Cash in on the China Internet Explosion

Invest in dot-com stocks? What are you, nuts?

Whoa, and in China? The Shanghai Composite is down almost 50 percent since October.

It may be a measure of the riskiness of stocks anywhere in the world right now, but Morgan Stanley has an answer to those two queries:

Yes, Internet and media stocks and, second, yes, because it’s a "safer haven” for investment dollars now, according to a new report from the investment bank.

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The reason? China’s dot-com boom is just starting.

Don’t confuse price with value, says a Morgan Stanley research team, led by Richard Ji.

In short: Price is what you pay, value is what you get.

As Warren Buffett would say, wait for the best price then go long-term, counsels the report, entitled, "Bargain Hunting in Digital China.”

While realistic about the complex hurdles ahead for China’s economy, including a 12-year high inflation rate and a currency that could appreciate as much as 11 percent this year, the bank is nevertheless bullish on Chinese new media.

Part of the reason is a growing consumer public. China’s Internet population will soon surpass that of the U.S., and its growth there is outpacing other consumer sectors.

Just 16 percent of Chinese are online now — far below the 60 percent to 70 percent levels in the U.S., Japan and Korea. So, there’s plenty of room for growth before the market becomes saturated.

Chinese new media players, too, are substantially more profitable than their global peers and should thus be valued by traditional valuation methods, the report notes.

The operating margins for listed Chinese Internet companies averaged 35 percent last year, nearly three times that of their U.S. counterparts, largely due to China’s lower labor costs.

They are also among the biggest cash-flow generating companies.

The bank benchmarked for margin of safety, high earnings yield, rising return on investment, counter-cyclical nature, and brand loyalty.

In the end, the bank’s top three picks are Perfect World, Tencent and Focus Media.

With a low teens earnings multiple and compounded earnings growth of more than 50 percent for the next three years, Perfect World — which consistently ranks at the top of Morgan Stanley’s valuation screens — offers a favorable return versus risk ratio, the bank said.

The bank expects that Tencent, the largest online portal in China, will be defensive amid market choppiness thanks to the brand loyalty of its users.

Focus Media is currently trading at low-20 times the bank’s projected 2008 earnings. "For long-term investors, we believe it may be time to accumulate the shares of this leading advertising platform,” the report says.

Chinese Internet users enjoy faster spending power growth than the general Chinese population.

Seventy percent of Chinese Web surfers are below the age of 30 and tend to be early adopters and sometimes "impulse buyers” for new online services.

Finally, nearly a quarter of Chinese Internet users have college degrees, compared to 5 percent for the country’s general population.

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