"I do think the Chinese stock market is cheaper than the American stock market. I do think that China has a bright future." – Charlie Munger (Trades, Portfolio) 2017 Berkshire Annual Meeting
Munger's quote reminded me of a recent Tweedy Browne (Trades, Portfolio) quarterly update where the firm shared an interesting Chinese investment idea: Baidu (BIDU, Financial). Baidu is the Google of China and just like its U.S. inspiration invests heavily in ventures unrelated to search like online video, navigation and AI. Well, they all have their applications within search, but the investments are not constrained to search. Baidu's valuation is rather pedestrian for the Google of China. It dominates the market while Google parent company Alphabet (GOOG, Financial) (GOOGL, Financial) has exited the Chinese market completely.
The longer a search engine can operate with a dominating market share in a certain geography the stronger the moat it can establish. That's because it collects search data which it can utilize to create a more effective product compared to competitors who lack the same relevant context. As Tweedy Browne put it:
Baidu represents our first investment in a Chinese company. It owns the dominant search engine in China and has an 80% market share. Baidu's highly profitable search engine business is currently being masked by several money-losing subsidiaries. That, combined with concerns about recent slowing revenue growth (partly due to a medical scandal in 2016, which impacted its search engine business) and some market share loss in online advertising to Tencent (HKSE:00700, Financial) (TCEHY, Financial) (FRA:NNND, Financial) (FRA:NNN1, Financial) (TCTZF) and Alibaba (BABA), has given us an attractive pricing opportunity in its shares. The company’s core search engine business has nearly 50% margins, relatively high barriers to entry and should in our view continue to benefit from the expanding Chinese online advertising market, which is widely expected to grow at a 20% rate annually.
The firm is rather cheap because of the Wei Zexi incident last year in which it advertised harmful products, there was a backlash from the community and the government decided to step in with additional regulation in the online search business. Per Tweedy Browne:
Assuming zero value for Baidu’s noncore businesses, we purchased Baidu at an enterprise value to 2017 estimated earnings before income, taxes and amortization multiple of only 11.5x. We believe this leaves significant upside optionality from the nonsearch businesses, several of which are market leaders in important sectors such as online travel and online video.
The company rarely trades at such a low operating cash flow to price ratio. Baidu is led by an owner/operator Robin Li who worked at IDD Information Services and Infoseek in the U.S. He owns 16.1% of the shares but controls a majority of the vote. Wall Street frowns upon dual vote classes of shares and it has a point, but when an owner/operator controlling a large piece of the economic pie has them I'm OK with that.
Disclosure: Author owns Baidu shares.
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