Commodities and Agriculture: Buy While They're Cheap

As we pointed out two weeks ago, a sustained recovery in vital resource stocks won’t happen until there’s real visibility on how low--and for how long--the global economy can go. See our premium service, Vital Resource Investor, Oct. 16, 2008, Five to Buy Now. What’s happened thus far in the current rally can basically be explained as an inevitable reaction to the total sector washout—severely oversold conditions that attract bargain hunters and encourage short sellers to take profits.

Many stocks are now well off their lows. But the gains we’ve seen in recent days can just as easily reverse with the next piece of negative news on the economy, either here in the US or overseas. The bad news from Asia is that the source of demand growth in resources during the past few years has the potential to impact negatively.

The fact that these stocks are historically cheap is indisputable. Goldcorp, for example, is now trading where it did when gold was selling for less than USD400 an ounce, barely half its current price. Giant miner Rio Tinto sells for just five times trailing 12 month earnings, while iron ore mega company Vale trades at even lower valuations. Smaller plays sell for barely the value of their cash in the bank.

But the underlying fundamental factors behind the bull market in vital resource stocks of recent years are still very much in force. In fact, the recent drop in prices ensures they’ll be stronger than ever in coming months.

Lower commodity prices and tough credit conditions are already threatening the survival of smaller resource producers. Even the giants we favor are being judicious about new capital spending, as significant new supplies of resources are ever-further away and ever-deeper underground. That means continued pressures on supplies, even as resource nationalism remains on the ascendancy.

And falling prices certainly don’t encourage use of alternatives or permanent changes in consumer behavior that permanently destroy demand. In fact, the steep drop and drying up of capital almost certainly ensures demand will rise faster than ever as the global economy comes off the floor. Given that much of the demand for resources comes from major infrastructure projects, resurgence may happen a lot sooner than most people think.

Most major commodities are still priced in US dollars on global markets. As a result, the surge in the purchase of US dollars during the financial crisis was a major factor that turned the selloff into a full scale rout. With so many dollars issued in this system-wide financial rescue, however, it’s only a matter of time before the dollar’s upward explosion reverses with a vengeance. And with the European Union in arguably almost as bad shape as the US, commodities are near-certain beneficiaries.

The bottom line is we have an exceptionally cheap group of companies in a market still powered by long-term fundamentals and strong cash flows that can turn sharply higher literally on a dime. The key isn’t to time the turn exactly. Rather, it’s to have built positions in these strong companies beforehand and to stick with them patiently.

Brazil-based iron ore giant Vale is one of our favorites at this juncture.

The company recently reported good third quarter results. Although iron ore is its main product, copper, nickel and lower production costs allowed for the USD6.25 billion in earnings before interest, taxes, depreciation and amortization (EBITDA).

That said, investors are still very negative on steel and its materials. In the short term, the stock may lack a catalyst but could easily participate in an up market move just because of its oversold conditions.

Longer term we continue to favor Vale because it offers the best-quality iron ore in the market. And the Chinese will eventually use more as they increase the quality of their products.

Given China’s stunning steel requirements, it isn’t a surprise that iron ore is the most leveraged commodity to China. As a result, it’s been hit hard as steel production in China has been reduced and industrial production has slowed down. Consequently, Chinese iron ore port inventory is still elevated and is moving slowly.

The current price weakness is driving high-cost producers either on the sidelines or out of the game all together, thus allowing the major producers to control new production growth. This development fits well with our on-going theme of investing first in bigger, more diversified companies. Investors are still trying to limit risk and, therefore, aren’t chasing small, commodity-leveraged, low-volume companies as was the norm a year ago.

This is a good time to allocate funds into Vale in order to get exposure to the eventual increase in Chinese steel production. Furthermore, Vale is more diversified with copper, aluminum and copper operations than most investors believe and should be able to navigate the current turmoil.

China Green Holdings is a China-based producer and supplier of fresh produce, processed and pickled products, branded food and beverage, rice and rice flour products.

The company sells its products both domestically and internationally through a highly integrated business, operating large-scale standardized plantations, food processing units and a distribution network of supermarket and retail outlets. Its ownership of every segment ensures stable supplies and a rare degree of control over raw material price fluctuations.

China Green Holdings doesn’t have control over essential raw materials such as seed crops, fertilizers and pesticides. Nevertheless, product quality is more easily maintained and costs curtailed as many other layers of middlemen are removed.

China is the company’s primary and fastest-growing market. Japan—which has been operating there for a decade--contributes 32 percent of total sales, and Europe contributes 9.5 percent. This exposure offers respectability for the company’s products because of the demanding quality standards in these markets. That ensures the same for its domestic outlets.

China’s recent milk scandal should work to the company’s advantage, given its long advocated, high production standards. China Green has 100 percent of its milk powder sourced from New Zealand. The company continues to inform consumers on the issues and is boosting its reputation as a safe, healthy, green company. The fact that consumers are becoming more quality-conscious represents a great opportunity for China Green.

Exports should play a more important role in the future; China’s agricultural shipments abroad have been on an uptrend, especially vegetables and fruits. Vegetable exports grew by 22 percent last year, up from 7 percent four years ago.

We also expect that China Green will be the supplier of choice for the big foreign retailers operating in China, such as Carrefour and Wal-Mart.

China Green has transformed itself from an export-oriented vegetable supplier into a company with a growing presence in domestic China, and management remains committed to a balance between domestic and export businesses. It’s also improved its profitability because it put more weight behind its processed business, which offers higher margins.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join my colleagues Roger Conrad, Neil George and Elliott Gue for the DC Money Show this week, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.