Lean Hogs, Prime Profits

Includes: HOGS, SEB, SFD
by: Investment U

By Garrett Baldwin

This week, I sat in on a lecture by a Purdue University’s agricultural economics professor on food trends over the next 10 to 30 years.

Okay, “sat in” is a bit twentieth century.

Actually, I listened to a 45-minute lecture on an iPod while driving to the Eastern Shore of Maryland. Given the amount of time I spent stalled in bridge traffic, I usually would have been sighing heavily and yelling at drivers.

But as the audio played, I had so many “a-ha” moments that I found myself waving people in to the lane in front of me while I rewound lecture portions and scribbled notes. And one statistic I noted will change the way you look at global food production and help you dig deeper to find new investment opportunities in the agriculture markets.

Two figures from the audio leapt out in the first five minutes: From the year 2000 to 2020, the population in developing countries will have increased by 40 percent. At the same time, income growth in these nations will have jumped by an average of 4.3 percent each year. The latter figure is helping to increase the size of the middle class in these nations, with China leading the way by a wide margin.

By 2020, China will have more than 250 million citizens reach middle-class income levels.

And these citizens have grown tired of just eating rice, wheat and other grain-based goods…

Let Them Eat… Pork

The increase in wages is creating a “dietary transition,” and creating significant demand for something Americans eat several times a week: Pork.

From 2007 to 2017, Asian demand for meat products will increase from 115 million tons to 149 million, a 30-percent leap, according to WorldPoultry.net. And China’s middle class is driving this huge boost. The luxury of a meat-based diet is finally affordable in this region of the world.

The dietary transition, from a grain-based diet to a meat-based one, is quickly turning global agricultural production into an eye-opening investment opportunity.

The United States now exports 24 percent of all pork it produces, up from 19 percent just last year. Our pork exports to Japan alone shot past the $1-billion mark for the seventh consecutive year just this week. And with new markets and new customers opening up all over the East, it will continue to be a very strong decade for American pork producers and investors.

Commodity Producers Aren’t Always No-Brainers

Naturally, the surging demand would lead the average investor to jump toward companies like Smithfield Foods (NYSE: SFD), the largest pork producer in the world. And with the company currently sitting below book value, it seems like a no-brainer. Still, the company earned record first-quarter profits yesterday and fell by four percent… Why?

Smithfield is susceptible to the most-pressing challenge to meat producers: Rising feed prices. Corn comprises 85 percent of a pig’s diet. And demand for corn, spurred by ethanol production and booming human demand, has led prices to rise nearly 60 percent since 2007. The cost to feed animals has risen to historic levels, chopping into margins.

And this could be the new norm. A Tyson Foods executive told The Wall Street Journal this week that corn prices could stay at their current highs for years to come. Tight margins and other market vulnerabilities (such as animal disease) don’t mean that the producers offer the best opportunity if you’re looking to get in now.

So what do you do? If you’re an investor who is just turning an eye to the agricultural market, there’s one – and only one – statistic you need to know for the rest of the decade:

  • For every calorie of meat produced for human consumption, it requires 10 calories of corn, rice and grain production to feed the animals.

Just one calorie of meat… requires that we produce 10 calories of animal feed. This creates an enormous strain on resources, particularly water, energy and land usage… and drives up the price for human consumption of corn and grain, as well. With meat consumption growing by 2.8 percent each year in these foreign markets, animal feed demand will have doubled in just 20 years. Because of this demand and cost, you’ll want to look beyond a Smithfield.

Focus on the Supply Chain

Every commodities market, whether trading barrels of oil or pork bellies, has unique characteristics that challenge and frustrate new investors. But there has always been one rule I tend to follow. If you can park yourself into the supply chain as demand rises, you will make some money. More important, you won’t be as susceptible to price shocks as you would if you’re investing in an ETF or ETN, or a company like Smithfield, which again faces rising feed costs.

So if you’re looking to invest in this growing demand, don’t just go out and buy an ETF. Consider the shipping companies with contracts that are sending pork and grain from North America to China. Find fully integrated agribusiness firms like Seaboard (AMEX: SEB), which owns grain processing plants, pork production and the ocean transportation to ship both grain and meat. The company is also diversified enough to profit in biofuel generation from corn and sugar.

Finally, it’s important to look for companies with increasing revenue from processed meats. Processed pork carries higher margins because it is typically sold to wholesalers rather than directly to butchers. By eliminating the mark-up at the butcher stage, these companies sell products wholesale and pass on rising input costs to the consumer.

Once again, you’re keeping your focus on the heart of the supply chain, and seeking companies focused on controlling their margins.

Zhongpin (Nasdaq: HOGS) is a large Chinese holding company firmly entrenched in the Chinese meat and food processing markets. It sells directly at that wholesale level and to 31 fast food companies that are spreading wildly across the nation. And though it’s down significantly from its 52-week high, there’s a lot to like when the growing middle class increases demand and continues this dietary transition toward meat products. The company’s estimated growth rate for 2011 sits at 18.2 percent. It’s expected to grow at 26.7 percent in 2012 to keep up with demand.

Two other positives:

  • The company recently had two relatively large insider purchases by the CEO and the Executive Vice President within the last week, a positive signal of confidence among company leaders.
  • An analyst at Chardan Capital Markets recently said the company could soon attract a takeover bid from a multinational agribusiness firm that’s looking to profit from the booming meat demand in China.

Stomachs are growling in China… it would serve you best not to ignore them.

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