You Should Be Betting on Coffee

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Coffee consumption in the emerging markets grew by 10% in 2012, while consumption for the commodity in developed markets, such as Western Europe, decreased by 1% year-over-year (y-o-y).

A growing middle class in highly-populated countries, such as Brazil, Russia and China, is poised to keep demanding higher quantities of coffee. According to the Financial Times,  "Analysts expect emerging markets to account for 50% of global coffee consumption by 2020, with instant coffee behind the rise."

The gap between the emerging markets and developed countries' consumption is still huge. In 2012, the emerging markets consumed 27.9 million 60 kg-bags of coffee, while consumption in traditional markets is more than 100% higher at 60.6 million bags of equal size. Hence, the long-term growth potential is huge.

The easiest way to get exposure to coffee is through the ETFs that represent the market price of the commodity.

My favorite ETF for this is the iPath Pure Beta Coffee ETN (NYSEMKT: CAFE), which was built to provide investors with exposure to the Barclays Capital Coffee Pure Beta Total Return Index. The fund "reflects the returns available through an un-leveraged investment in the futures contracts in the coffee markets." If you take a look at the fund's performance, you will not see the bullish story that I am telling in this article. The ETF is down by 35.3% y-o-y.

Another ETF that is very similar to the aforementioned one is the iPath DJ AIG Coffee TR Sub-Index (NYSEMKT: JO). This ETF also reflects available returns through an un-leveraged investment in the futures contracts on coffee. Its performance is practically identical to the one shown by the iPath Pure Beta Coffee ETN. Both ETFs trade at 1x NAV and have an expense ratio of 0.75%.

Even if both of the above ETFs look identical, they are not. Both funds have have moved together but there are some key differences: (1) the iPath DJ AIG Coffee TR Sub-Index is much more liquid, and (2) iPath DJ AIG Coffee TR Sub-Index just rolls its future holdings every month, while the iPath Pure Beta Coffee ETN does this in a way that's designed to reduce the impact of two dangerous characteristics all of the futures markets share: contango and backwardation.

Given the point about liquidity and always preferring simple ETFs, I think the iPath DJ AIG Coffee TR Sub-Index its a better idea.

Of course another, more indirect, way to get exposure to the potential growth in international demand for coffee is through the companies that actually sell the end product. One great example of a company that is expanding fast into the emerging markets is Starbucks (NASDAQ: SBUX).

The roaster and retailer of specialty coffee operates in more than 50 countries. Starbucks is expected to catch the higher demand for high quality coffee that is already happening in most of the emerging world.

As well as for the case of the actual commodity, Starbucks's current valuation doesn't reflect the potential growth the company is expected to experience. Trading at 25x P/E and 13x EV/EBITDA for 2013 but with a return-on-invested-capital (ROIC) ratio well over 30%, I think Starbucks is a great way to catch a coming trend.

I am sure that the poor price performance of coffee in the international commodity markets is a buying opportunity. The International Coffee Organization (ICO) just warned that an "outbreak of coffee-leaf rust in Central America was one of the worst ever." The ICO also said that the effect on the 2013 and 2014 crop "was likely to be worse than the current crop year."

Taking all of the above into account, I think current historically low prices and a future tight-supply season make for the perfect "go long" moment. Time shall tell if my forecasts are right or wrong in the short term, but I am sure coffee is a safe long-term buy.

Federico Zaldua has no position in any stocks mentioned. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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