Who May Get Squeezed in the Agricultural Commodity Supply Chain?
Jay is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Don’t people like bull markets or a booming market of any sort? Well, it really depends on who you are as a market participant and what market you are in. A rising financial securities market of stocks or bonds would be good for both investors on the buy side and issuers on the sell side. But in the world of physical commodities, be it agricultural, industrial, or oil and gas, it can be less clear as to who wins and loses under different market conditions. In the case of agricultural commodities, if you are farmers or traders and speculators holding long positions, a rising commodity market may be the best you can hope for. But if you are crop handlers or food processors, such as Archer Daniels Midland (NYSE: ADM) and General Mills (NYSE: GIS), rising agricultural commodities will only add costs to your doing business.
Investing in Agriculture-Related Stocks
The idea of exposure to the agriculture sector has always existed for investors. But in practical terms, investing in agriculture is not something that can be carried out easily and effectively. No farming businesses are publicly-traded companies; they all operate either on family-owned land or as privately-held corporate farms. However, the stock market can still provide certain degree of indirect exposure to agricultural commodities. Using the stock market, an investor will basically invest in agriculture-related public companies on the premise that changes in the agriculture sector and agricultural commodity markets will in some ways affect business results of these companies. For example, fertilizer companies or farming equipment manufacturers may see changes in demand for their products as farming conditions change. However, companies that use agricultural products as direct material inputs, namely crop handlers and food processors, may feel the most immediate business impact that can be in lockstep with changing market conditions in agricultural commodities.
Crop Handlers or Food Processors?
In fact, many investors regard publicly-traded crop handling and food processing companies as being more representative of the agriculture sector. A good year in crop harvest can mean stable supplies for crop handlers and food processors, and vice versa. Agricultural commodities flow from farmers to crop handlers and then to food processors to form a commodity-supply chain. Caught in between farmers and food processors, crop handlers sometimes may have to accept rising commodity prices, but may not be able to raise prices of ground crops sold to food processors. Both crop handlers and food processors are considered consumer non-cyclical companies and are somewhat confined to stable pricing. While food processors may also see upticks in the costs of their food ingredients with rising commodity prices, they may experience less price shocks than what crop handlers have to absorb from initial jumps in commodity prices.
Selective Financial Information
For the last five years, crop handler Archer Daniels Midland, known to investors simply as ADM, has seen its revenue and operating income up one year and down the next, and then up another year and down again, as commodity prices fluctuated. On the other hand, food processor General Mills saw mostly a rising trend in revenue and operating income during the same period. As a result, investors have valued the two stocks accordingly. While ADM stock is trading barely at its book value, the stock of General Mills is four times its total shareholders’ equity. Another crop handler, Bunge (NYSE: BG), about half the size of ADM and with a market capitalization of $9.6 billion compared to ADM's $18.1billion, had an even more volatile performance in both its revenue and operating income. Its financial statement shows double-digit swings in both up and down directions from one year to the next. Understandably, Bunge stock is trading at a much lower price-to-book multiple than that for ADM: 20 percent below the company's book value. To the contrary, Kellogg (NYSE: K), a smaller food processor as measured by its market capitalization of $18.5 billion against the $25.9 billion market capitalization for General Mills, also showed mostly increases in revenue and operating income over the last five years. Kellogg stock is thus trading at a much higher price ratio of 10 times the book value.
A crop handler sometimes may see its profitability at the mercy of the commodity market. But upper in the supply chain, a food processor can use crop handlers as a line of defense to help somewhat cushion commodity price increases. While rising agricultural commodity prices may benefit farmers, they pose challenges for businesses that process crops and produce foods, especially for companies that directly handle crops. Keeping in mind how the supply chain of agricultural commodities works, investors can make better decisions when investing in agriculture-related companies.
JJtheArdent has no positions in the stocks mentioned above. The Motley Fool owns shares of Archer Daniels Midland Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.