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By Joe Escalada

Chemical companies are favorite plays among macro strategists. These strategists conceive of an extreme future and identify a company that would benefit most from such a future. One common imagined scenario is extreme inflation leading to much higher food prices, and increased prices for crops generating more demand for agricultural chemicals.

Avoid this strategy for three key reasons:

1) We have seen decades of fantastic commodity returns, and commodities might be in a bubble. Financial speculation has turned markets that were in backwardation (even after adjusting for the time value of money, convenience yield, and storage costs) into contango. This is just a fancy way of stating that there was more of a risk premium for holding commodity futures than there is today. This change coincided with increased popularity of commodity futures as an asset class. Go figure.

2) Performance in the face of inflation depends on how much better company X is at passing on higher costs to its consumers than its suppliers are passing on higher costs to company X. Chemical companies are a spread on expenses and revenues, like any other. Their suppliers include laborers, landowners, and energy companies that power their plants. All of these suppliers will push for price increases in an inflationary environment or if they see company X making windfall profits. This struggle results in commodity producers underperforming the inflation of commodity prices.

3) Macro strategy underperforms stock picking. If you are seeking alpha, it makes more sense to pursue bottom-up securities research.

Bottom-up value investing is a better bet than playing macro scenarios using stocks that underperform their commodity products, which may be in a bubble. Value investing involves finding stocks selling at attractive prices with “economic moats” to protect their margins from competition. For example, product differentiation is an economic moat that protects against price competition. In general, companies with differentiated products are more profitable that those that produce generic commodities. Let’s consider the following chemical stocks and evaluate them as value investments:

Agrium Inc. (NYSE:AGU) recently traded at $64.49 per share. At this price level, the stock has a low 0.2% dividend yield. AGU shareholders have suffered a -29.7% change in share price over the past year. Currently, shares of this large-cap stock trade at a price-to-book ratio of 1.6, a price-to-earnings multiple of 7.5, and a price-to-sales multiple of 0.7 (trailing twelve months). Clearly, AGU appears cheap.

But does it sell differentiated products? Unfortunately, it produces fertilizers and competes directly with other fertilizer producers.

Another producer of commodity fertilizers is Mosaic Company (NYSE:MOS), which recently traded at $47.36 per share. At this price level, the stock has a 0.4% dividend yield. MOS shareholders have suffered a -37.8% change in share price over the past year. Currently, shares of this large-cap stock trade at a price-to-book ratio of 1.7, a price-to-earnings multiple of 7.7, and a price-to-sales multiple of 2.0 (trailing twelve months). Over the past decade shareholders saw a 2.9% average annual return on equity.

Another company that produces generic fertilizers is Potash Corp. of Saskatchewan, Inc. (NYSE:POT), which recently traded at $38.82 per share. At this price level, the stock has a 0.7% dividend yield. POT shareholders have suffered a -24.5% change in share price over the past year. Currently, shares of this large-cap stock trade at a price-to-book ratio of 4.5, a price-to-earnings multiple of 11.8, and a price-to-sales multiple of 3.8 (trailing twelve months). Over the past decade shareholders saw an 18.8% average annual return on equity.

Yet another producer of generic phosphorus and nitrogen fertilizers is CF Industries Holdings, Inc. (NYSE:CF), which recently traded at $129.97 per share. At this price level, the stock has a 1.2% dividend yield. CF shareholders have endured a -3.2% change in share price over the past year. Shares of this mid-cap stock trade at a price-to-book ratio of 2.0, a price-to-earnings multiple of 7.2, and a price-to-sales multiple of 1.5 (trailing twelve months).

Farmers are like cooks: they have recipes to produce their products. You add x amount of seed, irrigate with y amount of water, and add z of chemicals to achieve a desired crop. Chemical fertilizers are a key ingredient in these recipes. Cooks will buy the cheapest refined sugar, and similarly farmers will buy the cheapest generic fertilizers. Demand lower multiples from generic fertilizer producers. Potash appears to be the cheapest.

Fortunately, not all chemical stocks sell generic fertilizers. Monsanto (NYSE:MON) and Fluor (NYSE:FLR) offer differentiated products and services, but also trade at higher price multiples:

Monsanto Co. recently traded at $67.72 per share. At this price level, the stock has a 1.8% dividend yield. MON shareholders have sustained a -1.2% change in share price over the past year. Shares of this large-cap stock trade at a price-to-book ratio of 3.1, a price-to-earnings multiple of 22.9, and a price-to-sales multiple of 3.1 (trailing twelve months). Over the past decade shareholders enjoyed a 7.0% average annual return on equity. Monsanto is a seed and agricultural product company whose branded products include Roundup.

Fluor Corporation (FLR) recently traded at $48.31 per share. At this price level, the stock has a 1.0% dividend yield. FLR shareholders have suffered a -26.5% change in share price over the past year. Shares of this mid-cap stock trade at a price-to-book ratio of 2.5, a price-to-earnings multiple of 15.3, and a price-to-sales multiple of 0.4 (trailing twelve months). Over the past decade shareholders saw a 17.1% average annual return on equity. Though neither is a screaming buy, Fluor Corporation appears to be the more attractive, less expensive stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Potash And Fluor: 2 Cheapest Ag Stocks Around