Agricultural Commodities: Profiting From Supply and Price Increases

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Includes: ADM, AGCO, DE, MOS
by: Alexander Hoffmann

Agricultural commodities are currently overcoming their decade long lethargy and stagnation in prices. The US is expected to experiences a record year in crop production, in fact a result of the increasing demand for bio fuels - especially ethanol - that are produced of corn, palm oil and sugarcane. Corn prices are jumping from one top to the next and pulling up the prices of potential substitute crops.

I must confess I am a big fan of agriculture. I love talking about tractors, pesticides, grains, harvest and yields. So I want to answer the question how to play this development in the stock market. Farmers experience a huge increase in their profits. However, due to the high segmentation of the market and the comparatively small size of each single farmer it is not possible to invest directly in farmers. So we have to look what happens if the annual profits of a farmer increase as a result of an increase the price for his goods and an increase in the amount of sales.

But let’s first of all take one step backwards. The more the farmer expects to receive for his crops, the more he is willing to pay for an insurance against possible harms to his crops. If he expects he can sell his crops for one dollar, he is willing to pay up to 99 cents to insure against adverse events. As most harms are the result of an infection of the crop with fungi, insects or herbs (sounds dangerous; and is in fact dangerous), farmers will increase the use of pesticides to prevent these infections. Basic economics now tells us that if the marginal utility increases, the marginal costs can increase too. So we have the first ones profiting from increasing prices and production besides the farmer: the producers of pesticides.

Now what happens if the farmer collects his proceeds? Why not get rid of this old 1970 tractor and buy a new, modern tractor with all the amenities and technology (and they in fact have a lot of technology inside). It also helps to increase next year’s profits. So, we have a new industry profiting from increased crop prices: Manufacturers of tractors or, a little bit more general, producers of farm machinery.

You and I probably won’t eat what is harvested. We need companies processing the crops that are harvested into the foods and drinks we consume. There even have to be companies storing the crops and transporting the finished goods from Kansas or Wisconsin to our neighborhood grocery store. Such business is driven by volume. The more goods you process, store and transport, the bigger your profits. As we expect a record crop production this year, these companies seem attractive as well.

So now we have three segments we like: Pesticide producers, manufactures of farm machinery and providers of logistics and processing for agricultural goods. Let’s go out and find some interesting companies. Pesticide producers are mostly well known chemical companies like Dow Chemical (DOW), Germany based BASF [BAS.DE] and Du Pont (DD), and speciality companies like Monsanto (NYSE:MON), Syngenta (NYSE:SYT) and Mosaic (NYSE:MOS). The story we made up before does not work for chemical giants as their business goes far beyond pesticides. We would have to consider sales of plastics, fibres and performance chemicals. So the specialty companies remain: Monsanto seems heavily overpriced with a P/E ratio of 40 and a market value of nearly four times sales. Switzerland based Syngenta has a similarly high P/E ratio of about 32. Only Mosaic has a reasonable valuation at a P/E ratio of 18 and a market value of about two times sales.

There are only two noteworthy manufacturers of tractors and farm machinery: John Deere (NYSE:DE) and Agco (NYSE:AG). While John Deere is more generally oriented and also manufactures lawn mowers for example, Agco is strictly focussed on professional farm machinery. Both companies have attractive valuation. John Deere is quoted at about 15 times earnings and 1.1 times sales. Agco is even more attractive at 15 times earning and 0.6 times sales.

Finally, we have the agricultural processors and service providers left. For them, size is everything as size helps them to capitalize economics of scales and to use their market power to pass higher procurement prices to their customers. Archer Daniels Midland (NYSE:ADM) is by far the largest company in this industry with sales accounting for roughly 60% of the industry’s total. What I especially like about Archer Daniels Midland besides its attractive valuation – P/E ratio of 13 and Price to Sales of 0.6 – is their engagement in the booming ethanol market. The company is one of the leading producers of ethanol in the US.

Summarizing, Monsaic (MOS), Agco (AG), John Deere (DE) and Archer Daniels Midland (ADM) are attractively valued companies that are going to profit from the increase in the supply and the price of agricultural commodities.

AH

Disclosure: At the time of writing the author had a long position in ADM.

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