Monday was an ugly day on Wall Street.  Stocks had the sharpest decline we have seen in two months with the S&P dropping a full 3% by days end.  Headlines pointed to concerns over the economic recovery and skittish investors after such a strong run from the March lows.  This is a critical juncture in the market as a decline in investor confidence could quickly snowball into a much more significant decline in the market.  Estimates of a potential decline range from a few days of selling, to a test of the March lows, to dour pictures of new lows and great depression style calamity.

While my estimate is for a month or two of weakness with the markets holding above the March lows, it is important to respect the potential for a much bigger decline if the economy continues to show anemic signs of recovery.  In particular, stocks with excessive speculation could be vulnerable to decline as investors flee to safer opportunities and place a larger portion of their account in cash.

Baidu, Inc. (BIDU) more than doubled the market’s loss Monday with a loss of 6.6% on heavy volume.  It appears institutional investors are quickly liquidating positions in the “Google of China.”  The concern is that if the economy is weakening, BIDU will not be able to grow advertising revenue as quickly.  With the stock trading at 48 times 2009 expected earnings, there is very little room for disappointment.

Bullish investors point to the fact that BIDU has seen strong historical growth despite the tough market environment which is certainly true.  However, the year-over-year revenue growth has slowed in each of the last four quarters.  Q1 2008 saw revenue growth of 130%.  In subsequent quarters, the growth declined to 122%, 103%, 69%, and in the first quarter of 2009 revenue growth was only 45%.  The execution is certainly impressive, but may not justify such a high multiple on the stock.

In a market environment like we are experiencing today, perception can much more of an effect on stocks than reality.  This is why we often see stocks pushed above what many would consider to be a “fair value” as investors become excited about a growth story and buy at any price.  Conversely, there are times when investors perceive more risk and will sell stocks down to a level that is fundamentally cheap and offers incredible bargains.  As traders, picking up on these subtle changes in perception can yield impressive gains over time.

The sentiment appears to be changing for well-followed and generally accepted growth stocks.  The change similar to the overall market’s concern over a potential stall in the accepted economic recovery theory.  But in the case of individual stocks like BIDU, the change is magnified.  We can see that the beta (rate of change compared to change in the market) is very high with BIDU.  But more than just a statistical measure, it appears that fear in the general market will be magnified for BIDU as the stock is leveraged toward the future growth of this well known company.

Now to be fair, Baidu is an excellent company with a strong management team.  The balance sheet has no debt, and a healthy cash balance.  So the fear of a complete business failure is totally unfounded.  Growth will likely still be relatively strong despite an economic downturn simply because of the demographics in China.   But that growth may come in below expectations.

The first quarter is understood to be a seasonally weak time due to dynamics surrounding the Chinese New Year.  So while revenues and earnings were above the year ago levels, the first quarter revenue and earnings figures came in well below fourth quarter levels for a sequential decline.  It will be very important to see how the second quarter numbers come in.  If the company is able to show seasonal and year-over-year strength, the numbers will go far towards propping up the stock even in a declining market.

However, if those numbers show growth continuing to slow it could be very difficult for investors to swallow and the stock could drop to a more reasonable multiple of 25 to 30.  A lower multiple coupled with lower 2009 and 2010 earnings expectations could be devastating to the stock.  Consider a multiple of 30 on lowered 2009 estimates of $5.00 would leave us with a price of $150, a 44% drop from current prices.

In the current market it pays to be cautious.  I would recommend considering BIDU as a short opportunity to offset risk in other long positions.  One could use a stop at $315 which would be a new recovery high for the stock.  If this level is breached the short should be closed as BIDU would obviously be stronger than we anticipate.  But if correct, this short could yield strong gains in a rough environment.

FD: Author does not have a position in BIDU

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