8/14/2012 4:10 PM ET|
Investing for the summer scorcher
With nearly two-thirds of the nation in a drought, corn prices are soaring, and food prices are bound to jump. How might the weather affect what's in your portfolio?
Talk about a summer sizzle. If you think the July scorcher most of the country suffered through was the worst ever, guess what? You're right.
Last month was the warmest July for the lower 48 since 1895, the first year for which we have consistent records, says the National Oceanic and Atmospheric Administration. Blame it in part on a La Niña weather pattern, which moves the jet stream northward in a way that creates warmer and dryer weather for much of the U.S.
This helped push the nation deeper into a massive dry spell. As of July, 63% of the U.S. was in drought, the worst percentage since 1934.
The good news is that some relief may be on the way. "I think we have reached the peak," says AccuWeather meteorologist Paul Pastelok, citing increased rainfall around the northern and western edges of the drought-stricken heartland.
The bad news: This relief is far from certain, and it comes too late to save much of this year's devastated corn crop. "It's a little early to celebrate," says Pastelok.
The drought has spiked the prices of key grains, such as corn and soybeans, which trickle down into hundreds of products. You'll feel the impact of the drought in grocery checkout lines, restaurants and perhaps in your stock portfolio, for at least a year, even if you live outside the sun-scorched parts of the nation.
But while you'll shell out more for food, there are also ways for investors to make a little money. Here's a roundup of stocks and funds to use as drought plays, and the risks, as well as some to avoid for now.
Putting some money into corn
To see why this drought has such broad impact, take a look at corn.
Corn supplies will be stuck at limited levels well into next year, possibly through next fall. But corn demand won't really fall, says James Dunn, a professor of agricultural economics at Penn State University. "The big thing to remember about corn is that there aren't many substitutes."
That's certainly the case with the two biggest uses for corn: feeding livestock and producing ethanol for use in gasoline. For food producers, the third big consumer of this crop, corn is only a small percentage of the overall cost. So they won't buy less just because it costs more. The other main use of our corn is to satisfy foreign demand, which won't ease, because corn shortages are global.
The result of shrinking supply and solid demand: soaring prices. Corn for delivery in December has shot up more than 60% since June to more than $8 a bushel, from around $5. "The next time we see corn under $8 will be in late summer of next year," predicts Dunn. "It might go under for a day or two, but the supply and demand for corn are pretty much locked in until then."
Goldman Sachs commodity analyst Damien Courvalin says corn will probably go up to $9 a bushel within three months. And a hedge fund analyst I know, whose fund just made a bundle on the jump in corn prices, thinks it could go as high as $12 a bushel between now and the end of the year.
One way to play this is to buy Teucrium Corn (CORN), an exchange-traded fund. It's trading just above $50 a share now, up from around $36 in June.
But like any commodity play, particularly one that has already risen dramatically in price, this has risks. "It's very dangerous to get involved in corn when it is up this much," says the hedge fund analyst. While he personally owns shares of Teucrium Corn, he says his fund has already taken profits by selling most of its corn position.
With grain prices likely to stay high, it makes sense that farmers looking to cash out with bigger yields will buy a lot more crop nutrients from fertilizer companies. "They are going to be selling a heck of a lot of fertilizer," predicts Dunn.
But this is only half the story. For the past year or more, global distributors have been reducing inventories of phosphate- and potash-based fertilizer because of concerns about economic slowdowns in Europe and China, and the terribly wrong expectation, until recently, that corn prices would fall because of a bumper crop this year. "There was a global destocking. No one wanted to hold inventory, on the expectation that they could buy it cheaper," says Ben Landy, a materials sector analyst with T. Rowe Price.
Farmers have also been conservative in their use of fertilizers, especially in emerging markets.
Higher grain prices will change this and lead to a bullish cycle of more aggressive buying in fertilizers, Landy predicts. "The improvements in fundamentals still lie ahead, and the stock valuations don't reflect that yet," he says.
Morgan Stanley analyst Vincent Andrews has an overweight rating on Potash, in part because it is the largest low-cost producer of the most profitable fertilizer.
JPMorgan Chase analyst Jeffrey Zekauskas has an overweight rating on Mosaic, the largest phosphate producer and the second-largest potash company in North America. Zekauskas says the stock looks cheap at around $58, far below the $93 a share he estimates as the replacement value of its assets, its mines.
Goldman Sachs analyst Lindsay Drucker Mann has a buy rating on CF Industries (CF), another fertilizer-maker. "We expect positive corn price momentum to put an end to the 'buyer's strike' in the fertilizer markets," says the analyst.
Stocks mentioned in this article include Monsanto (MON).
Singling out Monsanto
Whether genetically modified plants are safe is open to debate. But it is clear that they bump up crop yields.
Modified plants resist insects, droughts, heat and weeds better.
Monsanto (MON), of course, is the market leader in these plants, and it also makes pesticides that help increase yields. So when growing conditions are tough, farmers are more likely to buy more from this company.
That's the rationale behind buying Monsanto as a play on the drought. One big source of growth is the growing interest among Latin American farmers in genetically modified seeds, says Deutsche Bank analyst David Begleiter, who has a $92 price target on this stock. It recently traded for $87. Another plus here: Monsanto has a $1 billion stock buyback program in place that should lift share prices.
Stocks to avoid
The drought's impacts are so negative that even some potentially good plays carry risk.
So far, the drought has been good for shares of Lindsay (LNN), which sells irrigation equipment. This makes it seem like a natural play on a drought, but I'd be careful with this one. The stock has traded up to around $73 from $55 in the past two months, and any potential drought-related benefits may be priced in. Even management cautions that a spike in sales next year may be unlikely, according to Janney Capital Markets analyst Ryan Connors, who has a neutral rating on the stock.
I'd also avoid meat producers Sanderson Farms (SAFM), Tyson Foods (TSN), Smithfield Foods (SFD), Pilgrim's Pride (PPC) and Seaboard (SEB). They have sold off a lot, and they look like tempting buys with meat prices expected to rise. But it is too early to buy these.
"They aren't going to have affordable corn until at least next fall," says Dunn. That's a long time -- and it's a big deal, because corn is so important to their business. "Chickens and livestock are essentially walking ears of corn (with some soybean meal mixed in), and thus farming margins are highly negatively correlated with the cost of feed," says JPMorgan Chase analyst Ken Goldman.
They likely won't be able to raise prices as much as their feed prices are increasing. Why not? Consumers wouldn't accept it and would cut back. Meat producers like these, which raise their own livestock as opposed to buying it from independent producers, are squeezed particularly hard.
To understand how much they can get hurt, consider these numbers: At Sanderson Farms, a $2 increase in the price of a bushel of corn adds around $186 million in costs, estimates Goldman, and the company makes only about $215 million in gross profits in an average year. So a swing in corn prices "can be debilitating to earnings," he says.
As the weather turns
Two potential changes on the horizon could bring down corn prices dramatically -- and reverse just about all of the above investment themes.
First off, Washington may relax rules requiring the use of ethanol in gasoline. Because ethanol production sops up 40% of the corn crop, this could free up a lot of corn and drive prices down. "I think they'd be foolish not to do it," says Penn State's Dunn. This could also make the meat stocks rally and possibly cool off the fertilizer stocks, though the bullish trend of the need to restock the supply chain would still be in place.
Keep a close watch here if you decide to move on these drought plays.
Second, the weather could change. Many forecasters, including Thomas Downs, an agricultural meteorologist with Weather 2000, expect an El Niño weather pattern this winter. This could be good news for farmers, he says, because El Niños are often followed by rainier spring and summer weather in much of the country. It could cut the percentage of the country affected by drought by half, says Dale Mohler, an AccuWeather meteorologist specializing in commodity forecasting.
Meteorologist Todd Crawford of Weather Services International goes along with this scenario, but he cautions that it's tough to predict weather more than about three or four months in advance. "The truth of the matter is, speculating out that far is hard."
And while it's clear the planet is in a warming trend -- whether manmade or not -- this doesn't mean we'll have perpetual drought. Warming trends can make heat waves more extreme, but they can also bring more rain. "The idea that droughts like this are going to happen every year is just an overreaction," says Crawford.
At the time of publication, Michael Brush did not own or control shares of any company or fund mentioned in this column.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
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