8/14/2012 4:10 PM ET|
Investing for the summer scorcher
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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