Ooompa Loompa: Why Chocolate is the Golden Ticket

| About: The Hershey (HSY)

Commodity traders have been forecasting a coming bull market in cocoa since about forever. It may be materializing now. The real story however is the bull market in chocolate. People around the world are eating more of it and are eating a greater percentage of dark chocolate (which contains more cocoa). People are also using chocolate as a small luxury and spending quite a lot on "upscale" chocolate. I put upscale in fright quotes because much of what goes for quality chocolate is actually pretty bad (Dove, Hershey's Gold). However folks are buying it, and the money is running in. Note that the true high-grade cocoas (Columbian, Ven., etc.) have seen their prices go through the roof.

So how to play this. First, I guess I buy the long term cocoa story. If consumption keeps growing at 3.0% - 3.5% a year, there's no way that production will keep up. On the other hand, stocks of cocoa are still quite high, about half a year's worth of consumption, and almost all these stocks are safely in store in consuming countries. Moreover the cocoa market is in absolute full carry so it's hard to wait around for the long term.

Much better I think is to buy the stocks of chocolate companies. That way you gain directly from the consumption increase. Which to buy? Here are some ideas:

Lindt [Swiss:LISP] - These guys are superbly positioned to take advantage of the new upscale market. It's also run by a first rate executive team. However its P/E is not cheap, and I hate growth stocks.

Barry Callebut [Belgian: BARN] - These guys make industrial chocolate which they sell to chocolate companies and other end users. Not as well run, but with great African operations. A push into consumer sales might be a call option.

Hershey (NYSE:HSY) OK, I know all the chocolate purists are saying that their products stink. True. And I know that Hershey is literally the textbook case of a company screwing up its supply chain. However, they have the best franchise in the business. Right now the stock is very depressed because of a bunch of tactical mistakes. Looks good to me.

Here's one unit of the trade:

Buy: 500 shares of HSY
Buy: 1 (one) share of Lindt (these are trading for about 30,000 CHF)
Buy: 1 lot of March cocoa
Sell: 1 mini S&P futures (Long-only traders will not want to do this.)

The March cocoa is a hedge against input prices for these companies running up. I am a little hesitant to do this since the commitments of traders shows that the big funds are heavily long, and that is usually a bearish sign. So you may have to take some short-run pain on this - but of course it is a hedge.