The drop in shares of Tencent demonstrates the costs of rising competition among China’s Internet leaders

Just because bad news is expected doesn’t mean it won’t hit a stock’s price hard.

Shares of Tencent Holdings (700.HK in Hong Kong and TCEHY in New York), China’s biggest Internet company by revenue, fell to a seven–month low on August 11 after announcing on August 10 second quarter financial results that missed analyst projections. After rallying briefly, the stock has resumed its decline.

Everybody should have known this was coming. China’s Internet biggest companies from Baidu (BIDU) to Tencent to Sina (SINA) are seeing costs rise as they invest in new services that will enable them to turn their huge user bases into more revenue. For example, on August 17, Sina, the owner of China’s third-most visited website, announced second quarter results that missed projection on the rising cost of adding features such as virtual currency and games t its Weibo micro blogging service as competition with a rival product from Tencent Holdings gets more intense. Sina said that costs for Weibo may climb to $100 million in 2011.

In the second quarter, no surprise, Tencent Holding reported increased spending on its micro blogging service and e-commerce website. The company reported that net income grew by 22% last quarter to 2.35 billion yuan ($366 million) from 1.92 billion yuan in the second quarter of 2010. Analysts had been expecting net income of 2.58 billion yuan for the quarter.

The problem clearly wasn’t on the revenue side. Revenue climbed 44% to 6.74 billion yuan from 4.67 billion yuan in the second quarter of 2010.

But general and administration expenses more than doubled to 1.36 billion yuan, up from 666 million yuan in the second quarter of 2010. Selling and market expenses rose 60% to 369.5 million yuan.

For the winners in this market all this spending will create profit machine as big companies with lots of user grow bigger as users are drawn to the size of the user base and the depth of services offered by the company. Tencent claims that it added 27.6 million active user accounts for its QQ instant-messaging service in the quarter to bring the total to 702 million. Investors need to take these numbers with a dash of soy sauce since Tencent’s total-account-figure exceeds the official total for all Internet users in China. But even a 50% haircut (a reasonable discount to my mind) still adds up to a lot of eyeballs that will add their yuan to the Tencent till down the road.

You can already see that in the growth of revenue from areas recently targeted for investment. Sales of Internet value-added services (which includes online games and QQ-related subscription fees) rose to 5.39 billion yuan from 358 billion yuan in the second quarter of 2010. Online advertising sales grew by 29% year-to-year.

Don’t buy shares of Tencent or Baidu if you’re looking for a quick killing. The negative sentiment about growth in investments and costs is likely to continue for a while before the market starts to focus on the income that this investment is bringing in. Use this period, two or three quarters I’d say, to build positions in the companies that you see as winners in this contest.

Tencent Holdings is now selling at a price more than 20% below its 52-week high.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Tencent Holdings as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

The last month has reordered global risk and reward.

It’s not just that the U.S. Standard & Poor’s 500 fell 18.3% from its July 21 intraday high to the August 9 intraday low. Or that the German index, the DAX, is down 15% in two months. Or that emerging markets such as Brazil and Shanghai spent time in actual Bear market territory.

But we’ve also seen EuroZone leaders unable to put a period to the euro debt crisis. We’ve seen the Standard & Poor’s credit rating of the United States go from AAA to AA. (Fitch Ratings re-affirmed the U.S. as AAA on August 16.) Japan has slipped back into recession. Inflation has topped official targets and shown itself stubbornly resistant to central bank policies. Economic growth has slowed or threatened to slow in most of the world’s economies.

Trends that investors depended upon to value stocks—or to tell them where and when to chase momentum—have been broken, damaged, or threatened.

Stocks are cheap in most of the world’s stock markets—if past trends are going to reassert themselves after a short interruption. If the trends are truly broken, however, who knows? What’s a Google (GOOG), or a Vale (VALE) or a Baidu (BIDU) worth if domestic and global rates of economic growth are about to drop by a percentage point or two points or more—or less?

You do have the option of stubbornly insisting that “things” are headed back to normal. Or that growth and stock prices will revert to the mean. But that’s just begging the question of what normal is and where the mean might be. Unless you’re willing to throw out the data from the last decade (or more, I’d argue) on economic growth and the performance of individual asset classes, it’s hard to come up with a long-term trend that can be convincingly projected a decade into the future. And even then your trend line would still have to come to terms with changes in global demographics and the global economy that, to me, say for the next decade it will indeed be different this time.

To the degree I can I prefer not to make investing a matter of faith or a gamble on alternatives with unknowable odds of success or failure.

“To the degree I can” isn’t a very large measure right now. For example, I think the most likely range of U.S. economic growth is somewhere between 1% and 2.5% for 2011 and 2012. Doesn’t sound like much? Just 1.5 percentage points? Certainly but the swing is 150% from the minimum and 60% from the maximum. And, of course there’s no guarantee that the actual outcome will fall within that “most likely” range. (We’ve got some recent experience in results that fall into the narrow tail of improbable outcomes but that nevertheless turned into very real outcomes.)

And the United States isn’t by any means the hardest economy to handicap right now. Brazil is inflating its own credit bubble, the government’s will to restrain wage increases is certainly questionable, and inflation is not under control. In the EuroZone the European Central Bank has seriously damaged its credibility leaving the restoration of confidence to political leaders who won’t lead and an untested European Financial Stability Facility that isn’t yet ready to go into operation. Indian politics make U.S. politics look like a model of rational discourse and while the Reserve Bank of India may be the last adult in the room, any parent will tell you that batting the children around doesn’t usually produce good behavior.

I could go on. But I think you get the point.

I don’t think there’s a magic method for bringing reasonable certainty to our projections about the global economy and about most national economies. We’re stuck with the fact that these are uncertain times. The result of that, unfortunately, as that I think it’s very hard to tell in most parts of the financial markets, and especially in the global equity markets, what the risk might be. You can calculate the reward, but not the risk. That’s the investing equivalent of dividing by zero.

But I do think there are three pieces of the global equity markets where the risk/reward proposition is not just calculable but is actually running in investor’s favor at the moment.

First, there are dividend-paying stocks. If the global economy continues to slow, global interest rates will be headed down and that will make dividend yields worth more. (The value in a 3.5% (or better) dividend yield on a stock such as EI DuPont (DD) or Abbott Laboratories (ABT) when the 10-year Treasury is hovering near 2.2% should be clear to most investors.) The proposition gets even more attractive when the dividend is paid in a strong currency such as those of Norway, Sweden, Switzerland, Australia or Canada. Take a look at the 5% yield from Norway’s Statoil (STO in New York and STL.NO in Oslo.) Australia’s Westpac Banking (WBK in New York and WBC.AU in Sydney) pays even more, 7.3%.

I can think of two kinds of downside risk. The individual company won’t be able to keep up dividend stream. I think you can minimize this risk by buying shares with strong cash flows behind them. The global economy might do better than expected leading to higher interest rates and higher inflation, both reducing the value of your dividends. Which is why you’re also looking to buy strong businesses—shares of these stocks should go up if the economy grows more quickly than is now anticipated.

Second, there are shares of domestically-oriented Chinese companies. I’m not sure I’d say that China is enjoying the global economic slowdown—Chinese exporters are seeing sales fall—but the Chinese economy—and especially the Chinese domestic economy–comes out on the plus side when everything is added up.  A slowing global economy probably means an end fairly soon to China’s interest rate increases. The consensus, which can, of course be wrong, is that the People’s Bank won’t risk China’s economic growth during a global slowdown by raising interest rates more than once more. (And end of rate increases would remove a big weight from stock prices.) The government in Beijing seems to be picking up the inflation-fighting slack by allowing the yuan to appreciate slightly more quickly. That has the effect of reducing the growth of the country’s money supply—and of increasing the buying power of Chinese consumers. I think adding to positions in domestically-oriented Chinese companies such as Baidu (BIDU) and Tencent Holding (700.HK) or in overseas companies that sell to Chinese consumers such as Yum! Brands (YUM), Sands China (SCHYY), and Coach (COH) would be a good way to play China’s relative growth advantage.

Third, there are the shares of U.S. exporters, especially those that sell to China. A stronger yuan—and a weaker dollar (How long can the safe haven effect balance out a slowing U.S. economy?) elsewhere in the world—makes U.S. products cheaper to customers. I think this will help U.S. companies pick up some more market share, which in many cases should be more than enough to offset any slowing in an economy such as China’s. That is, in fact exactly what Cummins (CMI) said in a recent conference call where the company talked about a temporary slowdown in Chinas sales but a gain in market share over the slightly longer time frame. Besides Cummins I’d look to shares of Johnson Controls (JCI), Joy Global (JOYG), Borg Warner (BWA), and Timken (TKR).

No guarantees that these stocks will go up. If there’s a global sell off, they’ll go down with everything else. But if the global economy just stumbles along, these shares should beat the market indexes. And, in my opinion, the risk/reward ratio comes out on the right side of the wager.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Baidu, Coach, Cummins, DuPont, Johnson Controls, Joy Global, Statoil, Tencent Holding, Timken, and Westpac Banking as of the end of June.  For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

China’s inflation rises to 6.5% in July–Good or bad news?

China’s rate of inflation increased to an annual 6.5% in July from 6.4% in June.

That’s certain. What that means for the financial markets and China’s economy is all speculation at this point.

Going into the numbers there was optimism that July would show that inflation had peaked. Some economists were even looking for confirmation of a peak in a drop in July’s reading to 6.3% from June’s 6.4%. They didn’t get that.

But the July number may still be good news. Read more

The cooking oil indicator says inflation has peaked in China

I’m getting a ton of email yesterday and today from readers asking whether to buy, when to buy, and what to buy. Being down 500 points on the Dow Jones Industrial Average does raise those kinds of questions.

I do have one concrete suggestion in answer to all that—and it’s based on a bit of good news yesterday out of China.

The government in Beijing has lifted its ban on price increases in cooking oil.

Don’t laugh. This is huge. And I think it’s a signal that you can start to ease your way into (or deeper into) Chinese stocks.

Here’s my thinking. Read more

Can the wreck of a single high-speed train change the course of China’s economy and politics? I wouldn’t bet against it

The collision of two high-speed trains in China on July 23 that left at least 39 people dead is quickly becoming a symbol for many Chinese of all that’s wrong with China’s government and economy—even if Beijing has cracked down on any public discussion of the event. The government’s central propaganda department has decreed that the theme of all reporting should be “in the face of great tragedy there is love.”

If you want to understand the tensions in Chinese system of government and development that might put a knot in the straight line projections of China’s future, spend a minute studying the way that this event is rippling out across China.

On July 23 a high-speed train on the newly opened Beijing-Shanghai line crashed into the rear of another high-speed train that had stopped after losing power. The first four cars of the moving train fell off a bridge and the last two cars of the stopped train derailed. At least 39 people died and 190 were injured.

Ripple 1: Nobody believes the government’s explanation that the wreck was a result of lightening hitting the first train and knocking out power. Experts on the signaling system used on China’s high-speed rail lines say that the second train would have received a stop signal even if lightening had knocked out power to the first train. Experts such as Sun Zhang of the Urban Mass Transit Railway Research Institute told Caixin that at least three or four redundant safety mechanisms kick in if a train stalls.

Ripple 2: Everyone believes that the government investigation will be a whitewash designed to make the problem go away as quickly as possible.  Less than 24-hours after the wreck, rumors were flying across the Internet that government construction crews had moved in to bury wrecked train carriages near the track. A widely viewed online video—maybe–shows bodies falling out of those train cars. A photograph taken on July 25 at the wreck site shows that the cars had not been buried. But almost nobody posting on the Internet believes the government’s explanation that the cars were merely being moved—and not actually buried—so that workers could get access to the rest of the wreck site.

Ripple 3: Everyone believes that the government will find scapegoats but that those truly responsible won’t really be punished. Could Beijing have handled this any worse so far? I don’t see how. The government has removed three railway officials from their jobs—Long Jing (head of the Shanghai Railway Bureau), Li Jia (head of the Shanghai Railway Bureau committee of the Communist Party), and He Shengli (deputy chief of the bureau.) This might have been effective except that to replace Long Jing Beijing appointed An Lusheng. He was demoted in 2008 after China’s biggest rail disaster when two trains collided in Shandong province killing 71. He was back in his old job within two years and now has been brought in as the solution to this disaster.

Ripple 4: You can cut the cynicism with a spoon: Somebody got rich and somebody else died. What’s new? In February Liu Zhijun, China’s railway minister, was removed from his job because he was the subject of an investigation into corruption. In March a government audit showed that about $30 million had been embezzled from the Beijing-to-Shanghai portion of the high-speed rail network. (The July 23 wreck took place on exactly this segment of the system.) And the common belief is these are almost certainly just the tip of a mountain of profits that went to contractors who cut corners on projects or padded costs and to land developers who got sweet deals on real estate near the new high-speed train stations. A lot of Chinese believe that it’s who you know, who your relatives are, and how much clout you (or your parents) have in the party that determine who gets rich in today’s China. This wreck feeds into those beliefs.

Ripple 5: China the innovator took a big hit. Before the wreck China and Japan were engaged in a heated “discussion” over who owned the patents to high-speed rail technology. In June China filed 21 international patents for its high-speed rail technology claiming that it had taken earlier high-speed rail technology from foreign partners and “adopted it, digested it, absorbed it and innovated based on it, transforming a 250-kilmeter per hour train into a 350-kilmeter per hour train” in the words of He Huawu, chief engineer of China’s Ministry of Railways. The rejoinder from Japanese and German makers of high-speed trains was that it looked to them like China hadn’t achieved higher speeds by innovating but by cutting corners on safety. That argument looks a lot stronger after the wreck when so many pundits are comparing the zero passenger-death record in the 47-year history of Japan’s high-speed Shinkansen system to the record of China’s four-year old high-speed rail system. Forget about just putting a damper on Chinese exports of its high-speed rail equipment. This wreck casts doubt on China’s strategy of moving up the technology value chain.

Ripple 6:  More bad debt. China’s Ministry of Railways showed just 15 million yuan in profits for 2010 on revenue of 686 billion yuan. Cash flow from operations came to 157 billion yuan compared to 150 billion in interest due and redemption of maturing debt. And 2010 was a better year than 2011 when debt repayment plus interest is projected to hit 250 billion yuan with cash flow from operations at 200 billion yuan. Those figures are all from before the wreck, of course, and they’ll undoubtedly get worse in coming months as some passengers shun the high-speed trains. But at least the ministry can borrow from the government. That’s not true for the real estate developers who have staked billions of yuan on projects linked to new high-speed rail stations. If those stations are canceled or delayed as part of the government’s rethink of the country’s high-speed rail system, or if traffic through those stations is lower than expected, then developers will book big losses. That’s a big deal for a sector that’s already over-extended and worried about a falling supply of new loans.

Ripple seven: The wreck feeds into a very important current debate among China’s leaders about where to set the speed limits of sustainable growth. Before the wreck, China’s leaders, most prominently Premier Wen Jiabao, spoke of the need to balance growth with slower inflation, with better education and healthcare, and with rising incomes for lower paid migrant workers. The argument was abstract when built on statistics or vague when built on people’s feel for the quality of their own lives. But now the country has a readymade and all too vivid symbol of what happens when an economy tries to go too fast—it comes off the tracks.

Don’t underestimate the power of an image to change the debate in China.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/