The Potential for a Big Run in Agriculture Stocks

The old Wall Street adage says to “buy on bad news, sell on good news.”

This simple strategy paid off well for decades.

The cycle was simple. A large-cap company would have one or two bad quarters. Expectations for future quarters would fall. The herd would run away. Once expectations were low enough, the company would be able to beat them. The herd would come piling back in and run up shares. Expectations would rise and the whole cycle started all over again.

It was a near clockwork cycle for most companies and a very profitable one for investors who bought on bad news.

Over the last two years, however, anyone who followed that advice has likely been hammered. Bad news was followed by more bad news which was followed by more bad news. In most cases, the bad news didn’t stop until absolutely terrible news was released.

That’s why in this “new normal” market environment, simply buying on bad news won’t cut it. You have to buy on the right bad news. Because if you can find the right bad news to buy on and position yourself correctly, the next few years will be very prosperous.

A Case of Not-So-Great Expectations

There hasn’t been too much “bad news” to speak of over the past few weeks. Well, the news may have been bad in a few spots, but the market didn’t take it badly.

Like Goldman Sachs (NYSE:GS) lack of investment banking revenues. The investment banking revenues come from raising money for companies or consulting services and are generally much more consistent than trading revenues.

Then there’s the cost-cutting which has been driving tech stocks. The NASDAQ is up 20% so far this year. Of course, a rational investor would have to wonder what all the excitement is about. Materials and energy costs have dropped considerably since Q2 last year and the tech companies shed jobs just as fast as every other industry.

But as we like to say, great expectations usually lead to great disappointments. In the current market rally, the inverse is happening.

So there’s a lot of bad news and a lot of not-as-bad-as-expected news. We want to find the bad news worth buying on. One of the perfect examples of the bad news worth buying on is in agriculture.

Can It Get Any Worse?

To say agriculture has fallen out of favor is a bit of an understatement. We’ve been over the coming surge in agriculture commodities and agriculture stocks, but the market just doesn’t seem to care.

Agriculture commodities have dropped an average of 20% in the past two months. They’ve been flat since we started looking into the ag (re)boom in the spring, when the terrible harvest came in from the southern hemisphere. Agriculture sector stocks have fallen right alongside them.

Few areas have been hit as hard as fertilizer stocks. As we’ve discussed before, farmers have been unwilling to take on the risks of buying a lot of fertilizer in hopes of recouping the expense in a volatile grain market. Although the reasoning and action behind the farmers’ move makes perfect sense, Wall Street and analysts are valuing fertilizer stocks like farmers will limit fertilizer use forever.

A slew of bad news for fertilizer stocks over the past few months has only compounded the problem.

Potash Corp (NYSE:POT) has consistently scaled back potash production. The price of potash had held up $750 a tonne until Silvinit, a Russian potash producer, and K+S, the German potash producer, both announced deals with India to sell potash for $460 a tonne.

On top of that, the market price for the other two major fertilizer components, phosphates and nitrates, has stayed flat as well. Nitrate and phosphate prices collapsed back to 2005 (pre-agriboom) levels after the bubble burst and haven’t moved much since.

All of this has been viewed, rightly so, as bad news for fertilizer stocks.

The table below shows how analysts’ estimates in the fertilizer sector have plummeted in the past few months:

This is the exact kind of situation we are looking for when looking to buy on the right bad news. Most of the bad news is out and it’s tough to imagine expectations getting much lower.

In a way, the sector is out of bad news and it would take some absolutely terrible news to send this beaten up sector lower.

Up Next: Not-As-Bad-As-Expected News

It’s times like these that I think of the words from Seth Klarman. The ultra-successful value investor once said:

“…most investors tend to project near-term trends—both favorable and adverse—indefinitely into the future.”

That’s exactly what’s happening right now and we can see it in the sharp divergence among performance in different sectors.

Take tech stocks for example. Wall Street is looking at the short-term success of companies’ cost-cutting measures. They’ve been buying up stocks in the sectors as they expect the near-term trend to extend indefinitely into the future. In reality though, cost-cutting measures are usually a one-time, quick fix.

In the case of agriculture stocks, farmers have cut back fertilizer consumption in the face of economic uncertainty. Still though, the outlook is bright and agriculture commodity prices are still, on average, about 50% higher than they were in three years ago. The potential for a big run in agriculture this fall is a very real possibility.

Analysts and investors remain as bearish as ever as they, in typical Wall Street fashion, expect the short-term trend of farmers cutting back on fertilizer usage to extend indefinitely into the future.

When it comes to putting hard earned investment dollars to work I am always looking for the best risk/reward opportunities. In a market like this – almost any market, really – you’re going to find the best risk/reward situations in out of favor sectors. Those are the places you’ll find the bad news worth buying on.

By Andrew Mickey

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