Baidu: A Wide-Moat Business With 40% Upside Potential

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Disclosure: I am long BIDU. (More...)

Summary

• Baidu will maintain its leading position in PC search and extend its leadership into the mobile search business.
• Mobile payments, map services, online video and app distribution will be key revenue and earnings growth drivers in coming years.
• Stock is trading at a 40% discount to fair value; ramping margins could be a long-term catalyst.

Baidu's (BIDU) core search engine business is expected to continue delivering solid revenue growth over the next several years, largely driven by China's rising Internet user base. Baidu recently entered the mobile segment by providing mobile payments, map services, online video and apps. These initiatives are not yet generating meaningful revenue, but I believe they will become long-term revenue growth drivers on the back of rising demand for mobile services.

Even with Baidu shares up more than 80% over the last 12 months, the stock is still trading at a substantial discount to its Internet peers. I believe this is unjustified given the company's robust growth, ramping margins and wide economic moat. Taking these factors into account, I believe Baidu is one of the best investment opportunities of 2014.

Business Overview

Baidu is the dominant Chinese search engine, with over 70% market share, and the second-largest search engine in the world behind Google (GOOG,GOOGL). The Baidu.com website is the most trafficked website in China, and the "Baidu" brand is ranked as the most valuable Internet brand in China. The company generates revenues primarily from pay-for-performance advertising ("P4P"). Its P4P platform helps connect millions of Internet search users to its more than 753,000 marketing customers who pay it a fee based on click-throughs for priority placement of their links in the search results. Baidu was founded in 2000, and listed on the Nasdaq in 2005.

Baidu Benefits From a Tremendous Network Effect

Baidu is the dominant Internet search engine in China, with over 70% search market share as of 1Q14. Some investors have been concerned that Baidu will eventually lose its market share advantage to competitors such as Qihoo 360 (QIHU) and Sogou (including Soso). Although rising competition is a risk one should consider, I still believe Baidu will remain the dominant Chinese search engine going forward, because the company benefits from a tremendous "network effect."

Figure 1: Baidu's Total Search Market Share (PC + Mobile)

Note: This market share estimate is an average based on various sources.

Source: M&E Research, Analysys International, iResearch, CNZZ and EnfoDesk

Baidu ended 2013 with more than 753,000 marketing customers, making it the largest Internet search engine in China by some distance. This customer base has grown at an impressive 41% per annum between 2003 and 2013, and will likely continue growing at double-digit rates for the foreseeable future. More customers have led to more information on Baidu's online platforms, and consequently, attract more search engine users. This creates a self-reinforcing network effect that is very difficult for its competitors to replicate, since it takes a fairly long time for other companies to achieve a user base of similar size. Moreover, millions of Internet users rely on Baidu's dominant online platform to connect with each other and share information and knowledge. It is highly unlikely for users to give up the massive network and information source by switching away from Baidu.

I believe the increasing Internet penetration in China will help widen Baidu's economic moat over time. First-time Internet users are more likely to choose Baidu as their preferred search engine, simply due to the fact that it is probably the one they are most familiar with. In my opinion, this gives Baidu an enormous competitive advantage. The Internet penetration rate in China has increased steadily from 6% in 2003 to just below 46% in 2013. However, this penetration rate is still low compared to developed countries. The Unites States, for example, has a penetration rate of nearly 80%. Over the long term, the growth in the number of Internet users in China will contribute toward the growth in the number of Baidu users. I believe this will further strengthen the company's network effect and widen its economic moat.

Figure 2: Internet Penetration Rate in China

Source: M&E Research and CNNIC

Mobile Business Will Be a Long-Term Growth Driver

The number of mobile Internet users in China has grown at 47% per annum between 2007 and 2013, and reached 500 million by the end of 2013. Still, considering China has a population of over 1.3 billion, this represents a mobile Internet penetration rate of only 37%. Although, with the continued rapid adoption of mobile devices in China, the number of mobile Internet users is likely to see further growth in coming years.

Figure 3: Mobile Internet Penetration Rate in China

Source: M&E Research and CNNIC

I believe Baidu is the strongest-positioned to benefit from the fast-growing mobile search market. According to the 2013 survey on "Internet User Search Behavior" by CNNIC, over 89% of mobile Internet users in China picked Baidu as their favorite mobile search engine, dwarfing its main competitors Qihoo 360 and Sogou (including Soso). This suggests that Baidu's mobile search will eventually achieve success similar to its PC search business.

Buy, hold and prosper: The power of patient investing

It's behavior that determines your success or failure as an investor -- not knowledge, skill or luck.

If you ever needed a lesson in the power of patience, let me remind you of a date in recent history: March 9, 2009.

On that day, the Dow Jones Industrial Average($INDU -0.89%) closed at a gut-wrenching low of 6,547. Stock prices had been cut in half in just 15 months.General Electric (GE -0.59%, news) had plunged from $38 to $7, Cisco Systems (CSCO -0.84%, news) from $29 to $14, and Bank of America (BAC -2.17%, news) from $43 to $4.

Making money in the stock market is hard not because finding great companies is difficult but because the best and easiest-to-understand strategy for winning is so difficult to adhere to. That strategy can be described in three words: buy and hold.

Five years from that 2009 bottom, the Dow was up roughly 10,000 points to a new record. No, the stock market doesn't always bounce back so dramatically, but it always bounces back.

No matter what the chart followers say, the market does not rise and fall in repeating patterns. If it's down sharply in a three-year stretch, for example, it won't necessarily rise just as sharply over the next three years. The market works on its own time­table, but there are some eternal verities:

Best buy-and-hold stocks

1. Stocks of large U.S. companies have reliably returned about 10 percent annualized over the past two centuries. They should do just as well for the next two.
2. In the short term, the market can be risky -- if we define risk as volatility, or the severity of the ups and downs. In the long term, the market is much, much less risky.
3. Individual companies can vaporize (Enron and Lehman Brothers, to name a couple), but a diversified portfolio protects you from the risk that an individual company will implode and provides a smoother ride.
4. Compounding is enormously powerful. Over long periods, small price gains and dividend payouts mount up (but note that the expenses charged by mutual funds, brokers and other advisers add up, too).

And that's it! That is all you need to know about succeeding in the stock market. Buy a solid, low-cost, diversified mutual fund (or assemble your own diversified port­folio), forget about it for a long time, and you should do well.

As an example, consider Dodge & Cox Stock (DODGX -2.08%, news), with an expense ratio of 0.52 percent. Over the past 15 years, a $10,000 investment in Dodge & Cox, a member of the Kiplinger 25, grew to about $40,000. At that rate, in another 15 years it will become $160,000, and in another 15 years it will be $640,000. And that spectacular growth comes from an annualized return of 9.5 percent, roughly the historical norm. Any 30-year-old who can put away $30,000 -- not every year but just once -- has an excellent chance of becoming a millionaire by age 70.

Psychological hurdles

It is behavior that determines investment success or failure -- not knowledge or skill or luck. Benjamin Graham, the Columbia University professor and financier who was Warren Buffett's mentor, wrote: "The investor's chief problem -- and even his worst enemy -- is likely to be himself." What he meant was that people let their emotions get in the way of smart investment moves. They tend to buy when stocks soar and sell when stocks sink.

• Video: The deadly sins of investing

The selling part is especially dangerous because people want to avoid losing. Richard Thaler and Cass Sunstein write in their book "Nudge" that academic research has found that "losing something makes you twice as miserable as gaining the same thing makes you happy."

TICKERS IN THIS ARTICLE

NAME		LAST	CHNG	% CHNG
	$INDU	16,026.75	-143.47	-0.89
	GE	25.43	-0.15	-0.59
	CSCO	22.46	-0.19	-0.84
	BAC	15.77	-0.35	-2.17
	DODGX	167.83	-3.57	-2.08

They point out that in 1992, participants in retirement plans administered by Vanguard were allocating 58 percent of their assets to stocks. But by 2000, as stocks had quadrupled in value, the proportion rose to 74 percent. Then, as stocks fell sharply over the next two years, the allocation fell to 54 percent. "Their market timing," they write, "was backward." We saw the same phenomenon during the recent cycle, with investors bailing out of stock funds as prices sank and returning only recently, as indexes hit new highs.

The values that help you succeed in the market are the values that Aristotle extolled: moderation, persistence and humility. The question is how to adopt behaviors that fit those values when the minute-by-minute noise of the market is so dramatic. Here's some advice:

Avoid the noise. One way to make yourself get out of bed in the morning without hitting the snooze button is simply to move the alarm clock away from your bed. The investment equivalent is moving stock-price information as far away as you can. Twenty years ago, I told the editor of the Washington Post's business section to quit running pages and pages of stock prices. Stop encouraging readers to check how their shares were doing each morning. The Post did drop the tables, but mainly because readers can now get prices by the second on their computers and smart phones. Don't fall into that habit. Check your holdings once a month or once a quarter.

Think of your holdings not in dollar terms but as investments in great businesses. When GE drops in price, think of the event not in terms of money that you have lost but in terms of someone else's transitory valuation of your little piece of GE. Do you really want to give up a stake in a wonderful company just because others fleetingly believe it is worth less?

For many investors, sitting still is not an option. They have to do something. If you're in that category, I suggest you set up a "fun and games" account, a separate portfolio that represents, say, 5 to 10 percent of your assets and in which you can trade to your heart's content. Compare its results with that of your buy-and-hold portfolio over five or ten years. Chances are high that your emotions and the costs of trading have taken a toll.

Make purchases in the same amount every month or quarter. This technique, known as dollar-cost averaging, forces you to buy more shares when prices drop. Instead of feeling bad about market declines, you may actually feel good because you are picking up more assets at better prices.

Think buy, not sell. Hunt for bargains. The recovery, by the way, is not over. For example, GE trades today at $26, still about one-third below its 2007 high. Cisco sells for under $23, also about one-third off its high. Bank of America is at $16, still down about 70 percent. I recommend them all.

In urging a buy-and-hold strategy, I am not suggesting that you mindlessly keep companies that have gone sour. The reason to sell, however, is not that the price of a stock has declined but that the business has deteriorated and is unlikely to recover -- a key new product has failed, a rival has started a price war, or the new CEO is clueless. If you have chosen stocks well, these events will be rare. And if you are wise, you will err on the side of keeping what you have. If you had done that five years ago, your portfolio would be up, oh, some 200 percent.

By James K. Glassman, Kiplinger

James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is "Safety Net." He owns none of the stocks mentioned.

Source: http://money.msn.com/how-to-invest/buy-hold-and-prosper-the-power-of-patient-investing