A Massive Bubble and an Incredible Buying Opportunity

The headline of this article promises that I will reveal two things: A massive bubble and an incredible buying opportunity. Generally, those would have to be two different things. Not today. Today, both are true of China.

The massive bubble
The IPO calendar here in the U.S. has been dominated by Chinese companies in recent months, with 13 companies (and more coming) from the Middle Kingdom having gone public here since October. These IPOs, headlined by the massive recent gains in "YouTube of China" Youku.com (NYSE: YOKU), have generally been a success as investors have bought in to these businesses and their growth opportunities in the world's fastest growing economy. Today, all 13 of those recent IPOs trade at very healthy valuations.

Source: Capital IQ.

Now, if you've read my columns before, then you know that I'm generally bullish on China for the long term. That said, some of the numbers in this table are ridiculous. Not only are these Chinese companies, and therefore carry with them all of the risks of investing in China, but some of them aren't even good Chinese companies. Take Youku.com, for example. Investors are currently valuing the business at more than $4.3 billion despite the fact that the company had just $35 million in revenues through the first nine months of 2010 and lost more than $2 million at the gross profit level. Tack on operating expenses and this $4.3 billion business has lost more than $21 million so far this year.

Even better, owners of Youku.com stock don't even actually own the operating business in China, but rather have "contractual arrangements" with the companies that are actually running this business in China. Good luck getting those contracts enforced by a Chinese court if the real owners ever decided they wanted to be rid of their foreign "shareholders." And what are the prospects for the "YouTube of China" anyway? Well, the real YouTube is reportedly marginally profitable at best despite being one of the world's most popular websites and having the world's best Internet marketer -- cash-rich Google (Nasdaq: GOOG) -- standing behind it.

These stocks, in other words, are overvalued.

The incredible buying opportunity
If recently listed small Chinese companies are trading at rich premiums, one might assume that the same is true of small Chinese companies that have been publicly listed for longer. In fact, it might even make sense for them to be valued higher since they have longer public track records.

This, however, is not the case. Due to recent allegations from short sellers that many small Chinese companies can't be trusted, U.S.-listed Chinese stocks today are trading for just 1.2 times sales and 6 times  EBITDA on average. You don't need to be a genius to notice that that's a lot less than the multiples investors are awarding newly listed Chinese companies, implying that the less the market seems to know about a company, the more its willing to pay to own it.

That's stupid, of course. Although these companies are newly listed and, in some cases, have reputable venture backing, I suspect they suffer from many of the same deficiencies that plague Chinese companies writ large: weak internal controls, poor communication skills with outside investors, lower standards of corporate governance, and a preference for size and sales growth over profitability and efficiency. Think I'm wrong? A glance at DangDang's registration statement reveals that it has a dual-class shareholder structure that gives its Chinese owners effective voting control, and Mecox Lane is already subject to several class action lawsuits for allegedly filing an "inaccurate registration statement," and hiding some of the challenges the business was facing from investors.

What to do with this information
Ultimately there has to be a reversion to the mean here. Either the newly listed small Chinese companies will trade down reflect the sentiment of their peer group, the peer group will trade up to reflect newfound optimism about China, or both groups will meet somewhere in the middle. Although some long public small Chinese companies are no doubt troubled and will never make money for investors, some others have been unfairly maligned and are too cheap today. The country is the world's most exciting emerging market and investors -- who pay the right price to own the right companies -- should do well as companies in that market grow to meet its increase consumer, commodity, and infrastructure needs.

But investing in China comes with myriad risks, which makes it imperative to not overpay (and paying more than 92 times sales to own a contractual arrangement with a poorly run website is overpaying). So what should investors do? One clear strategy to profit from the massive valuation discrepancy that exists between old and new small Chinese would be to buy a diversified basket of the old, cheap ones and short a basket of the shiny, new, expensive ones. And while the natural hedge is part of the allure of this trade, fast-forward ahead one year and I'll bet you'll have made money on both sides.