Investing Like A Farmer

Includes: CNW, DE, SMP, TSCO
by: Jenks Jumps

Recommendations for the best investment "safety net" are plentiful and are even responsible as the debate of whether the current market will climb higher or pull back intensifies. Should it be gold? One hedge-fund manager, Stephen Diggle, believes farming is the ultimate safety net. And, his opinion of gold? "You can't eat it."

The Food and Agriculture Organization of the United Nations (FAO) is the largest self-governing agency working to alleviate hunger, improve nutrition, and secure food safety. In October 2012, the FAO met in Rome and delivered its annual report. Takeaways from the report include:

National governments are the second largest source of investment in agriculture. The report urges governments and donors to channel their limited public funds into ….. agricultural research and development, rural infrastructure and education.

Evidence from many countries shows that investing in these areas often "has much higher returns than spending on subsidies for agricultural inputs such as fertilizer." While such subsidies may be politically popular, they usually do not offer the highest returns.

Farmers are the largest investors in agriculture and must be central to any strategy in the sector.

If farmers are the largest investors in agriculture, it is probably safe to deduce agriculture is also their largest investment. Assuming farmers followed the sage advice of Peter Lynch and Warren Buffett to "invest in what you know" for the remainder of their investment, what would their stock portfolios include? And, just how fertile would that portfolio be? What could they expect to reap?

The University of Illinois created a theoritical AgIndex comprised of 21 publicly-traded companies divided into five sectors: 1) fertilizer, 2) equipment, 3) seed and genetics, 4) crop protection and 5) first processor. In 2011, a look back over the past 5 years revealed the market value of the index exceeded that of the S&P 500 - even through the financial crisis of 2008. While it might be tempting to simply select a few stocks from this index, an individual farmer's portfolio would then be highly exposed to the same risks as his or her livelihood.

For the purposes of this exercise, seed and genetics companies and crop protection (fertilizers and pesticides) companies were excluded immediately. The debate between planting genetically-modified seeds and using chemicals contrasted to organic farming is too broad and deep for this analysis. Sure, it could be argued the purpose of financial gain should not encompass moral belief. Regardless, there was a viable company in the index that symbolizes "green" - John Deere green that is.

Deere & Company (NYSE:DE) is a global agricultural and turf equipment and construction and forestry equipment manufacturer and distributor. Slowdowns in the economy have definitely caused hesitation regarding major new equipment expenditures. According to Farm Equipment, the outlook for 2013 is mildly optimistic. Per bushel prices for corn and soybeans rose in 2012 to record levels giving farmers of such some breathing room. As well, the USDA estimated 85% of domestic farmers took out crop insurance in 2012. Payouts for the summer drought have started being disbursed. Questions still exist about whether farmers will invest in new or used equipment but Deere offers both. And, Deere offers financing for both. Its financial services segment also offers risk mitigation products or crop insurance.

An example of the growing importance of crop insurance is evident in looking at Everest RE Group (NYSE:RE). In 2010, Everest's offerings did not include crop insurance at all. In just two years, crop insurance now makes up 26% of its mix.

Deere & Company is trading at a price to earnings (P/E) ratio 67% less than the industry average. Analysts are projecting a five-year growth estimate of 10% per annum. For 2013, Deere has already raised both its full-year sales and net income estimates from 5% to 6% and from $3.2 billion to $3.3 billion respectively. In the past 30 days, analysts have upped their earning per share (EPS) estimates for both 2013 and 2014 on Deere. For the past nine years, Deere has recorded a compound annual growth rate of 22% on EPS.

On February 27th, Deere increased its dividend yet again for the 5th time in 3 years. In 2010, the dividend was $0.28 per quarter. The May 1st 2013 payout will be $0.51, closing in on a double.

Deere has actively exercised its share buyback program since 2004. Another example of how well Deere has executed its strategy and built its strength is its receivables levels. While sales have increased threefold from 1998 to 2012, receivables are at the same level. Operating profit has improved from 3.4% in 2002 to 13.1% in 2012 inclusive of a 42% drop in 2009 and recovery thereafter. Return on equity is at a decade high of 44.7%.

John Deere green is as synonymous with tractors and combines as Wranglers are with blue jeans to a farmer. VF Corporation (NYSE:VFC) manufactures Wranglers and over 30 other brands, including names like North Face, Vans, Nautica and Timberland. The diversification of its demographics make it a viable portfolio option. But, another compelling and even more diversified alternative for farmers would be the retail chain Tractor Supply Company (NASDAQ:TSCO).

Tractor Supply currently operates 1,176 farm and ranch stores in the United States offering not just workhorse Wranglers to farmers but also their Justin boots and their Carhartt coats. As well as clothing and footwear, the stores offer basic maintenance products from livestock, hardware, fencing, feed and agricultural lines.

Tractor Supply plans to grow square footage 8% annually through new stores with a target of 2100 stores. Same store sales growth goals are set at 3 to 5% annually. Operating margins are also expected to continue to improve annually as already established. Current operating margins rose over 50% to 9.37% up from 6% in 2009. Between new stores, same store growth and operating margin improvement, Tractor Supply plans to grow EPS at a mid-teen percentage. The goals appear realistic as Tractor Supply is 3 times bigger than its next 5 competitors. Analysts project five-year EPS growth at over 17% per annum.

While the current dividend is only 0.8%, it is impressive that Tractor Supply increased its dividend 67% from $0.48 to $0.80 in 2012. Tractor Supply has very little debt of $1.3 million and has $139 million in cash. It is unlikely dividends will dramatically increase in the next few years, even with Tractor Supply's solid cash position, because of the aggressive store growth planned.

Either VF Corporation or Tractor Supply would be logical in a farmer's portfolio. VF Corporation is a solid, dependable income provider with steady growth. Tractor Supply doesn't offer much of a dividend but does offer more potential for share price appreciation. Tractor Supply fits well into the growth stock slot in a portfolio.

Similar to the organic farming debate, another debate to avoid is the pickup brand debate. Whether it is "Built Ford (NYSE:F) Tough" or whether "Chevy (NYSE:GM) Runs Deep", it won't impact this particular portfolio. Rather, the company that is logical to include in the portfolio that still represents the importance of a pickup to farmers is Standard Motor Parts (NYSE:SMP). Standard Motor manufactures and distributes replacement parts for vehicles. The vehicle fleet on the road in the United States has an average age of 11 years. The need for replacement parts should not wane any time soon.

Standard Motor is an established company now growing its business through acquisitions. Even with acquisitions, Standard is concentrating on reining in long-term debt and improving earnings before interest, taxes, depreciation and amortization (EBITDA). Acquisitions are only pursued if there is minimal risk and the addition would be accretive to earnings in the first year. In the past 2 years, Standard Motor has acquired 3 companies.

In 2012, Standard Motor paid a $0.36 dividend annually. After suspending its dividend in 2009, it is targeting growing the dividend to a rate of one-third of EPS. On January 30th, Standard announced another increase to $0.11 quarterly which more than doubles the dividend that was reinstated in 2010. It narrows the gap between the current rate of 22% of EPS and the target rate of 33% of EPS.

Besides increasing sales, Standard Motor has established a five-year trend of improving gross margins. Manufacturing and production has shifted to low-cost environments, inclusive of other countries, to support this effort. Analysts are projecting a 14% growth rate of EPS per annum for the next five years. By that estimate, even with Standard Motor hitting its 52 week high on March 1st and again on March 4th after announcing another quarter of increased revenues, it is still undervalued by about 10%.

The top three agricultural lending financial institutions in the United States are Wells Fargo (NYSE:WFC), Utrecht-America Holdings and BancWest. Utrecht-America is the U.S. subsidiary of Dutch lender Rabobank Group. BancWest is owned by BNP Paribas SA. However, the Farm Credit System is actually the largest agricultural lender in the U.S. It is a nationwide network of borrower-owned lending institutions providing over $191 billion in loans. Farm Credit has coverage in every county in every state including Washington D.C. and Puerto Rico. For diversification in a portfolio, a financial sector's stock makes sense to add to the industrial goods, consumer goods and services sectors' stocks. But, from the aspect of what farmers know and use, it may not be the best fit because the primary player is not publicly traded.

Realistically, the most important aspect of the farming business has nothing to do with financing the farm or working the farm. Rather, the factor most key to farming would be transporting the harvest from the farm. Without transport, the production effort would be futile. In fact, the largest user of freight transportation in the U.S. is the agriculture industry. The United States Department of Agriculture (USDA) provided an update to its modal share analysis for 1978 to 2010 in March 2012. Barges, railroads and trucks both compete for business as well as complement the other in transporting the nation's agricultural products.

From 1978 to 2010, the tonnage of grains exported has stayed relatively stable. Most grains do not cross a border. During the same timeframe, domestic tonnage has at least tripled. Corn, soybeans and wheat are the top three commodities accounting for the increase. In 1978, railroads accounted for 50% of grain transport. By 2010, that percentage had decreased to 30%. Barge transports, starting at 20% in 1978, peaked in the early 80's to nearly 30% before dropping to 2010 levels of just over 10%. The losses in railroad and barge shifted to trucking driving it from 30% in 1978 to almost 60% in 2010.

Unique to the agriculture industry are commodity traders known in the industry as the ABCDs. The four companies are Archer Daniels Midland (NYSE:ADM), Bunge (NYSE:BG), Cargill and Louis Dreyfus. Only Archer Daniels and Bunge are publicly-traded. These four companies are not the only commodity traders but are overwhelmingly the dominant players. Going hand-in-hand with trading in bulk commodities are the challenges of storage, transport and delivery. The ABCDs offer business solutions for those challenges as well. Before deciding to round out the portfolio with Archer Daniels or Bunge, farmers dedicated to organic farming should be aware both companies have business segments involved in fertilizers as well as biofuels.

For a pure transportation, specifically trucking, play, Con-Way Inc. (NYSE:CNW) is a transportation and logistics leader. Con-Way has a three-year target through 2014 to improve margins through lean initiatives without compromising safety. Con-Way has a history of flexibility with the agriculture industry. In 2009, for example, it modified its service for customers in the western United States solely to meet the unique demands of planting season.

An area of concern is that Con-Way has not met earnings estimates the past three quarters. Analysts are forecasting five-year EPS growth of over 18%. EPS growth in 2012 was 17% compared to 2011. The 2013 estimate is a 23% increase over 2012. Using the five-year EPS growth estimate of 18.6% and 2013 EPS estimate of $2.28, Con-Way's YPEG equates to $42.40. If Con-Way can stabilize its quarterly financial performance, the stock could likely be valued more in line with its growth projections.

If investing like a farmer meant investments in Deere, Tractor Supply, Standard Motor Parts and Con-Way, the portfolio would be diversified across sectors. Deere and Standard Motor offer international exposure. The mix provides both growth and income potential. All four stocks pay a dividend with two, Deere and Standard Motor, expected to grow dividends. The average five-year EPS growth estimate of the four is nearly 15%.

So, sowing into a farmer's agriculturally-oriented portfolio could easily mean a green harvest.

Disclosure: I am long SMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.