China's Good, Bad and Ugly Stocks

JUNE 11, 2011   THE WALL STREET JOURNAL

By TOM ORLIK

U.S.-listed China stocks are taking a beating. But in the rush to judgment, investors risk confusing the good with the bad and the ugly.

The bad are getting all the headlines. A group of Chinese firms that crept onto U.S. markets in the past few years, only to be exposed as frauds, are darkening investors' view of all Chinese firms. That is hardly surprising when major institutional investors are losing big. A 73% fall in the stock price of Canada-listed Sino-Forest since the start of the month means a paper loss for leading shareholder Paulson & Co. of more than $500 million.

The ugly are those with a compelling story to tell, but little or no history of profitability. Into this category falls Renren, pitched as the Chinese Facebook, Youku.com, seen as China's Youtube, and Dangdang, viewed as the country's Amazon.com. The Chinese imitators do offer similar services, but they face fiercer competition than their U.S. peers and have a far less developed advertising market to tap for profits. In the last six months, all three rode a wave of enthusiasm to high valuations at their initial public offerings, only to see prices slump as investor's looked more closely at the competition they face in their sector. Dangdang and Renren have both halved in value since the closes on their first day of trading, and Youku is down 50% from its April peak.

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Nelson Ching/Bloomberg

Sina's stock is down 23% since the start of the month, against a 5% fall in the Nasdaq Composite. Above, Sina's Weibo micro blogging website.

That leaves the good, those firms with a dominant market share and a history of profitability that are also sliding. Baidu, with 75% of China's online search space, Tencent, with 72% of instant messaging, and Sina, the most visited portal and owner of the phenomenally popular Weibo microblog, all fall into this category. Baidu and Tencent have fallen close to 10% since the end of May. With suspicions about corporate governance high, Sina's management chose a bad time to sell shares—a move disclosed at the beginning of the month. Sina's stock is down 23% since the start of the month, against a 5% fall in the Nasdaq Composite. Yes, these stocks' valuations reached frothy levels, too, but at least there was a more solid business behind them.

With more negative noise on China's growth and inflation expected in the summer months and bears crawling over other companies in search of weaknesses, sentiment will stay negative. Investors that have lost a fistful of dollars on one China stock may not be inclined to risk a few dollars more on another. But a lack of discrimination on the way down makes no more sense than on the way up. For investors that can distinguish the good from the bad and the ugly, a continued market slide will start to present opportunities.

Write to Tom Orlik at Thomas.orlik@wsj.com