sector, which generates hundreds of millions of dollars monthly.”

And finally…

“… the company has nearly $4 billion in cash to fund new projects and acquisitions, and that institutional and mutual fund investors own 55% of its stock….”

So, who is it? Thinkolator sez… drumroll please! This is Netease (NTES), one of the early Chinese gaming companies who helped to build the massively multiplayer online role-playing game (abbreviated MMPORPG — think “World of Warcraft” and their ilk) business in that market (I owned the stock for a while, but that was probably a decade ago).

They were, much like the US gaming companies (or Hollywood studios, for that matter), driven largely by their ability to develop (or license) a few hit/blockbuster games and milk those franchises, which made earnings a bit lumpy (not every release was a big hit, or came out on time). To some extent that’s still true, though they’re substantially larger and more diversified now — and, perhaps most importantly, they’ve been a bit behind their competitors in building a meaningful presence in mobile games, but after a couple years of investment they’re finally building that business nicely now, and mobile revenue helped them to beat earnings estimates quite handily a couple weeks ago.

And yes, it’s a perfect match for the tease — they do have a large cash pile, close to $4 billion (that’s more than $25 per share, shares have recently been near all-time highs at about $145 and peaked around $150 a few weeks ago). They did post 43% revenue growth last year (though now, with another strong quarter reported, the year-over-year revenue growth stands at about 55%). And depending on what date you use, the stock has gone up roughly 110% over the last year (as I type, it’s up 107% for the past 12 months). And their biggest hit game (for the past decade or so), Fantasy Westward Journey, has been successfully turned into a mobile game and a big hit in the iOS app store, and recently reported 2 million concurrent users for the game, so that’s a decent match for the “two million users” clue (though they obviously have far, far more customers than that). And they are licensing in hot games from Western developers, notably Hearthstone (a Warcraft game, they’ve been the Chinese licensor of World of Warcraft for years) from Activision Blizzard.

I can’t tell you whether NTES will keep up this torrid growth, I’m afraid, but the analysts are trying to catch up with the pace and have bumped estimates up for both this year and next year, and the shares are trading at a pretty reasonable growth multiple of 20X 2015’s expected $7+ in earnings per share (about 17X the $8.50 or so that’s expected for 2016) if you are confident that they can keep up the 20%+ earnings growth that’s forecasted. The only real chink in the armor of late has been huge spending increases, but they do have the money (that cash hoard) and the spending has apparently been necessary as they’ve ramped up mobile game development and sales activity to spur revenue growth… but if the spending keeps increasing much faster than revenues, as it has recently, that would eventually catch up with them. I don’t think anyone’s terribly worried yet, partly because they’re launching so many new products and doing well with them, and because mobile games in general have lower margins than their core PC games, but if there’s anything analysts will poke at in the next couple earnings reports it will probably be growth in SG&A expenses.

If you account for the cash pile, incidentally, the valuation starts to look even more reasonable — net cash is roughly $27.50, so if you take that off the top you’d get about $117. With $8.50 in earnings next year, if they can hit that, you’re looking at an ex-cash PE of about 14. Certainly no guarantee of success, and stocks that rise this dramatically are often scary to buy, particularly in volatile sectors or in controversial markets like China, where you might want to add more “margin of safety” to your calculations about future growth possibilities… but that’s not a bad price to pay for 20% earnings growth in a hot sector and a growing consumer market.

I don’t know a lot about NTES or their product development cycles or end market, and I don’t think I’ve looked at the stock in any great detail since 2006 or so, but that’s quite a bit cheaper than the megacap Chinese internet names like Tencent (TCEHY) or Baidu (BIDU) (two more stocks I can regret selling way too early, yay!), so if you like Chinese mobile gaming it’s probably worth doing some research on Netease.

P.S. It doesn’t really apply directly to NTES, but there’s a good recent article in the Economist here about the crazy, obvious bubble valuations of many of the small, domestically traded stocks… quite reminiscent of the NASDAQ bubble valuations of 1999.


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Eric
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Eric
June 4, 2015 9:16 am

Yea, a stock I actually own, and the best I ever bought. This was teased 7 or 8 years back by Motley Fool Rule-Breakers and is up 12X since. I can’t say it would be a good buy now, but it might be. Mobile gaming is big business in China, and it seems to have grown pretty steadily over the years. But has the valuation been pushed up in recent months because of the overheated domestic stock market?

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jack
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jack
June 5, 2015 1:11 am
Reply to  Eric

Thanks for your take on it Eric. I subscribed to several Motley Fool letters including Hidden Gems a long while back. Never had much luck with them. Glad your experience was different. I like NTES, am way late to the party, but still nibbled a bit. Down a few percentage points thus far.

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