Tiger Woman on Wall Stree (22 page)

Baidu was well situated to take advantage of this trend—until it caught the media’s and the government’s attention. In 2008, CCTV aired an unexpected segment showing how Baidu carried ads from unlicensed and potentially dangerous medical companies with unproven claims for their products. Baidu’s shares lost roughly half their value in the week following the exposé, as the company said it would no longer accept paid listings from companies that accounted for 10 to 15 percent of its revenue. Conspiracy theorists said CCTV had published the report because Baidu had not purchased enough ad time on CCTV’s networks.

Baidu allegedly made peace with the broadcaster by spending a generous amount the next year on CCTV commercials. But CCTV apparently felt the pinch of shrinking ad revenues as corporations moved their budgeted allocations for advertising from traditional ad channels such as TV to online sources, and the TV network attacked Baidu again. In the fall of 2011, it aired another 30-minute program about an advertiser looking to post ads on Baidu for a miracle weight-loss drug. The situation was a setup: the would-be advertiser was an undercover CCTV reporter interested in documenting some of Baidu’s more suspicious practices.

And document she did. When she presented her falsified documents, the Baidu representative recognized them as fakes. But
rather than showing her the door, the sales representative advised her how to “improve” her fake certificates or even borrow another company’s valid ones. Ironically, the representative also told the reporter that fake medical sites were receiving more scrutiny since CCTV had aired a related exposé a few years ago, so the Baidu employee suggested posing as a company in an industry with less supervision, like mechanical parts. The reporter followed his advice, setting up a website for mechanical components, but later had no problem switching the content back to promotional material for the weight-loss drug.

Some people argued that these salespeople were merely commission-based agents, not full-time employees, and that management was not aware of their poor decisions. In order to grow quickly, Baidu and many other companies had hired agencies across the country to sell online ads, especially in China’s less populated areas. But that was no excuse: Baidu’s senior management had plenty of time to clean house between CCTV’s 2008 and 2011 exposés. And if senior management was indeed kept in the dark, that would indicate a lack of internal controls.

Domestic news reports exposed other unflattering aspects of Baidu’s business. For one, the search engine allowed advertisers to purchase their competitor’s brand names as keywords. Hypothetically speaking, KFC could bid for the keyword
McDonald’s
, and as long as it outbid its rival, a KFC ad would show up when consumers searched for McDonald’s. If that wasn’t bad enough, Baidu sales representatives reportedly called up advertisers and asked them to increase their bids for keywords. If the company refused to pay more, Baidu could make the company’s site disappear from its search results, regardless of the importance of the information provided (imagine if it were an effective cure for a rare disease).

Most Baidu investors were oblivious to these behind-the-scene dealings and continued to award the company a generous valuation. Only a well informed and rational investor would see that
Baidu’s ad revenue was likely to become subject to greater regulatory and policy changes and therefore should be considered volatile. CCTV’s media exposure had on two occasions reduced the company’s healthcare product ad listings, causing Baidu’s revenue to suffer. Events of this nature added significant uncertainty to the search engine’s income stream. Beyond the effect on its stock price, the CCTV reports also prompted questions about the business’s long-term sustainability. As more consumers were cheated online and bad-mouthed their experience on Baidu, how sustainable would the search engine’s monopoly be?

The emergence of Qihoo, a new competitor that quickly grabbed market share, showed that Baidu’s grip on the search market was not as secure as it seemed. Qihoo got its start making antivirus software similar to McAfee’s and Norton’s products. The company entered the search engine market in August 2012 and won over almost 10 percent of the market in just three months. Apparently Qihoo had learned something from the scammers and hackers it was used to dealing with. The company essentially tricked most of its users into making Qihoo’s 360 Safe Browser their default web browser and search engine. Users of Qihoo’s antivirus software would unwittingly click on pop-up windows, which would then change their settings to make Qihoo their default browser. The company’s tactics were so brazen that China’s State Administration for Industry and Commerce (SAIC) reportedly handed it a warning for unfair competition. SAIC called out the company for such offenses as making its antivirus software difficult to uninstall, giving users of non-Qihoo browsers security warnings suggesting their browsers were unsafe, faking incompatibility between its antivirus software and competitors’ browsers to prevent their installation, and tricking users into thinking the 360 browser download was an official patch from Microsoft.

Although regulators disapproved of Qihoo’s tactics, they clearly worked. The company stole many unsophisticated Chinese
Internet users from Baidu, winning over U.S. investors in the process. As of July 2013, Baidu’s market share in PC search had declined from almost 85 percent in 2010 to 67 percent, thanks to Qihoo as well as the vertical competition such as the search functions on e-commerce sites. Only time will tell which search engine will be the market leader in the long term. To monitor the competitive dynamics between Qihoo and Baidu, my firm worked with a group of computer engineers who continuously monitored traffic volume on PC, tablets, and smart phones. One interesting finding was that, despite the initial surge in Qihoo’s market share from 0 to 10 percent, the company stagnated around that level. In addition, most of its browsing traffic occurred during the weekend, indicating that Qihoo’s browser and search engine did not penetrate into the corporate world, where people tend to do the most browsing during the workweek.

Through the years, I’ve examined most hallowed wisdom about investing in China, and I’ve found much of it to be misleading to a fault. One example is the work of Jim Rogers, a quintessential China bull. Rogers cofounded the Quantum Fund with famed investor George Soros in the 1970s, retired from his fund in the 1980s, and traveled the world on his motorcycle. He fell in love with China, eventually moved to Asia, and documented his love affair with China in his book
A Bull in China: Investing Profitably in the World’s Greatest Market
.

Rogers’s 200 pages of empty-calorie analysis can be summarized in one sentence: buy every stock in every industry in China. The book exemplified a “top-down” approach to stock selection, which typically rests on shortsighted and overly simplistic logic. Rogers argued that America was in decline and China was on the rise, as clearly evidenced by GDP growth, and he urged investors
to get in on the ground floor of “the greatest economic boom since England’s Industrial Revolution” as fast as they could. Throughout the book, Rogers enthusiastically endorsed major public companies in every sector that was growing—pretty much all industries in China. He gave only a skin-deep overview of their businesses and historical growth rates, with little company-specific fundamental analysis.

This “macro call”—an investment strategy based on one’s broad market view, a term that also signifies the top-down approach—is very common among institutional investors I encounter in New York. During corporate lunches and group meetings, where institutional investors are given access to a company’s executives and can ask them questions, I often hear such investors focus on getting color and anecdotes on the state of the economy as opposed to updates on the individual company’s businesses.

When selecting stocks using top-down analysis, investors first consider the strength of an economy as measured by its GDP growth, then look at industries within that economy, and, finally, analyze individual companies. This approach often does not work, for a simple reason: GDP measures economic activity, not profits. GDP is one driver of corporate profits but not the only one. A stock’s performance is driven by the corporate profits available for distribution to shareholders, now and in the future. There are many steps between the profits earned by companies and the dividends paid out to shareholders, including governance, taxation, and administrative and regulator expropriation. Assuming that the growth data are even reliable, GDP alone bears little relevance to the return to shareholders—especially minority shareholders—in a company.

Moreover, China’s reported macrodata are known to be fairly inaccurate. Most years, the total sum of the figures reported by individual companies, sectors, and industries does not match the overall figure released by the National Bureau of Statistics. There
are many reasons why the data are so unreliable. Chinese bureaucrats do not have any interest in reporting anything that doesn’t paint a good picture of their performance, and the statistics bureau remains woefully inadequate.

A friend of mine, the founder of a highly reputable U.S.-based provider of China macroeconomic data, told me he recently decided to halt the company’s research offerings to its Wall Street and corporate clients. The founder, one of America’s leading experts in data analysis and forecasting, confided that the data source his company received from its partner in China, an affiliate with the National Bureau of Statistics, was simply not workable. Data were often missing from the series the Chinese partner supplied, and the partner used a methodology for econometrics analysis that was 30 years behind what most Americans used, significantly diminishing the accuracy of the American company’s analysis.

GDP forecasts issued by economists at major investment banks are equally untrustworthy. These experts are no more independent than the equity research analysts and stockbrokers who package IPOs and sell them to investors. The economists at major banks try to curry favor with Chinese bureaucrats in exchange for permits to open new branches. As such, their forecasts are essentially a point-for-point rehash of what the bureaucrats tell them is coming down the pipeline in terms of fiscal and monetary policies. This is repackaged and sold as euphoria to support those banks’ profit-generating activities, such as introducing IPOs; underwriting corporate, sovereign, and municipal bonds; trading securities; and opening new branches in China.

This is not to say that the top-down methodology never works. It does occasionally, in situations where a single macrotheme overpowers other factors, such as the financial crisis in the United States or the ongoing crisis in the euro zone. But based on my experience and observation, by and large this approach tends to be less thorough than company-specific fundamental analysis—often referred
to as “bottom-up” stock selection. Top-down approaches are also prone to too many errors, especially in a centralized economy where the government’s plans and policies can change unpredictably. The latest example is the boom and bust of the solar industry in China, where government subsidies initially helped Chinese manufacturers wipe out their global competitors but eventually created so much overcapacity that subsidies were canceled and many domestic players were destroyed.

  *  *  *  

The online travel sector provides one example of why Rogers’s top-down approach of picking stocks does not and will not work. Rogers was bullish on travel companies because he believed that Chinese people would want to travel more as disposable income increased. That thesis was proven correct: China’s outbound travel market has registered double-digit growth for years, and the volume of online airline and hotel bookings has soared.

But even though demand for their services increased, online travel companies haven’t benefited much from the trend. In fact, their profitability has declined as a result of a severe price war. As Chinese consumers gained access to transparent pricing information from different service providers, they actually became more sensitive to price. Relative to Americans, Chinese consumers have more free time and lower budgets and therefore are more likely to spend time searching among various online travel providers for a deal.

During the early 2000s,
Ctrip.com
International was the market leader in the online travel industry, with 52 percent market share and an EBITDA margin of almost 45 percent. The company’s high profit margin inevitably invited competition. China’s next biggest competitor, eLong, launched a price war to grow its 8.7 percent market share. eLong had enough financial resources from its major shareholders—it was owned 56 percent by Expedia in the
United States and 16 percent by Tencent, a Chinese Internet giant—to engage in a long and bloody war. In 2012, eLong slashed the commission fees for its suppliers, and its hotel booking service volume jumped to almost 80 percent of Ctrip’s, from 20 percent in 2009.

Ctrip answered back by vowing to match the competition dollar for dollar using coupon programs, discounts, and other promotions. The online travel industry had been a cash cow, and Ctrip had plenty of money to sustain the price war. The companies’ actions tipped into the irrational. At the peak of the price war, Ctrip decided to invest $500 million to accelerate its promotion programs, causing a significant 40 percent drop in its net profit in the third quarter of 2012. eLong’s profits vanished, and it suffered a loss for the first time, as its marketing costs increased nearly 75 percent
year on year
.

At the beginning of 2013, as eLong’s hotel booking volume neared that of Ctrip, investors wondered whether the pricing would reach a rational equilibrium, as standard game theory would predict. That didn’t happen. Ctrip’s CEO Fan Min said in 2013 that Ctrip had $800 million to $900 million in cash, which “can support the company to continue the
price war for many years
.” In 2013, Ctrip’s management confirmed that it would extend cash rebate programs to air tickets, an even more competitive market.