World's Scariest Stocks: Baidu

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What else is stewing in our cauldron of evil? Prepare yourself before proceeding to the rest of our world's scariest stocks.

I love you, Baidu (Nasdaq: BIDU), but you scare me all the same.

China's leading search engine was rolling along nicely until this week, with investors slamming the stock on Tuesday after it delivered a disappointing outlook for the current quarter.

Yes, the stock has had an amazing run. Even with this week's wobbly knees, Baidu's stock has more than tripled since its December lows. So before I get to the stock's spooky turn, let's roll the clock back to merrier times, when anything seemed possible.

Buy, buy, Baidu
I fell hard for Baidu as it was gearing to go public in 2005.

As the dominant market leader in its country, "China's Google" was an easy to story to get behind. After all, if Google (Nasdaq: GOOG) resides in a country with just a quarter of China's population, how high must the ceiling be for a rapidly growing economy in the world's most populous nation? Google is a global player, sure, but Baidu was brutally underpriced, given a clear lane for an easy layup.

In one of the easiest Motley Fool Rule Breakers calls I ever made, I recommended the stock to the newsletter's subscribers three years ago, while it was still in the double digits.

The overall market is trading lower today than it was then, but Baidu has become nearly a five-bagger on the newsletter service's scorecard. China's economy grew. Folks migrated online. The arrival of Google and smaller local players never made a dent in its market share.

It was all treats and no tricks for Baidu ... until now.

Bad to the Baidu
Earlier this month, Chinese regulators began to twist the screws on the country's leading online-gaming specialists. The five public companies that specialize in creating these virtual games --  for which hundreds of thousands of engaged players are often on the same game at the same time -- got slammed. Market leader NetEase.com (Nasdaq: NTES) and recent IPO Changyou (Nasdaq: CYOU) were dealing with double-digit percentage losses through the otherwise buoyant first two weeks of October, as fears of tighter restrictions, stringent approvals, and the nixing of foreign investors caused a lot of unease.

"All five of these rapidly growing companies are trading between 10 and 14 times next year's projected profits," I wrote at the time. "The geopolitical risk is already priced into these shares."

Can the same be said about Baidu, which is fetching a whopping 40 times next year's bottom-line guesstimates? The same government that has cracked down on Internet cafes, censors the Web, and can force Yahoo! (Nasdaq: YHOO) to hand over the name of a dissident blogger can also take down the Internet faster than you can say "underage gymnast."

Then we also get to some of Baidu's less savory practices. Late last year, Baidu came under fire for running ads from unlicensed medical marketers. This may seem like an inconsequential story, but the search engine shocked investors when it warned that cleaning up its act would come with a 10% to 15% blow to the top line.

This week's guidance is also the handiwork of Baidu's decision to do the right thing, ethically. Instead of blending ads into the organic search results -- a move that deceptively drives ad clicks -- it's discontinuing the practice. It's in the process of migrating its advertisers to a Google-esque platform, where the sponsored listings will run on a column away from the natural query results. This change is the right thing to do, but it also has Baidu targeting a surprising sequential dip in revenue for the current quarter. Instead of the 54% year-over-year top-line gain that analysts were expecting, Baidu is looking at a 32% to 36% advance.

It's great to see Baidu do the right thing, but are investors overpaying for a cleaner Baidu?

Searching for clues
I'm not bailing on Baidu. You won't see me booting it from the Motley Fool Rule Breakers scorecard. China's growth -- as both an economy and a Web-wired nation -- is still in its infancy.

However, the lofty valuation of a white-hat Baidu is not for the timid. Despite the past few months of rallies, bargain stocks are everywhere. There are plenty of quality Chinese growth stocks -- leading real estate agency E-House (NYSE: EJ) and interactive educator Noah Education (NYSE: NED), for example -- that are trading at forward earnings multiples in the low teens.

Baidu is priced dearly. What you pay will eventually be worth it, but for now, the stock frightens me on many different levels.

Warning: We've rounded up more scary stocks. Click if you dare.