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The new hot stocks

Created:
20 July 2007
Written by:
Nathalie Olof-Ors

A couple of months ago, Nestlé, one of the world’s largest food producers, made a comment in its quarterly results. The Swiss company highlighted “significant input prices pressures, mainly in agricultural raw materials” which had partially offset the performance of its milk products and ice-creams. Margins were still up 6.5 per cent since the owner of premium brand, Haagen-Dazs, managed to price part of the cost increase to its customers. A day later, French rival Danone released a similar statement, in which it reassured the market by confirming its 2007 targets despite “recent increases in raw materials prices”. Ten days after that, Unilever spoke of “significant headwind from rising agricultural commodities costs which may require further pricing action”.

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These repeated comments about food price inflation are significant. While the three companies have enough negotiating and pricing power to weather down these pressures, the remarks send cautionary signals for the rest of the sector as they showed that even the giants in this industry are not immune to the growing inflation of food prices. They also highlight a growing opportunity for investors – if commodities prices are on the rise, then they’re probably worth investing in.

Over the past year, 'soft commodities' have indeed been on the rise. On the London futures market, coffee has risen steadily, up 57.7 per cent on a 12-month basis. Cocoa prices are up 16.4 per during the same period. On other futures markets, palm oil in Kuala Lumpur is up 67.7 per cent despite recent corrections, while soy beans in Chicago rose by 26.45 per cent. Cereals too have been racing ahead, with a sharp hike in the price of wheat (up 54 per cent in Chicago), oats (up 50.38 per cent) and, in particular, corn (up 63.83 per cent). With the growing demand for biofuels, its price nearly doubled from September to late February, an increase so rapid that it raised the spectre of food shortages in Mexico.

Yet not all commodities have been 'going with the grain' as the contrasting performances on these highly volatile markets demonstrate (see box). But the sector is becoming a major investment theme. Back in December, Ewan Cameron Watt, chief economist at Blackrock, made agriculture one of his leading investment theme in his 10 predictions for 2007. At Threadneedle Investment, Dominic Rossi, head of global equities, also forecast that the sector will make hay, stressing that soft commodities provide “an alternative source of fuel and investment ideas”. Schroders too is anticipating a bull market - it has launched a fund specialising in agriculture (aimed at institutional investors). And Close Fund Management raised £45.2m when it listed a second commodities fund that includes sugar, corn and wheat.

Fund managers are indeed keen to plant seeds in this sector - the theme of rising food prices is backed up by strong fundamentals. The first key driver is demographics, in what Rodolphe Roche, fund manager at Schroders, describes as a “Malthusian crisis”. While production has been fairly stable over the past three decades, the world population is not only growing, which in itself already weighs on the prices of natural resources, it is also getting wealthier, which implies a change of diet in favour of more meat products. With the fast expansion of the BRIC countries (Brazil, Russia, India and China), this all adds up to intense pressure on prices thanks to the increasing demand for fodder. To put it in context, producing a kilo of beef requires seven kilos of cereals, while a kilo of pork requires four kilos of grain. As the middle class in China is expected to grow to 300m people by 2010 according to some estimates, this leaves significant upside for soft commodities.

The second key driver is, of course, biofuels. While wind power and solar energy have blossomed over the past few years, biofuels is rapidly becoming the new hot sector, ranking high on political agendas. A few weeks ago, Gordon Brown urged railway operators to use more biofuels after Virgin Trains introduced an engine partly run by fuels derived from crops. And in his State of the Union speech, George W Bush made biofuels a case of national security, urging fellow citizens to “dramatically reduce dependence on foreign oil”.

Accordingly, the current administration has raised its production target to 35bn gallons a year by 2017 (the 2005 Energy Act had initially set a target of 7.5bn gallons by 2012). But as Rodolphe Roche points out: “Supply is inelastic. It is limited by the surface suitable for cultivation, which means that any increase of production is often done at the expense of other crops. Asia is already feeling the pressure as China, which used to be the major supplier for the region, now uses up its entire production (both for fuel and animal feed). This is changing the commercial map as Asia now has to import corn from the US and Argentina at the very moment when the excess production is shrinking.”

The third driver is climate change. Roland Kitson, manager at Close Enhanced Commodities, stresses that “supply is not the only constraint, it is increasingly disrupted by natural disasters, from torrential rains that can wipe out a harvest to severe drought, like the one experienced in Australia”. As a result, fund managers and institutional investors are becoming convinced that soft commodities are at the beginning of a new cycle comparable to the rise of oil and mining. The analogy makes sense as it might also lead to a revival of the lacklustre agricultural sub-sectors in the same way that hard commodity price rises transformed oil majors and copper producers, which had long trailed the FTSE 100, into hot stocks. Equally, it will probably have similar side-effects as these inflationary pressures will, once more, squeeze margins.

Let’s look first at the downside. Finding the potential losers is - at first sight - not too difficult. The most exposed companies are by definition the food producers, in particular the processors as the intermediaries are directly impacted by the inflation of their raw materials with little room for manoeuvre when it comes to passing this increase on to the end customers. Hence, analysts are currently careful on companies such as, for instance, Northern Foods. Shortly after its full-year results (disclosed in late May), its share price receded as new chief executive officer Stefan Barden cautioned investors over “sustained increase in input costs”. The company actually supplies food retailers with ready meals and sandwiches, a segment where the final prices are set by distributors. But even in the products sold under its own label, like Fox’s biscuits, Goodfellas pizzas or Dalepak frozen foods, opportunities for passing on rises are also fairly limited as these segments are all highly competitive. Broker Citigroup recommends selling, rating the group high risk, as it believes that “it is only a matter of time before inflationary pressures take their toll”. However, analysts’ reactions are still quite mixed. ABN Amro for instance took the opposite view, and maintained a buy recommendation. It even raised its price target to 145p (from 140p) shortly after the earnings release, judging that “the scope for further cost savings should still enable the group to post solid profit growth.”

These contrasting views can be explained by the fact that the impact of these inflationary pressures is not so clear-cut. Graham Jones, analyst at Panmure Gordon, insists that “at this point, it is still not possible to determine which companies will be worst hit and which can sustain these higher prices as it will depend on how quickly they adapt their costs structure or pass them to customers. Just as with rising energy costs which have had sometimes unexpected side-effects, investors will not be able to assess fully the consequences of these cost increases until the companies actually report them.”

The opportunities

Finding the companies that will reap the harvest of a boom in soft commodities is another story. The obvious way is to invest in biofuel companies which without doubt are the immediate beneficiaries. These are actually well represented on Aim, with companies such as Biofuels Corporation, which is currently building Europe’s largest biodiesel refineries on the Teeside, or D1 Oils, which produces biofuel from Jatropha, a South American plant. The choice on the Alternative Investment Market (Aim) also includes US-based ethanol producers like Renova Energy and GTL Resources and their Brazilian competitors such as Clean Energy Brazil and Infinity Bio-Energy.

But like other renewable energies, biofuels are based on technologies in their infancy, requiring massive capital expenditure leading typically to heavily geared balance sheets and modest earnings generation in the short term. And even if this sector promises sustained revenue growth in the future, profitability is so far uncertain as these companies are also among the first to be hit by the rising prices of their raw materials. On top of that, the sector has attracted massive inflows from institutional investors, becoming the new El Dorado of alternative energies, and is therefore vulnerable to market mood swing, as the recent performance of the sector shows. So any investors tempted by biofuels need to separate the wheat from the chaff. In this respect, D1 Oil appears to be a good bet in the long run. The company owns its plantations and is in a good position to protect its margins. The company has also raised a significant amount of money but won’t have to buy its raw material in the market.

Another option being explored by fund managers is investing in manufacturers of agricultural equipment, agrochemicals and crop science, food transportation and retailers. The problem for retail investors is that the number of large companies in these sectors in the UK market can be counted on one hand. The first one that springs to mind is Associated British Foods. The company already had a shot at bioethanol with its plant in Wissington, which according to JP Morgan estimates could add £5m to this year’s results and £10m for the full year in 2008. But ABF is now aiming higher after striking a deal with DuPont and BP to conduct feasibility studies on biobutanol. Tate & Lyle also produces ethanol, but analysts remain cautious on this share, still deterred by the difficulties in the sweetener division.

Among blue-chip companies, analysts and fund managers also mention food retail, as the sector generally has more scope to improve margins in an inflationary environment.

However those companies only offer an indirect exposure to soft commodities, and so far, the lack of large listed-companies in the UK has mostly been a source of frustration for most fund managers.

There are more opportunities among the small and mid caps. Aim provides a few exotic pure players such as Asian Citrus Holdings, which manages China’s largest orange plantation, or palm oil producers like Anglo Eastern Plantations, Rea Holdings and MP Evans. Although the risk profile of these companies is relatively high, Richard Lucas, analyst at Ambrian Patrners, favours Asian Citrus, explaining that the company has raised £18m recently thorough a share placing that will partially fund a £35m investment in an orange plantation in the Hunan region. “This should consolidate its position as the largest orange grower in China and fund its entry into the orange juice business,” he points out. He also highlights that margins are improving as the company has increased the proportion of its sales direct to the supermarket, relative to wholesale. Richard Lucas is however more selective on the palm oil producers. While the three companies benefit from growing demand in an environment where the supply is constraint (due to a lack of investments after the 1998 Asian crisis), he favours MP Evans. “We are confident that 2007 should be another record year fore the company, with further property sales coming through and strong cash generation, leaving the company well set to build on its already ambitious palm planting schedule. Of the three UK-quoted palm oil producers, MP Evans has the strongest long-term prospects provided it can find suitable land to acquire, and is our favoured long-term play in the sector,” he argues.

But the most promising companies on Aim are by far the agricultural biotechs such as Genus. Historically specialising in bovine genetics, the company provides breeding solutions which enhance the yield of cattle. In December 2005, Genus also invested in porcine genetics through the acquisition of Sygen, a smart move since it reduced its dependence on beef but also helped its international expansion in China and Eastern Europe. In this fast-growing market, Genus also stands out among all the biotechs as a company already generating profits.

Another rising star is Plant Health Care. This small American company specialises in endo- and ectomycorrhizal fungal inoculant products and bacterial technologies. Its main product, myconate, stimulates the growth of fungus that help plants draw nutriments and moisture from the soil. The technology is based on a natural process offering promising developments for agriculture: it not only increases crop yield, but also reduces the need for pesticide (as healthier plants can better withstand stress) and reduces soil erosion, as it helps to reduce the decline of nutrients that result from intensive farming. Applications for the technology are also being found in alternative energies especially biofuels, but also with biomass as plants produces more residues. Whether or not this Aim company can grow and thrive on the back of this promising technology will however depend on what happens on the commercial front as its distribution capabilities are so far limited. The recent news has nonetheless been encouraging as Plant Health Care struck a supply deal with Bayer CropScience.

Overseas opportunities

Quoted companies providing direct exposure to the soft commodities theme are actually well represented on foreign exchanges. And judging by their performance over the past 12 months, investors have not taken long to identify them. In agricultural equipment, American manufacturer of agricultural vehicles, John Deere’s share price is up 50.6 per cent on a one-year basis. In agrochemicals, Canadian group Potash’s share price has almost trebled while its German competitor K+S is up 85.22 per cent. In crop science, Swiss company Syngenta is up 54 per although Monsanto is down 16.75 per cent. On a smaller scale, Vilmorin, a French company specialising in botanical and agronomical research, is becoming the Paris market’s darling, up 66.3 per cent. In contrast to biofuels, all these companies have an established track-record, with strong market shares and earnings and they all pay dividends.

Alternative ways to invest in soft commodities

The soft commodities market has never been easy to access for private investors, even through funds. The Schroder AS Commodity and Agriculture fund, one of the few vehicle invested in this sector, is only accessible to high net worth individuals through their advisers as it is mostly invested in future contracts. The minimum investment required is $10,000.

Close Fund Management however provides a solution for retail investors. In June, the company launched a second version of its high performing Close Enhanced Commodities Fund, which is listed and traded on the London Stock Exchange. This closed-end vehicle invests in a basket of commodities, ranging from oil, gold and, copper and now includes soft commodities such as corn and wheat. Its composition will remain unchanged until the fund is liquidated at the end of its six-year life. As the market is highly volatile, the company has set up a downside protection which means that investors will at least get back the 100p per share of their initial investment when the funds reaches maturity. But the upside is unlimited, the objective being to reach a 200 per cent appreciation.

You said volatile?

The soft commodities market is by definition highly erratic. In fact, prices can soar within a few trading days. For instance, the futures contracts on wheat rose sharply over the past month, after Romania warned that the prolonged drought could reduce this year’s harvest by 46 per cent. But equally, abrupt changes of momentum are not rare as the price of futures contracts on orange juice illustrate. After a strong run at the beginning of the year, prices on the New York Board of Trade have gone done significantly over the past few months.

In the short term, prices depend on a set of variables that can’t be predicted (weather, natural disasters, quality of harvest) which highly contributes to this volatility, But in the long term, these market also rely on a fragile balance of supply and demand. One of the best examples is sugar. A few years ago, prices shot up, encouraging farmers to increase production at the expense of other crops such as soybeans. But this soon led to a vast oversupply, following record harvest (notably in Brazil), which today weighs heavily on prices. Over the past 12 months, the daily price of sugar in London is down 24 per cent.

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