China’s Internet: Investing in Muddy Waters

This essay originally appeared in the December 2013 issue of the China Economic Quarterly.

Greed has again replaced fear in the market for Chinese internet stocks. The window for Chinese internet initial public offerings (IPOs) effectively closed in 2011 after nearly a dozen firms tapped the US markets using a dubious legal structure known as a variable interest entity (VIE). Most of these companies were not high quality, but investors were willing to buy anything with a China internet angle—even though they were acquiring shares in an offshore entity that did not actually own the underlying business in China. Those issues remain unresolved, but investors are once again snapping up newly listed Chinese internet stocks.

Sina pioneered the VIE structure in 2000 to bypass rules banning foreign investment in the Chinese internet. By using a set of contracts, this legal sleight of hand gave offshore companies apparent legal control over their corporate entities in China. The work-around succeeded in the short term, but the mini-bubble did not last long as fears over the convoluted corporate structures, attacks by short sellers, lack of US-China accounting cooperation, and poor financial performances by some of the firms led to sharp declines in many of their share prices. Several now trade below their initial offering prices.

Nevertheless, investors now appear less interested in risks and more focused on growth potential. Four internet firms have listed in the US so far in 2013, and only one—Lightinthebox, which blew its first earnings announcement—has dropped below its offering price. Several more firms are in various stages of registration with the SEC and are likely to list before year end. Baidu and Tencent, global internet blue chips, have risen by approximately 50% this year and are now two of the six most valuable internet firms in the world. Alibaba will probably be worth more than both firms once it lists, probably in Hong Kong in 2014.

Not all of the dozen or so listings made in 2010-11 were duds. Qihoo sold shares at US$14.50 and now has a market capitalization of about US$10 bn. Ecommerce firm Vipshop, the sole Chinese internet IPO of 2012, went public at US$6.50 and its shares now trade at over US$70. Nor have recent headlines about fraudulent companies had an impact on demand for the new crop of IPOs. In late October, research firm Muddy Waters accused Netqin (NQ) of cooking its books. Shares of NQ plummeted but 58.com and Qunar, who priced their IPOs the week after Muddy Waters released its report, both significantly raised the prices of their offerings because demand was so great.

The short-sellers are a significant headline risk but their track record is mixed. In 2011 and 2012 two research firms accused Qihoo of being a fraud and set price targets in the single digits. Since then Qihoo’s shares have nearly quadrupled. Earlier this year another firm accused Vipshop of accounting problems, but it went on to complete a secondary offering and its shares have more than doubled.

It is difficult for investors to have exposure to China’s consumer growth without owning some internet stocks, and in fact the internet firms probably have cleaner books and certainly better business models than the majority of the traditional China consumer plays.

Global internet stocks, and social media ones in particular, are having a terrific year—so it makes sense that institutional investors would be interested in the Chinese internet firms, which are causing huge structural changes in China’s relatively immature consumer market. And it seems many investors are willing once again to play down the China risks and play up the growth potential—at least for now.

See related: China’s Internet: Gilding the Cyber Cage

This essay originally appeared in the December 2013 issue of the China Economic Quarterly.

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