Street Capitalist: Event Driven Value Investments

Jeffrey Sachs is probably one of the few economists that you’ll see mingling with celebrities like Angelina Jolie and Bono. He climbed to “rock star” status by working with the UN on pursuing the Millennium Development Goals, which are talked about in one of his books, The End of Poverty. Nowadays, some see him as less of an academic and more of an evangelist. However, whenever I see something by him in the news, I take a moment to read it. Here is an excerpt from his article in Fortune magazine:

Stagflation is back. Here’s how to beat it

Three decades ago, in a bleak stretch of the 1970s, an economic phenomenon emerged that was as ugly as its name: stagflation. It was the sound of the world hitting a wall, a combination of no growth and inflation. It created an existential crisis for the global economy, leading many to argue that the world had reached its limits of growth and prosperity. That day of reckoning was postponed, but now, after a 30-year hiatus, at least a mild bout of stagflation has returned, and matters could get much worse. We are back to the future, with the question we asked 30 years ago: How can we combine robust economic growth with tight global supplies of such critical commodities as energy, food, and water? It’s worth comparing the earlier episode of stagflation with our current travails to help us find our way. In fact, this time the resource constraints will prove even harder to overcome than in the last round, since the world economy is much larger and the constraints are much tighter than before.

We’ve been seeing a popular criticism that speculation is the main reason oil has risen so rapidly over the last few years. Sachs does not seem to acknowledge that and instead points towards a rise in demand coupled with tight supplies. High commodity prices could be lead to poor global growth:

The first stagflation was overcome at very high cost, including 15 years of slower global growth. While the world economy expanded by about 5.1% during the period 1960-73, it grew by a much slower 3.2% during the period 1973-89. A lot of the slowdown had to do with the worldwide profit squeeze and restraint on investments, jobs, and growth caused by tight energy supplies.

Sachs goes on to say:

Our global resource binds are much tighter now than in the 1970s, because the world economy is that much larger, the resource constraints are tighter, and quick fixes are harder to find. In 1974 the world population was four billion, and total world income was around $23 trillion (in today’s dollars adjusted for purchasing power). Now the world population is 6.7 billion, and the economy is around $65 trillion. The same annual growth rate of the world economy, say 4% per annum, requires vastly more natural resources – energy, water, and arable land – than in the 1970s and poses much larger risks for the world’s climate and ecosystems.

In terms of tradable ideas, I think it’s clear that Sachs believes we have global supply and demand factors that are putting us at risk and not speculative ones. If that’s the case, it could be dicey for anyone who is short oil or other in demand commodities. That doesn’t mean though that we wont see volatility in prices or any pull-backs in oil, that could be attributed to profit taking by traders.

The solutions Sachs gives are simple but difficult. We need to promote government support of ways to combat our current energy, food, and environmental problems. This means increased government spending at a time when we are already running a rather large deficit. Sachs gives the example of our defense spending as a place we could cut from, but that could be disastrous when fighting two simultaneous wars. I feel that some efforts could be solved through tax incentives as well. A number of venture capital firms are springing up that solely focus on clean technologies (see Al Gore at Kliener Perkins), these groups could be aided through a modified capital gains tax, likewise we could give greater tax incentives for hybrid cars, public transportation usage, or other “green” efforts.

With both political parties talking a good deal about the environment, we might be taking a step in the right direction but it is too soon to tell.

via The Economist

I posted this morning about the fact that commodities have risen quickly in just a few years, but that there seemed to be an indication that they would continue their appreciation due to actual demand reasons, rather than pure speculation. I feel like George Soros touches on this below:

Billionaire George Soros said the boom in commodities is still in a “growth phase” after prices for oil, wheat and gold rose to records.“You have a generalized commodity bubble due to commodities having become an asset class that institutions use to an increasing extent,” Soros said today at an event sponsored by the Centre for European Policy Studies in Brussels. “On top of that you have specific factors that create the relative shortage of oil and, now, also food.”

Soros Says Commodity `Bubble’ Still in `Growth Phase’ (Bloomberg)As someone who is primarily focused on finding undervalued companies, it can be a little tough to invest in the kinds of areas that seem overvalued but appear to have room for growth, such as agricultural commodities and fertilizer companies. The way I’m going about this is looking for some hidden or indirect plays at the trend, some of these are pretty illiquid and trade on the Pink Sheets/OTC so I can’t exactly name names until I’m finished doing my buying.

One thing that does not seem to be mentioned much in the usual financial blogs I read is the current global food crisis, the credit crunch seems to be getting more exposure even though this is a pretty big deal. After all, people are killing each other over bread in Egypt.

Agricultural commodities are booming along with most other commodities. Commodities are inherently seen as safer than traditional assets right now because you have to worry about interest rate cuts by the Fed (bad for dollar holders) and then the contagious credit crisis (bad for domestic equity investors). Some people thought emerging markets could provide some kind of safety, but now there’s a lot of arguments against decoupling.

So commodities have seemed like a good choice. I will say that some of the price increase for these agricultural commodities is due to speculation, they are seen as a safe haven from the falling dollar. However, unlike gold, whose value is derived solely from the fear of investors, agricultural commodities are having price hikes because of real concerns. Take a moment to study corn prices. World wide, food prices have gone up 87% in just 3 years. For things like corn, there are other factors driving up demand and prices. Biofuels and increased consumption. With everyone head over heals for ethanol, farmers worldwide are more than willing to grow corn to take advantage of the rising prices. However, if farmers switch towards corn, it means that they are sacrificing another crop. This lowers the supply of those other crops, which ALSO drives up their demand.

via the Financial Times

Soybeans are a good case of this. We have seen protesting in Argentina over export taxes for soybeans. I might be wrong, but I don’t think that soybeans make up a big portion of the average Argentine’s diet. This means that their farmers are growing mainly to export and take advantage of demand elsewhere. When they do this, they reduce the supply of other, more useful crops for home. The export tax is most likely a mechanism to push farmers towards growing for the domestic demand (and also to help reign in the Argentine Peso).

The prices aren’t going unnoticed. Just look at the April 6th strikes in Egypt. 500 people were arrested, over rising food prices. From this kind of outrage, we will definitely see some kind of action from governments. More taxes are a given and there isn’t much to do that will prevent against that. Governments will engage in these kinds of protectionist measures because food is something that affects everyone and food is essential for living. It’s one of those basic needs and any perceived danger of it going away will illicit irrational responses.

I believe that there may be ways to profit from the crisis. Jim Rogers, the famed commodity guru believes that these kinds of bull markets last over a decade. From my research, we’re maybe 3 to 4 years into that commodity bull market. Meaning, we should continue seeing rising prices for agricultural commodities such as corn and soybeans. In addition though, fertilizer could be a good avenue for value.

Here’s a chart of DAP prices:

Governments are inevitably going to try to force farmers to increase food production and the supply is already pretty tight. Production increases really seems like a must in order to fulfill this increased demand. Demand from nations with emerging middle classes like China are taking the already tight supply. The Chinese specially are indirectly affecting the prices because of their meat consumption. If the Chinese are going to want to keep eating meat, we’re going to need more cows and we’ll need more feed for the cows. This means that inevitably, in order to grow more we’ll need more fertilizer.

Here’s a group of fertilizer related companies:

All of these have gone up quite a bit these last couple years, but they still appear to have room to gain. At the very least, they seem like a good spot to counter any of the effects of the credit contagion.I want to make clear that these are not undervalued companies, all of them trade at historical highs and on most metrics that appear overvalued. The trend in rising food prices seems far too difficult to reverse. There’s a fat chance that we’ll see a widespread liberalization of agricultural policy, so production will continue to be inefficient, leading to supply bottlenecks in the midst of soaring demand. The fact that two big global macro investors, George Soros and Jim Rogers are both bullish on China means that the nation will continue to prosper, in spite of the current food problems and fear of global financial turmoil. If China keeps growing their consumption of food commodities will increase as well which would bode well for fertilizer companies.

All this means is that you can probably obtain a profit or at least protect your investment through prudent investments in one of the above companies, or perhaps if you can find one – a global/more off the beaten path fertilizer company (some are out there), or even a passive investment like this agricultural commodity ETF (MOO, DBA, TITN).