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The Latest Investment Victims of the Chinese Government

By Larsen Kusick, analyst, Phase 1 Investor
Monday, December 19, 2011

Just as I warned you six months ago, the crowd is getting soaked in Chinese "glamour stocks."
Back in June, I warned readers about the breakdown in Wall Street's favorite China stocks... the Chinese "Internet plays." These stocks include Baidu, Sina, and Sohu. These are companies with services similar to U.S. companies like Google, Yahoo, and Twitter.
I said, "Based on the exuberance in Chinese Internet stocks, these names could fall a lot farther... I wouldn't be shocked to see these stocks return to last summer's levels."
It turns out that the declines are as bad as I feared. Sina and Sohu have been crushed. They're down about 40% in the past six months. Shares of Baidu fared better – down just 5%.
But these stocks aren't plunging for the reasons I expected...
Back in June, I was cautious about investors' high expectations for earnings and revenue. So far, revenue and earnings results for these companies have been in-line with expectations. Considering expectations were super-high, it's an impressive performance.
Behind the scenes, however, there's a growing problem... The Chinese government has started to crack down on Internet companies.
You see, companies like Sina offer "social" services like blogging. Users in China love social media just as much as people in the U.S. Anything that resembles Facebook or Twitter is a big hit in China.
The difference is that China's government isn't a fan of free speech. For example, if you try searching for information about the 1989 Tiananmen Square protests in Beijing, you won't find anything using Baidu. That's because Baidu follows strict censorship rules that are set by the Chinese government.
For Baidu, government intervention is nothing new. Baidu's success is a result of the fact it follows the government's rules. Its main competition, Google, shuttered its operations in mainland China rather than cave in to the government's censorship demands.
Sina is the latest target of government censorship. Users of Sina Weibo – a Chinese equivalent of Twitter – have run into a variety of issues in recent months. In some cases, their posts aren't available to others. In other cases, users have simply had their accounts canceled.
In July, more than three dozen people died when two high-speed trains collided in Zhejiang province. Social media sites like Sina Weibo lit up with activity immediately following the disaster. These social media sites allowed Chinese people to criticize the government's handling of the accident.
That kind of freedom of speech is not something the Chinese government will allow. That creates serious doubts about the long-term potential of these business models in China.
Sohu hasn't yet run into government interference. Still, its gaming and video businesses involve millions of users. That means it could be the next target of the crackdown.
Even in the U.S., these types of "social media" services are fighting an uphill battle to generate profits for investors. In China, there's zero chance that these kinds of businesses can operate without the government leaving them alone. That sets a cap on their long-term potential.
So far, government interference hasn't shown up in these companies' quarterly results. They're all growing at double-digit rates. You can bet that will change in 2012, especially in Sina's case. Users of its services won't hang around if no one can read what they're writing. Fewer users will translate into lower advertising revenue.
The number of Internet users in China continues to grow. By the end of this year, there will be about half a billion Chinese citizens surfing the Internet. That's an enormous market for companies to target. It's larger than the entire population of the United States.
That's why Wall Street analysts still love these stocks. More than 50% of the analysts covering these stocks still have a "buy" rating on them. I take that as a good sign we haven't yet seen the bottom for China's Internet sector.
Like most China-related investments, they're overhyped, dealing with a difficult government, too risky for the average investor, and likely to fall farther.
Good investing,

Further Reading:

Internet stocks aren't the only ones getting slaughtered in China. Last week, editor in chief Brian Hunt pointed out that the Shanghai Stock Exchange just hit a new two-year low. The market "is starting to side with the bears," he writes. Read more here: Chinese Stocks are Plummeting.
In October, Larsen told Growth Stock Wire readers about a group of stocks that he is long-term bullish on. Larsen calls these "the perfect stocks for a 'so-so' economy." Get the full story here: How to Make Money, Even When You're Wrong.

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