Should You Bet the Farm on Ag Stocks?

The devastating floods that have wiped out millions of acres of corn and soybean crops in the Midwest have sent prices for those commodities soaring in the last couple of weeks. An estimated 5% to 10% of the U.S. corn and soybean crops could be lost because of floods: By the time the water recedes, it will be too late for crop recovery or replanting, AccuWeather.com said on June 18.

The resulting supply constraints will only add to tightness caused by surging demand in emerging economies such as China's and will translate to higher prices for such household staples as cooking oil and breakfast cereals, putting a bigger pinch on consumers' purses. Rising demand from population growth and weather-induced supply shortages aren't the only factors pushing up agricultural commodity prices. Broader acceptance of commodities as a valid asset class by large institutional investors desperately seeking to reduce risk in their portfolios is also taking its toll.

What do these developments mean for investors in agriculture-related stocks? Some industry players have enjoyed a strong runup, but valuations may have gotten ahead of themselves.

Farmers' Rising Incomes

Consumers may be paying more for food, but that doesn't spell higher profits for meat producers such as Tyson Foods (TSN) or for other food manufacturers such as Kraft Foods (KFT) that use lots of corn, wheat, and soybean oil. Their attempts to pass on higher ingredient costs to customers are being thwarted as households become more discriminating about food purchases and switch to lower-cost private-label foods.

The companies that may benefit most from the jump in crop prices are fertilizer makers such as Potash Corp. of Saskatchewan (POT) and Mosaic (MOS), as well as seed producers such as Monsanto (MON). Rising incomes for farmers have spurred these companies to start raising their prices.

"There's great demand for seed companies to perform essentially a miracle in getting seed to increase its productivity in the final harvest, but we're also going to have to put more pressure on fertilizers as we raise total acreage not only domestically but globally," says Joe Victor, vice-president for marketing at Allendale, a brokerage and commodity research advisory firm in McHenry, Ill.

Monsanto, whose cash flows have risen sharply mostly because of sales of glyphosates, a type of herbicide used to kill weeds that choke crops, will probably start to raise glyphosate prices more sporadically than the once a year it has until now, as raw material costs, tariffs, and tighter competitor discipline permit, analyst Laurence Alexander wrote in a June 5 research note for Jefferies (JEF). The prospect of higher margins from an expected hike in glyphosate prices of at least 15% in fiscal 2009 prompted him to raise his earnings estimate for 2008 by 10 to $3.40 a share and his 2009 estimate by 35 to $4.40 a share.

An Opening for GM Crops

Alexander, who has a buy rating on the stock, expects Monsanto to continue to use its cash for smaller, "bolt-on" acquisitions, speeding up its research and development pipeline, a stable dividend payout ratio, share buybacks, and investing in seed inventory in case it receives early regulatory approvals.