Agricultural commodities and stocks have become darlings of the investment world. Everybody seems to think that agriculture is a great business. Whether you read Jim Rogers or watch CNBC, everybody seems to wax lyrical about the future of agriculture. In this context, agricultural commodities and stocks have become go-go and mo-mo favorites of hedge funds and traders.
I’m a farmer, and I live in a developing country. I am in a position to tell the difference between Wall Street hype and the realities on the ground.
The long-term secular story for global agriculture is compelling. Increased consumption of higher value added foods from fruits and vegetables to dairy and meats in the developing world will put strains on existing global capacity.
Increased demand can only be met through intensification of agricultural practices that means mechanization, irrigation infrastructure, fertilizers, herbicides and pesticides, genetically improved seeds and etc. At the same time, the drive towards more ecological agricultural practices is creating profitable niches for farmers and distributors, a fact that simply adds pricing pressures throughout the chain.
Thus, the secular agriculture story looks all fine and dandy -- when looked at from a very long-term perspective.
But on a shorter time horizon, there are plenty of reasons to believe that many agricultural commodities and stocks are in for extensive punishment in 2011-2012. Consider:
1. Agriculture stocks and commodities trade like economically sensitive cyclicals. Perhaps they should not, but they do. The global economic cycle is still in the early stages of a downturn – the ultimate extent of which is not yet clear. This fact should continue to put pressure on all commodities prices, agricultural commodities included.
2. Agriculture stocks depend on credit to drive sales and margins. Whether it be to acquire fertilizer, machinery or other inputs, farmers rely heavily on credit. Distress in global financial markets can have a severe impact on credit availability for farmers around the world. Most agricultural stocks have business models that are directly or indirectly highly sensitive to deteriorating credit conditions.
3. Agriculture stocks and commodities are over-owned by highly speculative investors. Live by fast money, die by fast money.
4. Weather patterns normalizing globally. The prices of agricultural commodities were driven up dramatically in the past two years due to unusually severe El Niño and La Niñacycles. Normal weather patters restore yields, pushing up supply and driving down price.
5. Bumper crops imminent. Due to high prices in the past two years (related to bad weather), plantings all over the world have skyrocketed in virtually all key agricultural products. Thus, agricultural commodities markets are set up for a prodigious fall.
6. Agriculture stocks are expensive. Despite being low-tech commodity producers, fertilizer stocks such as POT and AGU are far from cheap on an EV/EBITDA basis. Higher tech companies such as MON and SYT look extremely expensive on an EV/EBITDA basis. Finally, agricultural equipment makers such as DE and CAT are also quite expensive on an EV/EBITDA basis.
Agriculture stocks are trading at near-peak multiples of peak earnings and cash flow. It is unlikely that this anomalous situation will be sustained. Earnings estimates will in all likelihood be adjusted downward in the next twelve months; at the same time, valuation multiples are likely to revert down towards historical means. All of this implies double risks for commodities stocks.
Investors need to remember that agricultural stocks are high-risk, high beta cyclicals. Such stocks do not typically command high valuation multiples. On this basis, agricultural commodity stocks would need to fall 30%-40% before they became interesting at all on a valuation basis relative to peers in other cyclical (non-ag) sectors.
Such valuations would correspond to the July 2010 lows. I believe that agricultural stocks will ultimately test those 2010 lows again in the next 12 months.
I also believe that key commodities such as corn and soy will continue to suffer serious declines due to bumper crops as well as liquidations of speculative holdings.
In particular, investors in agricultural stocks should follow credit market distress indicators closely. Agriculture is a business that is highly reliant on credit throughout the production chain. This is a fact that many investors – I dare say most – do not seem to understand. Tight credit conditions can cause price crashes in the along the entire supply chain in the agriculture complex, as well as final product prices.
Agriculture stocks and commodities have been pumped up by short-term speculators betting on a long-term thesis. The problem is that in the medium term, what rules price appreciation potential in this sector is the global economic growth cycle and the related credit cycle. Right now, those cycles are flashing all kinds of warning signals that directly impinge upon the agricultural commodities and the agriculture stock complexes.
I expect further significant declines in agricultural commodities of roughly 20%. At the same time, I expect agricultural related stock declines to register in the 30%-40% range.
Once some of the speculative air has been been taken out of the incipient agriculture bubble it will be possible to consider some long positions in the sector. In the meantime, investors can consider taking advantage of the current rally to reduce or eliminate exposure and/or to initiate shorts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.