Seeking out the 10 mid caps to rule them all is the only logical follow-up to seeking the 10 small caps to rule them all. Unlike small-cap companies that offer investors the potential for high-risk, high-reward returns, mid-cap companies usually have significantly less risk built in because of their proven business track records. These companies offer either distinctive products or exceptional value to investors -- or possibly both.

For reference, here are the choices for the previous eight weeks:

This week I’d like to highlight a volatile and potentially undervalued gaming company based in China, Perfect World (Nasdaq: PWRD).

What it does
Breathe folks -- in, out, in, out -- I’m about to recommend a Chinese company. While fellow Fool Matt Koppenheffer pointed out the comedy of errors that have resulted in the downfall of countless Chinese equities over the past year, I’m proposing that Perfect World doesn’t fall into that same moat.

Perfect World is a provider of massively multiplayer online role playing games, or MMORPGs. The company currently offers 11 premium 3-D MMORPGs (and a casual dance game) throughout China and the United States, while also assisting in film production, distribution, and advertising. But make no mistake about it, the life and soul of this company is its online gaming business.

How it stacks up
Perfect World’s ascension from a small online gaming provider to a $1 billion company has been nothing short of astounding. In 2006, Perfect World shareholders endured their last full-year loss on revenue of just $12.7 million. In 2010, Perfect World’s operating income jumped to $134 million -- more than 10 times higher than its revenue five years earlier -- on revenue of $375 million. That isn’t just growth, that’s an explosion!

This isn’t to say that the entire MMORPG sector isn’t on fire -- because it is. Rivals (Nasdaq: CYOU), Shanda Interactive Entertainment (Nasdaq: SNDA) and online gaming arm Shanda Games (Nasdaq: GAME), (Nasdaq: NTES), and Giant Interactive (NYSE: GA) can claim strong revenue growth, but none of them are nearly as undervalued on paper as Perfect World.



Forward P/E


Perfect World 1.84 6.6 $296.5M / 0 3.64 12.0 $1.6 B / 0
Shanda Games 2.58 7.7 $383.4M / 0
Shanda Interactive Entertainment 1.54 19.4 $1.21B / $133.4M
Giant Interactive 1.70 10.0 $956.8M / 0 4.69 9.5 $406.5M / 0
CDC Corp. 0.31 17.9 $100.4M / $73.5M

Source: Yahoo! Finance as of July 12.

CDC may seem cheap on paper, but it’s the only company currently not turning in a profit. Shanda Interactive has missed earnings estimates six times in a row, while its online gaming arm Shanda Games has seen earnings growth slow dramatically. NetEase and Changyou would make for compelling plays if they weren’t relatively already priced for perfection. Giant Interactive is most closely tied to Perfect World on paper, but even it has seen its earnings growth slow to a crawl. No company has shown more consistent growth of late in the online gaming sector than Perfect World.

How it could make you money
Stop me if you’ve heard this argument before: It’s China!

China has more than 1 billion residents, many of whom still remain an untapped and potentially profitable market. Chinese residents earn considerably less each year than we do in the United States, but as the country and its citizens grow more affluent, the propensity for consumers to go online for entertainment should grow as well. I feel the 29-fold jump in revenue since 2006 speaks volumes to this point.

Also, take note of the abundance of cash in this sector. Perfect World is a relative “small fry” with just shy of $300 million in cash compared to NetEase and Giant Interactive, which have $1.6 billion and $957 million, respectively. I wouldn’t rule out the possibility that a larger rival approaches Perfect World in the coming years as growth in the sector slows to a crawl due to an overabundance of competition.

Right now, on paper and based on Perfect World’s recent earnings history, the company appears to be a screaming value. With the company casting a spell of profitability on its shareholders, it may be enough to compel MMORPG players to step into the real world and click the buy button.

What’s your take on the Chinese online gaming industry? Share your thoughts in the comments section below and consider adding Perfect World to your watchlist to keep up on the latest in the online gaming sector.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.