Stop Playing With That Darn 'Spiritual Opium'

China moves its regulation sights on video games – or does it?... Stop playing with that darn 'spiritual opium'... Mr. Market is nervous... Steve's advice on Chinese stocks... Two of our picks get bought for $10 billion... Why capital efficiency matters...

Parents regularly tell their kids to 'stop playing those darn video games'...

A notable Chinese state-owned news outlet just did the same, but with harsher language...

China's Economic Information Daily published an article yesterday that described online video games as "spiritual opium"... and specifically cited a game called Honor of Kings, produced by Chinese tech company Tencent (TCEHY).

We hadn't heard the "spiritual opium" metaphor to describe video games, but it sure is a good one if you want to effectively ascribe a negative connotation to something in China – and grab attention amid an already-hot regulatory panic...

As a result, shares of Tencent and fellow Chinese video-gaming giant NetEase (NTES) tumbled at least 10% Tuesday morning amid the report... which ended up being deleted from the Economic Information Daily's website by noon. (Such it is with state-run media.)

According to a source cited by the South China Morning Post, the report was deleted – from the "investigation" section of the newspaper – because it does not represent the communist government's official stance.

It could also be simply that the Chinese government did not want tech stocks to lose even more ground, amid an already 50% drop... Last week, we reported that Chinese regulators have recently talked with major investment banks to ease their fears about changes in the regulatory environment in the country.

In any case, the damage was done, as global news service Reuters reported...

The broadside re-ignited investor fears about state intervention after Beijing had already targeted the property, education and technology sectors to curb cost pressures and reassert the primacy of socialism after years of runaway market growth.

And as NewsWire analyst Daniel Smoot reported yesterday...

These latest comments from Chinese state-owned media put downward pressure on TCEHY, as well as other Chinese gaming companies. They even weighed on foreign developers, as China has a colossal video-game market and any potential regulatory changes could weigh on future profits.

With all the news about increased regulation coming out of China lately, enough investors believed the newspaper's original reporting, figuring that it knew something they did not know about a regulatory crackdown coming in another industry...

We're reminded of something our Stansberry NewsWire editor C. Scott Garliss, who worked for 20 years on Wall Street, often says. In situations like these, institutional investors like to "sell first and ask questions later."

This is a continuation of the story we detailed one week ago...

In last Wednesday's Digest, we reported on the massive sell-off in Chinese stocks over the last several weeks stemming from reports of increased regulation in various industries like education and technology... We also wrote about the importance of sticking to your stop-losses...

For those who thought a 50% cut in leading Chinese tech names might represent a buying opportunity... we said, "Not so fast," citing the advice of our True Wealth Opportunities: China editor Steve Sjuggerud and analyst Brian Tycangco.

It's simply unclear where this regulation story (and the reaction to it) will end and how it will affect some of the most important names in China – like Tencent, Alibaba (BABA), or JD.com (JD), which subscribers were stopped out of in the past couple of months.

As Steve and Brian wrote in a special update to True Wealth Opportunities: China subscribers on Wednesday...

Even though we knew these companies were terrific businesses in their own right, we told you to stick to your stop losses. That meant realizing much lower gains, but it also meant being able to preserve your capital for a better entry point in the future.

For example, since Steve and his team issued a sell alert on Alibaba on May 14 (for a 12% gain), shares have lost roughly 5%...

It's a similar story with Tencent, which Steve told subscribers to sell on July 26 (for a 48% gain). Shares have lost another 7% of value... and they could head lower.

In an already-jittery market, it doesn't take much to send shares of a down-trending company lower...

Zooming out, the regulatory calls are real, but the fears might be a tad overblown...

For example, Chinese education stocks listed on the New York Stock Exchange have fallen by as much as 80% in panic selling after the country essentially banned for-profit tutoring. Says Steve...

Beijing is looking to address a growing social issue in China – the rising cost of education, which is already estimated to eat up around one-third of a typical family's annual disposable income.

Beijing believes this is preventing Chinese couples from having more kids, cutting population growth to a trickle.

Believe me, I know where the Chinese government is coming from. I had to send my own child to an early education program at age 4 because entrance standards had been going up for the private elementary school my wife and I had in mind for him.

The pressure to stand out, or at least have an advantage, is intense.

Steve says tutoring after school may be a rarity in America... but in Asia, it's practically the norm. And it can often add up to an extra 50% to 100% of school tuition...

These are real things happening behind the scenes in China's education market, and that's why Beijing is showing a lot of concern.

Similarly, according to Dan of our NewsWire team, the sentiment around video games could be more of a short-term issue than a long-term problem...

China isn't looking to destroy an incredibly popular and profitable industry. Rather, the country wants companies to implement features that limit playtime, protect minors from digital gambling, and promote social well-being.

... But Mr. Market doesn't necessarily care right now. When the words "China" and "regulation" meet in the headlines for several weeks straight, investors get nervous. Steve talked about this in his special update last Wednesday...

Nobody likes change... especially drastic changes like the regulations Beijing has started to impose on its tech industry. And as the Chinese government races to catch up with an industry that ran loose for 20 years, things are going to get a little rough...

Beijing is still catching up with the tech sector, and it will at times resort to pulling on companies' shirts to close the distance.

According to our Ten Stock Trader editor Greg Diamond, there are technical signs that suggest Chinese stocks are near a "bottom"... but they are nonetheless still weak...

And if you know Steve's work at all, you know that he's not going to invest in something until the trend is in his (and your) favor – he'll have much more on this point in a guest Digest essay tomorrow. Right now, that's just not the case with Chinese stocks.

Moving on, to some big (positive) news about two companies we're familiar with...

While many spent July taking their first vacation in over a year, American private equity giant Thoma Bravo went on a shopping spree... and subscribers of our flagship Stansberry's Investment Advisory are among the beneficiaries.

The private equity firm announced a $6.6 billion acquisition of Internet postage and shipping company Stamps.com (STMP) on July 9 and last Monday reported on its $6.4 billion deal for customer-relations Software as a Service (SaaS) provider Medallia (MDLA).

Our research team recommended buying shares of both companies in the Investment Advisory earlier this year.

We recommended Stamps.com in February and Medallia in March, and the positions are up 38% and 21%, respectively, since then – impressive short-term gains in what has frequently been a choppy market in 2021.

This all makes us consider: Who from Thoma Bravo might be reading us?

Or, just as likely, they simply like the same things about the companies that we do...

For Thoma Bravo, these are just the latest public companies to agree to a takeout (industry jargon for a company selling itself) by the private equity firm – which manages $78 billion in assets – becoming the firm's sixth and seventh multibillion-dollar deals over the last 12 months.

At least part of the catalyst for Thoma Bravo's deal frenzy has been the nearly $23 billion it raised last October, including a company record $17.8 billion for its flagship fund targeting specific types of companies...

The firm focuses on software and technology. And when it's looking to invest in private companies, or buy out public ones in this case, it tends to seek businesses with an attribute that Stansberry editors harp on over and over again: capital efficiency.

Capital efficiency is one of the simplest, yet most enduring investing principals...

As our senior analyst Mike DiBiase writes in the description of the "Capital Efficiency Monitor" in Stansberry's Investment Advisory...

Capital efficiency is the measure of the ability of a company to turn each dollar of sales into cash that's available for shareholders. The more cash a company is able to deliver for shareholders for every dollar brought in, the more capital efficient it is.

Stamps.com has been a fixture in our Capital Efficiency Monitor since 2016, and regular Digest readers will be familiar with the attractiveness of companies employing a SaaS model like Medallia's.

We've featured many essays discussing the benefits of the SaaS model, but for those who are new or would like a refresher, the Investment Advisory team summed it up succinctly in a recent special report...

In most cases, paying 10 to 20 times revenues would be a sign of a market lunacy. But the sticky SaaS business has different dynamics.

The best SaaS companies' renewal rates range between 95% and 98%. That means a dollar of SaaS revenue won in 2020 will – without any additional sales effort – revisit the company again in 2022, 2023, 2024... and unless the company comes up with a reason to change software providers.

In other words, a dollar of SaaS revenue really is much more valuable than a dollar of perpetual-license revenue... or a dollar of retail revenue... or even a dollar of almost any other kind of revenue. And that's why Wall Street values these companies so much higher than their perpetual-license peers – or any other business, for that matter.

The premium valuation the market generally gives capital-efficient businesses, like technology and SaaS companies, is often warranted.

But the public markets may not agree...

Both Stamps.com and Medallia struggled to drive shares higher for more than a year before their acquisition announcements. In fact, Stamps.com shares might be up 38% since February, but they were basically flat for the year before leaping 63% on the Thoma Bravo buy announcement.

In situations like these, selling to private equity buyers like Thoma Bravo, with much longer time horizons than public market investors, is a common tactic. And in many cases, it's an example of the efficiency of markets and a win-win for both the buyers and sellers.

The target shareholders are generally able to realize a significant return on an investment that wasn't appreciating on the public market. (Some investors, such as Investment Advisory subscribers who buy into these opportunities at advantageous times, benefit even more than the average shareholder.) And the acquirer gets a business at a discount to its estimate of the business's intrinsic value.

All in all, we're happy to see these deals get done...

First off, as we already mentioned, both deals are delivering strong returns for Investment Advisory subscribers.

And, secondly, the fact that two of our recommendations were bought out within two weeks for more than $10 billion combined represents some validation of our research efforts...

Despite the nuttiness of today's market, there is value (and a lot of it) in doing the fundamental research that allows us to identify great companies, trends, or ideas worthy of investing in.

Our editors do that each and every day... and our flagship Investment Advisory is no better representation of this idea. These two great recommendations are just one example...

Last month, our team tackled the "meme stock" explosion – and potential upcoming implosion – of names like GameStop (GME) and AMC Entertainment (AMC).

Instead of recommending shares of those companies that have been wildly erratic, our team found a better opportunity in an overlooked company that lets a lot of today's "meme stock" trading actually happen, no matter which direction the shares go.

If you want to get in on our team's next big ideas, be sure to give our flagship newsletter a try. Now is the perfect time. The next issue of the Investment Advisory is due out Friday, and you can try a subscription risk-free.

Click here for more details on how to get started.

It's a 'Melt Up' Until Proven Wrong

We are still in a raging bull market and a full "Melt Up," and we will continue to see it until proven wrong, says Chris Vermeulen, founder of The Technical Traders. But with that, risk is also high for a stock market breakdown.

"We are on the verge of getting into a deeper correction, then we will hit complacency where we will see precious metals and bonds come to life," he told our editor-at-large Daniela Cambone. "Everything is overpriced, and it's high-risk. We are in a topping area that everyone needs to be aware of."

Click here to watch this video right now. For more free video content, subscribe to our Stansberry Research YouTube channel... and don't forget to follow us on Facebook, Instagram, LinkedIn, and Twitter.

New 52-week highs (as of 8/3/21): ABB (ABB), Automatic Data Processing (ADP), AutoZone (AZO), Bristol-Myers Squibb (BMY), CBOE Global Markets (CBOE), Richemont (CFRUY), CoreSite Realty (COR), Costco Wholesale (COST), Dollar General (DG), Quest Diagnostics (DGX), Franco-Nevada (FNV), Intuit (INTU), Johnson & Johnson (JNJ), Lynas Rare Earths (LYSDY), Motorola Solutions (MSI), Novo Nordisk (NVO), NVR (NVR), ResMed (RMD), ProShares Ultra Health Care Fund (RXL), S&P Global (SPGI), ProShares Ultra S&P 500 Fund (SSO), Stamps.com (STMP), Trane Technologies (TT), ProShares Ultra Semiconductors Fund (USD), Vanguard S&P 500 Fund (VOO), and Waste Management (WM).

A quiet mailbag today... What's on your mind? Let us know at feedback@stansberryresearch.com.

All the best,

Corey McLaughlin and Jacob Abrams
Baltimore, Maryland
August 4, 2021