Fun: China's Endangered Species

It's not easy to stand out in a country with 1.3 billion residents, especially when money is still tight. An easy escape in China is to head out to the more than 100,000 Internet cafes and slip into a virtual fantasy life for just pennies an hour. However, it's about to get a lot harder to have a good time in cyberspace, now that the Chinese government is asking developers to curb the virtual rewards given to chronic users.

Minors who spend more than three consecutive hours playing games will be limited in the number of points they can accumulate. Play for longer than five straight hours, and you will receive an on-screen warning about the dangers of Internet gaming, and no points will be awarded.

Companies such as Shanda (NASDAQ:SNDA), NetEase (NASDAQ:NTES), Webzen (NASDAQ:WZEN), and The9 (NASDAQ:NCTY) have profited from the popular pastime. Now they are emerging as China's version of RJ Reynolds and Philip Morris. Instead of cancer sticks, we're talking fantasy games like NetEase's Fantasy Westward Journey, where as many as 1.3 million play at the same time. Second Life or Runescape, eat your heart out.

Come July 15, the companies will need to have the anti-addiction measures implemented within their massive gaming adventures. You've seen cigarette warning labels and "drink responsibly" television campaigns by liquor companies. For better or worse, welcome to the era of gaming responsibly in China.

A star is mourned
Unfortunately for the software developers, the vendetta is real. China has been cracking down on Internet cafes, and last month the government issued a moratorium banning the opening of new Internet cafes this year.

Despite its materialistic pursuits, this is still a country with little tolerance for dissension. If the government feels that the Internet and online games will poison its youth, it won't take heart from stateside examples where the geeks have inherited the Silicon Valley earth.

The climate would normally make this a lousy sector to buy into, but the pessimism is already priced into the leading game companies.

China's economic growth and booming exchanges have sent many shares into stratospheric valuations. The same can't be said for China's online-gaming giants. They are trading at earnings multiples in the teens if you look ahead to Wall Street's projections for next year.

You won't find valuations that reasonable in slower-growing Chinese sectors. Close to home, you won't find those year-ahead multiples in many of the leading video game software companies growing slower. Leader and Motley Fool Stock Advisor superstar Electronic Arts (NASDAQ:ERTS) is trading at 40 times its fiscal 2008 bottom-line estimate. Yes, EA is a special kind of company, but how bearish can one be on NetEase when it is trading at just 13 times next year's profitability?

The show must go yuan
China is at a crossroads. Its economy has been growing at a 10% annualized clip over the past few years. That kind of wealth creation keeps the masses loyal, but it also whets the appetite for leisurely pursuits that are now possible with chunkier billfolds.

Some of the hottest stocks have been companies like Home Inns & Hotels and Ctrip (NASDAQ:CTRP) that thrive on flatter class structures, with the wider middle class itching to travel.

With the country clearing its throat before the spotlight shines during next year's Olympics in Beijing, it has a difficult decision to make. If it cracks down too hard on Internet gaming, it will be seen as a bullying killjoy by the global gaming audience. However, if it's too soft and video game addiction proves to be a serious issue, it wouldn't want that to become a journalistic curiosity when all eyes are on China next summer.

So China's leading players are washing up. Baidu.com (NASDAQ:BIDU) was once seen as a haven for illegal MP3 downloads, but now China's leading search engine is playing nice with some of the record labels.

Will the video game companies clean up nicely? One would hope so. They should actually be the ones coming up with their own set of solutions. They're the ones spending the hours entertaining their players and getting to know them better along the way. They are the influential forces. As powerful as China is -- and will continue to be -- pushing the Internet-based video game sector against the wall may lead to more long-term harm than China realizes.

Ctrip is a Motley Fool Hidden Gems stock pick, while Electronic Arts is a selection in the Motley Fool Stock Advisor research service. NetEase, Baidu, and Shanda are Rule Breakers recommendations. But if you're looking for a little overseas sizzle to spice up your portfolio, why haven't you checked out the new Global Gains yet?

Longtime Fool contributor Rick Munarriz has been a fan of China's high-margin stocks for a long time. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. He does not own shares in any of the companies in this story. The Fool has a disclosure policy.