INTERNET: China Internet Sell-Off in US Fueled by Panic, New Realism

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Bottom line: The recent sell-off for US-listed Chinese Internet stocks represents some panic selling but also a more realistic view of these companies by western investors, and could presage a modest rebound for their shares.

New investor realism towards China Internet stocks

After all the turmoil on China’s stock markets over the last 2 weeks, I thought it was finally time to take a closer look at what’s happened to shares of US-listed Chinese Internet companies and give my view on what’s happened and what might happen next. I was quite surprised when the selling frenzy in China over the last 2 weeks spread to US-listed Chinese shares, since names like Baidu (Nasdaq: BIDU) and Alibaba (NYSE: BABA) seemed like they were being punished even though they never benefited from the massive price gains seen by many of their Chinese peers over the last year.

But after moving in tandem with China’s stocks over the last 2 weeks, US-listed Chinese shares finally broke the cycle and posted strong gains on Tuesday, even as the main Shanghai index slid another 7.6 percent. Some will say that US investors were acting in response to a surprise interest rate cut by China’s central bank after Chinese markets closed on Tuesday, and that may be partly true. But I also believe that their selling over the last 2 weeks reflects a new realism by US investors about China’s growth prospects, and that investors have also woken up to the biggest truth that governs China’s stock markets.

Put simply, that truth is that China’s stock markets are like a casino where people simply  trade based on random reasons, such as market rumors or recommendations from friends. Accordingly, the market is highly prone to big swings and volatility when sentiment is strongly positive or negative. Most of the rest of the time it moves mostly sideways due to low volume and activity dominated by small day traders who make their decisions based on the latest gossip.

I wrote earlier this week that the recent volatility in China shows why New York is still the best place for well-run Chinese Internet companies to list, and I continue to stand by that belief. (previous post) But to better illustrate that point, and to show why many premier US-listed Chinese companies could be poised for a rebound soon, let’s take a look at some of the numbers.

We’ll begin by looking at the Shanghai composite index, which rose by about 150 percent from its levels a year ago to a ridiculous high in June, even though such a run-up had no basis in any reality. If the market was behaving rationally, stocks should have actually fallen during that period due to growing signs of a slowing Chinese economy, which would have translated to weakening company profits.

Still Ahead After Sell-Off

And yet following the sell-off that began in June and included another 25 percent drop over the last 2 weeks, the Shanghai composite index is still up 34 percent from where it was a year ago. By comparison, shares of 2 of China’s top Internet companies, Alibaba and Tencent (HKEx: 700), are unchanged from a year ago, while Baidu is down 37 percent.

Of those big 3, Baidu has lost 21 percent of its value over the last 2 weeks, while Alibaba and Tencent have lost 14 percent and 8 percent, respectively. While the sudden drops look somewhat severe on the surface, I’ve argued for a while that Alibaba’s shares were overvalued and needed to come down to their IPO price, which is where they are now. Tencent was always an overlooked stock, perhaps due to its low profile and Hong Kong listing, which explains why it’s suffered the least over the last year.

Baidu’s recent major declines are among the most severe, and have pushed the stock down 37 percent below year-ago levels. But that reflects the very real fact that investors are increasingly worried that Baidu is playing a dangerous game of trying to outspend its rivals to win market share in new areas outside its core search business. That is eroding its profits, which is never a good sign for such a young company.

At the end of the day, the sell-off for US-listed Chinese shares looks reasonable not because it came in sync with the China-based sell-off, but because it marked the end of an unrealistic western expectations for these companies. The latest sell-off means that valuations for these shares are now much more realistic. That means we could expect to see shares for many of these companies rally a bit towards for the remainder of the year, as investors seek out bargains in this new era of more realistic expectations for Chinese Internet companies.

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