Sunday, September 13

Week 219 - Agricultural Production Equipment

Situation: Investing in commodities, or commodity-related companies, is a good way to lose money fast if you invest in the commodity when the commodity “supercycle” is ending. Agricultural commodity-related companies are the least risky way to invest in the commodity “supercycle.” Why? Because food is a necessity and, 10 million people a year emerge from poverty and will earn enough income to increase their dietary protein to the required 60 gm/d minimum. For example, investors in General Mills (GIS) and Deere (DE) have enjoyed a 30-yr total return that beat the S&P 500 Index while having a statistically lower risk of loss in a bear market. For all types of commodities (e.g. gold, oil, iron ore, cereal grains), suppliers of equipment typically make more money than those (e.g. farmers) who produce the raw commodity. In the United States, this phenomenon first became common knowledge during the California Gold Rush of 1849. So, this week’s blog is about companies that supply equipment to farmers. 

Mission: Examine key metrics for all the agricultural equipment suppliers among the 1000 largest US companies by revenue, i.e., those in the 2015 Fortune 500 list with its supplemental material on the next largest 500.

Execution: The 2015 Fortune 500 list has 11 companies that make agricultural production equipment (see Table); 6 of those companies are also in the 2015 Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges: Tractor Supply (TSCO), Cummins (CMI), Deere (DE), AGCO (AGCO), Caterpillar (CAT), Terex (TEX). For comparison purposes, the benchmarks at the bottom of this week’s Table include commodity-production companies involved in oil & gas exploration, gold & copper mining, metals production, and meat production, as well as indices for prices of 24 commodities (GSG) and gold/silver prices (^XAU). 

The story, as you can see from the Table, is a depressing one. We’re near the end of the latest commodity “supercycle.” And, we won’t know if the supercycle has ended until developing nations can again afford to build out their infrastructure. There are some hints that the next supercycle is emerging, e.g., improved performance by several large companies in the metals and mining sector (see Week 217). But much depends on China, where 40% of the world’s appetite for commodities resides. Demand there continues to fall, and the government’s penchant for manipulating the stock market could forestall any recovery in confidence that would be sufficient to increase the demand for commodities. 

But we should be advised of the prospects for each of the 11 companies identified in the Table. Perhaps there is one positioned to herald a new dawn. Five of the companies make, service and/or equip farm tractors, skid loaders, backhoes, end-loaders, and combines. Those five are: Deere (DE), AGCO Corp (AGCO), Tractor Supply (TSCO), Caterpillar (CAT), Terex (TEX). Trimble Navigation (TRMB) makes computerized equipment to outfit tractors for "precision agriculture" dependent on GPS, whether for planting seeds or guiding sprayers of fertilizer, insecticides, herbicides, and fungicides. Valmont (VAL) makes center-pivot irrigation systems that use well water pumped by electric or diesel motors. Flowserve (FLS) is a major supplier of pumps, and Cummins (CMI) is a major supplier of diesel motors. Fastenal (FAST) supplies building materials and has outlets throughout the Midwest and Great Plains. Toro (TTC) supplies the latest generation of plant watering systems, which is a metered drip irrigation that depends on a grid of buried "tapes"; Deere (DE) also provides a drip irrigation system. 

As elsewhere, technology seems to be the game-changer. Drip irrigation systems use 40% less water than center-pivot systems which, in turn, use 40% less water than flood irrigation. Precision guidance of tractors from space (via GPS), combined with soil monitoring and interpretation via a wireless hookup to centers run by Monsanto (MON) and duPont (DE), means that the right amounts of water, fertilizer, insecticides, herbicides, and fungicides will be deployed to nurture the right kinds of seeds for each variety of soil in a farmer’s acreage--all combined with computerized weather analysis in real time (based on satellite interpretation of local rainfall patterns combined with meteorological prediction). This is called the Agronomy Revolution, and it’s where the future lies. The problem is that it has doubled the prices that farmers have to pay for new tractors with their attached gizmos. Typically, we would expect farmers to have trouble affording all of this “new paint” unless something had increased crop prices enough to give them a feeling of wealth. That happened with the drought of 2012, and conveniently during the Great Recession because Congress had mandated a surge in ethanol production.

The problem for you, as an investor, is that there is no company in the Table (including those named under Benchmarks) whose stock meets our requirements to be a candidate for inclusion in your retirement portfolio. Those requirements are a) the company is an S&P Dividend Achiever, having raised its dividend annually for at least the past 10 yrs; b) the company is large enough to appear on the 2015 Barron’s 500 List; c) the company’s stock has beat the S&P 500 Index for the past 16 yrs without incurring as great a risk of loss in a future bear market, per the BMW Method; d) the company’s bonds have an S&P rating no lower than BBB+ and its stock has an S&P rating no lower than B+/M, and e) the stock lost less money during the Lehman Panic than our key benchmark, the Vanguard Balanced Index Fund (VBINX). The only commodity-related companies we’re aware of that meet those requirements are Chevron (CVX) and Exxon Mobil (XOM). However, Chevron has gone 18 months without raising its dividend (because of negative cash flow related to a 60% drop in oil prices over the past year).

Bottom Line: Commodities, and commodity-related companies, are at a historic low point in valuation. Even the companies that supply farmers and ranchers with equipment are limping along. Deere (DE) has the best 30-yr record but remains a speculative investment, given that it’s stock lost more than the lowest-cost S&P 500 Index fund (VFINX) during the 18-month Lehman Panic period (see Column D in the Table). But Deere is also the company best positioned to benefit from the Agronomy Revolution that is bringing us the next big step up in agricultural productivity. The devil’s advocate will ask the obvious question: “If these stocks are all at historic lows, doesn’t that suggest that now is the time to buy?” That game has a name: Catch the Falling Knife. Which is fine, given that great rewards only go to those who take great risks. Professional investors often pass through a phase where they try their skill at catching the knife as it falls, after which they give up trying. From that point on, they studiously avoid buying any asset while it is falling in price.

Risk Rating: 7

Full Disclosure: I have FLS, CMI, and DE stock.

Note: Metrics in the Table are current for the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).

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