The baby formula industry has enjoyed an amazing run. The share prices of Bellamy's Australia Ltd (ASX: BAL) and a2 Milk Company Ltd (ASX: A2M) have grown 451% and 331% respectively since April 2015. Bega Cheese Ltd's (ASX: BGA) share price hasn't moved in this time.
There has been growing demand in China for safe, high-quality baby formula products which these companies provide. Not long ago there was so much demand that people were buying products in Australia and selling them overseas for a large mark-up, leaving retailers' shelves bare and imposing a purchase limit per customer.
However, maybe the market had pencilled in too much growth and now reality is catching up with the share prices. Retailers are no longer facing major shortages of baby formula; perhaps the supply and demand curve will change to be in the consumers' favour?
Possible obstacles
There are two possible obstacles for the baby formula related companies.
The first is that the Chinese government is trying to crack down on the "grey market" goods being shipped into China unofficially.
The other obstacle is competition. There are many huge corporations in the food industry that would want a slice of this booming market. Nestle and others may swoop in to take more market share.
Blackmores Limited (ASX: BKL) is also launching its own formula to leverage off the success of its other products in Asia, directly competing with a2 Milk Company and Bellamy's. This Blackmores product will be supplied by Bega.
Outlook
With China recently increasing its one child policy to two in 2015, there could be a baby boom. This could resulting in more formula being required. As long as these Australian companies can grow their sales directly in China, it will unlock a large direct market for them.
The populations of South East Asia and Australia continue to grow, so as long as the average number of births remains steady (or increases), it's pretty safe to assume volume demand for baby formula will continue to grow.
Valuation
It's hard to know what the right price is to pay for these growing businesses. Bellamy's is trading at 24x FY16's earnings, a2 Milk Company is trading at 33x FY16's earnings and Bega is trading at 25x FY16's earnings (source:Commsec).
These are pretty high multiples for any industry.
When you take into account FY18's estimated earnings, the prices look more reasonable; Bellamy's at 12.5x, a2 Milk Company at 17.7x, and Bega at 17.3x.
Dividend
Bellamy's and Bega are not known for being big dividend payers; Bellamy's has a grossed up yield of 1.48%, and Bega's is 2.64%. However, in the years to come the dividend may grow substantially. A2 Milk Company doesn't pay a dividend (yet).
Foolish takeaway
It's always important to be mindful of the price you pay when buying growth stocks. Bellamy's shares are still 16% down from the all-time high in December 2015. But long-term investors could still get solid returns from these companies.
Bellamy's would be my pick out of the three for Foolish investors who want to buy into this baby formula trend. It's purely focused on baby formula production and looks promising for long term growth at the current price. A2 Milk Company and Bega have slower growing areas of their businesses which could dilute the overall speed of growth.
