As Silicon Valley Falters, China Closes the Gap in Tech IPOs

For the last few decades, the American economy has been fueled by technology start-ups. But with Silicon Valley venture investing down 37% in the last year, that trend seems to have lost some of its vigor.

You have to hand it to American investment bankers, though. For the last few years, Wall Street has gone to China in search of companies to take public on U.S. exchanges. Since 2005, Chinese companies have raised $210 billion in global IPOs, 14% more than U.S. companies. China leads the way in U.S. IPOs -- in 2009, 11 of the 14 foreign IPOs on United States exchanges were of mainland Chinese companies.The best example of this is (CYOU) -- a gaming company that is 70%-owned by Chinese portal, Sohu (SOHU) -- whose April 2009 NASDAQ IPO was so successful that it set off a $55 billion Chinese IPO flurry last year.

In my forthcoming book, co-authored with Professor Srini Rangan -- Capital Rising: How Capital Flows are Changing Business Systems All Over the World -- we discuss Changyou as an example of how access to global capital markets is transforming the way start-ups form and grow.

China Star

China is the sole bright spot in an otherwise dull decade for technology-backed ventures. Silicon Valley appears to have lost its magic touch. But what is really happening is that China is growing at 8.7% and is poised to surpass the U.S. in a few decades. Many of the executives who are running those Chinese start-ups have been educated in the U.S., they often get venture capital from the U.S., and increasingly they are going public in the U.S.

But U.S. investors need to be careful. As I wrote earlier, famed short seller James Chanos believes that China's economy is headed for trouble, with a real estate bubble that is going to burst and the only issue being how bad it will be. Housing starts in China spiked 194% in 2009 -- and 90% of the new supply is targeted towards the luxury market. One result is that the typical 1,000 square foot apartment in Beijing now sells for 80 times the local average income.

Recognizing the threat, China is trying to tighten its money supply. To that end it added 50 basis points (100 basis points = 1%) to the level of reserves (16% of deposits) that its big banks must keep aside in China's central bank. However, since those big banks typically keep 18% in reserves, this shouldn't inhibit lending much.

Some analysts worry that high-tech start-ups may be joining real estate as potential bubbles. To hedge the risk of an American-style Internet bubble implosion, investors ought to consider applying four tests to any Chinese IPO trading on a U.S. exchange:

  • The CEO and other top executives have their net worth tied up in the public shares,
  • The company participates in a large, rapidly growing industry,
  • The company is the market-share leader and has the skills needed to maintain that lead,
  • The company usually beats earnings expectations and raises revenue and profit guidance.
I leave it to readers to apply these tests to Changyou and other Chinese tech stocks that come along to decide whether they are bubble stocks or a bargains.
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