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One of the most significant challenges associated with investing abroad is actually confirming that a company and its products are as good as they claim to be in their SEC filings. This is particularly true when it comes to China, where investor mistrust of small auditing firms and Chinese internal controls have resulted in significant volatility and an opportunity for short-sellers to exploit an information gap -- something that's become common in the sector, with recent spotlights shined on Orient Paper (NYSE: ONP ) and China Biotics (Nasdaq: CHBT ) among others.
While those companies and their investors still struggle to dispute the relevant claims, what's clear is that many investors in Chinese stocks have not performed a level of diligence that makes them comfortable actually holding the stocks regardless of what accusations arise. This is a problem for a variety of reasons, but mostly because you should only buy stocks and at an allocation that you, to paraphrase master investor Warren Buffett, would be comfortable owning even if the stock market shut down for one or more years.
How we try to solve for that
It's in order to get comfortable with our own picks and exploit that information gap for ourselves that our Motley Fool Global Gains research team travels annually to China to meet with companies, tour their facilities, and get our hands on their products. That doesn't mean we'll get every pick right, of course, but our aim is to get a leg up when it comes to analyzing companies.
One of the companies we visited -- and subsequently recommended -- during our 2008 trip was organic fertilizer maker Yongye International (Nasdaq: YONG ) , based on the thesis that the Chinese government had made increasing agricultural outputs a priority, and that Yongye had a good product and a good marketing plan to benefit from this tailwind. That pick, thus far, has been rewarded, with the stock up some 75% since July 2009.
The stock, however, continues to trade at a seemingly discounted evaluation of just 6 times EBITDA despite growing sales at a better than 90% clip over the past year. One of the reasons this discount persists is because investors, in addition to being widely skeptical of the entire China sector, are wary of Yongye's hefty accounts receivable. Remember, though, that farming is a seasonal business, and Yongye, as it has in past years, should have no problems being repaid provided its Shengmingsu fertilizer works and farmers realize more significant sales as a result.
And while Yongye makes impressive claims about its product, we wanted to test them for ourselves. So we got our hands on some product and passed it along to our official Global Gains gardener (my dad), who agreed to test it this growing season. Below you can see the result as applied to jalapeno peppers (the larger comes from a plant treated with Shengmingsu):
Now, let me be clear: While this is a promising result (and that big jalapeno is prime for stuffing), this was a very small-scale test. My dad, not unlike Chinese peasant farmers, is skeptical of applying new products to his garden, one reason why Yongye generally chooses to enter a new market by giving free samples of Shengmingsu away to a particularly influential farmer in a given community. But our Global Gains research team was impressed by our own result using Shengmingsu and will expand the test conditions during the next growing year.
Does this make Yongye a screaming buy at current prices? Not on its own; Krispy Kreme Doughnuts (NYSE: KKD ) is an example of a company with a great product that's proved to be a terrible investment. But with a solid product in addition to a seemingly cheap valuation, impressive numbers audited by KPMG, and looming profit margin improvement thanks to vertical integration, Yongye stock may be worth a look if you're looking to increase your exposure to China.