Pigging Out on Zhongpin

Jul.10.08 | About: Zhongpin Inc. (HOGS)

Investing in China is risky business at best. The local exchanges in China are dominated by former State Owned Enterprises (SOEs) where the public float is limited and short selling is illegal. It’s a perfect recipe for a recurrent bubble. And, as we all know, bubbles pop.

The Shanghai Composite index is down around 50% this year and still appears to be overvalued. Yet, China is the greatest growth play that investors are likely to experience in this century. Shouldn’t there be a safe way to play this phenomenon without getting caught in the wild boom and bust cycles of the domestic exchanges? There is and the answer lies in US listed Chinese companies.

Briefly, the benefits of a US listed Chinese company as compared to the locally or Hong Kong listed alternatives are numerous and significant. They always include US GAAP accounting, and SEC filed earnings and news releases. They may also include: analyst coverage, available Investor Relations staff, and access to management at investor conferences or on earnings calls.

While GAAP Accounting and access to financials is incredibly important and cannot be discounted, I find three other factors equally key to my desire to play China through US listed Chinese companies. The first of these is corporate management. Unlike the SOEs, the companies listed in the US are owned by management. They have their skin in the game and will be focused on the bottom line, not some government driven agenda. These management teams are entrepreneurial, having founded the companies in most circumstances. And, in most cases, they are honest. Why else would they take their prize asset, the majority of their net worth, and subject it to US investor scrutiny and SEC regulation?

The second factor is a derivative of the first: the nature of these companies. By being privately held and founded by entrepreneurs, US listed Chinese companies tend to be smaller, faster growing and cleaner in terms of balance sheet and non-performing assets. I’m a long term investor and the best way to make money in the long term is through earnings growth. While the former SOEs may look cheap (at times) on an asset basis, they will not be consistent earnings growers for the next ten plus years. Meanwhile, there are many US listed Chinese companies in the 200-500 million market cap range that are very well positioned to see earnings growth of 20% or more over that timeframe.

Finally, the last reason to like the US listed Chinese companies is perhaps the most important: valuation. These companies as a group trade at P/E ratios that start in the low teens and may range into the mid single digits. This combination of low P/Es and high growth rates is an investor’s stock picking Eden. Combine this with the benefits of SEC regulation and, “it just don’t get no better than this!”

Sadly, this is not to say that all of these companies are destined to make investors money for the next ten years. There will be some blowups, missteps by management, and outright fraud involved:  this is a guaranteed fact surrounding every bull market. Investors must exercise caution and perform proper due diligence before delving into any investment, certainly one halfway around the world. Personally, I always speak to management, listen to earnings calls, talk to analysts and scrutinize filings for hidden clues. While no one’s track record is perfect, doing my homework has helped me avoid the losers more often than not.

Which leads me to one of my favorite investment ideas: HOGS!

Henan Zhongpin (NASDAQ: HOGS) is a pork processor located in Henan Province, smack in the middle of the People’s Republic of China. HOGS is very profitable, rapidly growing, perfectly situated in the Chinese economy, and trades below 10x expected 2008 earnings…it’s a no-brainer!

First, the industry. Pork is the main meat consumed in China, which is the world’s largest producer and consumer of the meat. While the population of China has ceased its growth, pork consumption is expected to increase. This is possible due to the wealth effect. Wealthy nations, and individuals, consume more meat products than their poorer counterparts. As the Chinese economy continues to boom, the increased wealth available to Chinese citizens will be a strong driver of pork consumption.

Within the pork industry is another fundamental change that benefits HOGS in particular. This is the shift from the traditional “wet” markets to modern “dry” processed meats. Basically, a wet market is a neighborhood butcher hanging a pig outside his shop. Unsavory at best and incredibly unsanitary. The Chinese authorities are slowly weeding out the wet markets in favor of processed, or dry, meats. This shift in the basic underpinnings of the pork industry will take years to fully implement and will be a continuous growth driver for companies such as HOGS.

Looking at the fundamentals of HOGS in particular, it is a combination of organic and acquisition growth that is driving its earnings. From 56 cents per share in 2006, the company reached 89 cents last year and is projected to reach $1.10 in EPS in 2008. HOGS has continually exceeded expectations and, with their recently announced plant expansion stands poised to do so going forward.

I could continue to gush over the management team (it’s solid) or the other factors affecting the pork market, China, or many other reasons to invest here. However, in my opinion, it’s a simple story that needs little financial acumen to appreciate: China is growing, Pork consumption is growing, HOGS is growing over 25% per year and is trading at less than 10x 2008 earnings. Buy HOGS now and thank me for years to come.

Disclosure: Author  holds a long position in HOGS in his personal account