Why food bills are heading higher

Related topics: Deere, agriculture, Potash of Saskatchewan, stocks, Michael Brush

As if the job market weren't bad enough, we're all going to have to cope with higher prices for everything from cereal and coffee to clothing and beer.

The reason: a phenomenal spike in agricultural commodities this year -- from cotton and corn to sugar and wheat -- is making its way to store shelves.

General Mills (GIS, news), Unilever (UL, news), Nestlé, McDonald's (MCD, news)and Domino's Pizza (DPZ, news)all recently cautioned that price hikes are around the corner.

In fact, you may be seeing them already -- and you're going to see more.

A recent survey of prices at Wal-Mart Stores (WMT, news)found the cost of Wonder Bread, Eggo waffles and Hershey's syrup advanced 14%-25% in the past two months.

A basket of 86 items, mostly food, was up 0.6% in the past two months, according to the research group that conducted the survey, MKM Partners.

That may not seem like much. But it spells significant increases if the price hikes continue -- which seems likely given the global trends driving food prices higher.

The big trends: a rising middle class in emerging economies that wants to eat better; weird weather patterns around the globe; the growing use of ethanol to fuel vehicles; and a shrinking dollar that makes commodities look cheaper. "Agricultural prices are going to go higher, and much higher over the next decade or two," predicts famed investor Jim Rogers, chairman of Singapore-based Rogers Holdings.

Sounds painful, right? But as investors, we have a way to ease the discomfort: Buy the trend and make money from it. Here's how.

A long-term trend

First off, investors who want to buy agricultural commodities now should know that, after such a big run-up, there could be a correction over the next few months. Signs of more farmland coming online or better weather conditions could spark that pullback.

But Rogers is worth listening to about the long-term trends because he's been studying commodities and getting the calls right for years. As he has predicted, the prices of agricultural commodities from sugar and cotton to corn, wheat, soy and coffee all recently hit highs not seen in years, if not decades. "We are still very much in a structural bull market, which will play out for another five or 10 years," agrees James Dailey, the portfolio manager of the Team Asset Strategy Fund (TEAMX).

Investors can jump in by buying exchange-traded fund or exchange traded notes designed to track the price of commodities, like Elements Rogers Intl Commodity Agriculture ETN (RJA, news), right now, then wait for pullbacks in the coming months and buy more.

They can also play this trend with stocks; I'll have names in a minute.

First, let's look deeper into the reasons experts cite to explain why agricultural commodity prices will keep rising (albeit with plenty of volatility along the way).

1. The global middle class wants good eats

The U.S. and Europe have fueled growth in emerging economies for decades by purchasing lots of goods and natural resources. That's created a rising middle class that expects to eat better -- which often means more steak, pork and hot wings. Cows, pigs and chickens consume a lot of grain, so this trend pushes up demand and prices.

"We helped industrialize the emerging markets, and we moved a lot of people out of poverty into the middle class," says Jerry Jordan, the manager of the Jordan Opportunity Fund (JORDX). "Now they are consuming more grains either directly" or as food for livestock.

That rising demand is outstripping the ability of farmers to produce more food through productivity gains alone, straining supplies and driving up prices, says Dailey.

2. Lousy weather hurts crop yields

Blame it on global warming, a rise in the ocean temperatures, sunspots or just bad luck, but the weather has taken a rough turn of late.

Drought in Russia and the Ukraine, dry weather in Brazil, floods in China, Thailand and Pakistan, typhoons in the Philippines, heavy rain in Canada and a hot summer in the U.S. have all made it harder for farmers to grow rice, wheat, corn, soy, sugar and other commodities.

A poor harvest in Russia has the country banning cereal exports for fear of inflation and food riots. Moves like this only drive international commodity prices higher. "You are going to see this more and more," predicts Jordan, of the Jordan Opportunity Fund.

3. Alternative-fuel demand sops up corn and sugar

Thanks to federal mandates, about 37% of U.S. corn this year will go to ethanol production, says Joseph Dancy, manager of the LSGI Technology Venture Fund. That's up from 20% as recently as 2006. "The U.S. is the world's largest corn producer and largest corn-exporting country, so this has a big impact on supply," says Dancy.

Last month, the Environmental Protection Agency approved a 15% ethanol blend in gasoline, which will up demand for corn even more.

4. A declining dollar drives up commodity prices

Meanwhile, the Fed keeps creating more money to try to spur growth. It may be what the economy needs, but investors see it as another reason to worry about the U.S. So they're selling the dollar, lowering its relative worth.

Because commodities are priced in dollars, this makes them look cheaper around the world and drives up demand. Consider, too, the flip side: If the Fed's moves work and spur growth, commodity prices will rise as growth increases demand, says Rogers. So prices go up either way, he believes.

Here are three ways to play this trend.

Play No. 1: Buy the commodities

The cleanest way to play the rising prices here is to buy the commodities themselves, believes Rogers. That way, there's no management in the mix to muck things up for you, as there is with stocks.

No, I'm not suggesting you put a grain silo in your backyard -- or even that you try to access the commodities futures markets, which require a sophisticated brokerage account. You can get exposure to commodities through ETFs or ETNs.

ETFs, however, can easily go off course and fail to track a commodity's price. This is because ETFs own futures contracts; they can lose a lot of money when they roll over those contracts as they expire. "You might call the commodity right but get terrible returns because of the tracking errors," says Dancy.

In contrast, ETNs are basically a promise from a bank that it will pay you the return of a specific commodity index. The risk is that the bank backing the ETN will go out of business. But we just went through a banking crunch; I'm guessing a repeat is unlikely soon.

Two ETNs to consider are the Elements Rogers International Commodity Agriculture ETN and the iPath Dow Jones-AIG Grains Total Return Sub-Index ($JJG). As for ETFs, Jordan believes the PowerShares DB Agriculture (DBA)is free of tracking error issues.

If you buy commodities now, think in terms of a multiyear time horizon because we could see some wild volatility over the next several months after such big gains this year. Investing experts don't all see the short term risks, but real farmers do.

"I view a lot of these predictions with skepticism," says Roger Johnson, a North Dakota farmer for more than four decades who now leads the National Farmers Union, a lobbying group in Washington, D.C. (His brother now tends to the farming.) "Because I have seen how quickly farmers can ramp up production when there is a strong price incentive, and I think that will happen. It does not take much. Just a little bit too much production drives the market in the toilet real fast."

But over the next 10 years or more, the trends I cited above should continue to drive commodity prices much higher, believes Rogers.

Play No. 2: Buy key stocks

The stocks of several companies that help farmers look like solid plays on higher commodity prices.

High on the list of many experts are companies that produce potash used as fertilizer. "One of the attractive aspects is that there are very few areas where it is produced," says Mark Schultz, the portfolio manager of the MTB Mid-Cap Growth Fund (ARMEX), which has outperformed its peers and the market for years. "Supply is very constrained." So as demand from farmers goes up, prices follow.

Schultz owns Mosaic (MOS, news), which he thinks still has room to move higher despite recent gains. Potash of Saskatchewan (POT, news)is another option. Dailey, of the Team Asset Strategy Fund, likes Intrepid Potash (IPI, news). And CF Industries (CF, news), which produces nitrogen used in fertilizer, should also benefit, says Evan Smith, who co-manages the U.S. Global Investors Global Resources Fund (PSPFX, news), which beats the markets and competing funds on average over the past five and 10 years.

Jordan, of the Jordan Opportunity Fund, owns CF Industries and Mosiac, and he also likes the grain producers Archer Daniels Midland (ADM, news)and Bunge (BG, news). He thinks all of these stocks could double in two to three years.

Meanwhile, investors have had doubts about the seed company Monsanto (MON, news)recently because initial performance of a new line of seeds was spotty. But Citigroup analyst P.J. Juvekar says Monsanto's track record suggests the line will do better as time goes on. Juvekar has a $72 price target on the stock, which recently sold for $61.50.

Deere (DE, news), the world's largest producer of agricultural equipment, looks like an obvious play on higher commodity prices. But Robert W. Baird analyst Robert McCarthy advises caution, citing strong sales over the past three years. "The large agriculture fleet is quite young," he says.

Dancy, of the LSGI Technology Venture Fund, likes the farm equipment company Art's-Way Manufacturing (ARTW, news). It sells sugar beet harvesters, among other things, and the price of sugar has skyrocketed, which should help this company, says Dancy.

Play No. 3: Become a farmer

Jim Rogers likes to tell young people now they should forget about business degrees and study agriculture to become farmers. "Agricultural prices are going to go much higher over the next decade or two. So what has been a horrible business is going to turn into a good business."

But Johnson, the North Dakota farmer who now leads the National Farmers Union, isn't so sure. He cites thin profit margins, and the high price of land and equipment, which can set would-be farmers back $2.5 million or more to start a 2,000-acre farm on decent land in North Dakota.

"Good luck," he says. "It's a high-capital business to get into. You better have a pile of money."

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.