Fertilizer stocks have been on a roller coaster in the last two days. Yesterday, they were on an upswing, following news that hedge fund manager Daniel Loeb took a stake in CF Industries (CF). Today, they are sharply lower, following the news that the marketing cartel that helps the companies maintain high prices for fertilizer products is breaking down; and global fertilizer prices are collapsing. Potash (POT) and Mosaic (MOS) were particularly hit, losing close to 19 percent of their market value, while Terra Nitrogen (TNH), and CF Industries suffered smaller losses (see table). What should investors do?
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The Mosaic Company
It depends on the investment horizon and style of each investor. Short-term oriented momentum investors may want to stay away from the sector. Fertilizer prices and revenues will continue to be under pressure as the marketing cartel breaks and overall demand continues to be weak-Potash and CF industries have already seen a double-digit revenue decline (see table). Long-term oriented value investors may want to stay with the sector, even accumulate more shares as stock prices continue to decline for three reasons: First, a few major players, which enjoy hefty profit margins, dominate the sector. CF Industries, for instance, enjoys an operating margin of 48.97 percent, while Terra Nitrogen is enjoying an operating margin of 74.24 percent; and pays a hefty dividend of 7.51 percent. Second, the sector is subject to economies of scale and strict environmental requirements that restrict the entry of new competitors. This means that whatever price pressures follow the breaking of the marketing cartel will be limited. Third, cartels undergo periods of crisis that are eventually resolved as soon as overall demand conditions improve.
The bottom line: The breaking of the marketing cartel may limit the pricing power in the fertilizer industry making a dent in the revenues and profits of fertilizer producers, but it won't eliminate the market power of major players. That's why the sell-off is a buying opportunity for value investors.