Should You Consider Potash Corp?

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Over the past several months, as the S&P 500 has been hitting all time highs, there have been many stocks that haven’t been performing so well. Shares of fertilizer producers, including Potash Corp. (NYSE:POT), are among these disappointments.

Fertilizer producers and Potash Corp. have underperformed for two reasons. First, the demand for fertilizers is largely dependent upon grain prices, as farmers use the proceeds from grain sales to make investments in various products in order to improve their operations, including fertilizer. By applying fertilizer to their fields, farmers are able to increase their crop yields and the quality of their crops relatively inexpensively, and so there is an inherent incentive for farmers to buy fertilizer so long as they have the capital to do so. As grain prices have fallen over the past couple of years, farmers’ incomes have fallen as well. This has reduced demand for fertilizer as well as the prices of most fertilizers, including Potash Corp.’s most important product muriate of potash.

Second, not only has fertilizer demand been declining more generally, but last year we saw an increase in the supply of muriate of potash when Russian fertilizer producer Uralkali (URAYY) decided that it was going to increase its productive capacity. This was unexpected given that potash supplies are often very stable and regulated by the largest potash producers. Uralkali’s announcement accelerated the downtrend in potash prices, and it also hit the share prices of potash producers worldwide, including Potash Corp.

Now, however, it seems that these negative market forces are abating, and it may be time to invest in Potash Corp. First, we have already seen the fallout of Uralkali’s actions, and so the market’s expectations of future potash supplies have already adjusted to reflect that company’s increased production.

Second, grain prices appear to be turning around. If we take a look at shares of the iPath Grain Subindex ETN (JJG), we see a strong uptrend has begun. In fact this fund, which tracks an index including corn, soybeans, and wheat, is up nearly 14 percent year to date, which means it is outperforming assets that have been getting more investor attention such as gold and silver.

While investors can simply buy JJG shares, there are advantages to holding shares in fertilizer companies such as Potash Corp. First, fertilizer companies return capital to shareholders. Potash Corp. has rapidly become one of the most shareholder friendly companies in the entire commodity space as it pays a 4 percent dividend and buys back its stock.

Second, fertilizer prices will likely rise faster than grain prices in the long run. Let us look at an example to see why. Suppose a farmer produces a bushel of corn for $3/bushel, and he can earn $4 by selling it on the open market. He has $1 now to make investments in improving his farm. If the price of corn rises by 25 percent to $5/bushel, he can now earn $2/bushel and his ability to invest in his farm has now doubled. Assuming all farmers are in similar situations, there is now twice as much capital to go into products that will generate more agricultural commodities. Now fertilizer is a commodity and its price fluctuates readily.

Many things that farmers invest in, such as tractors, do not fluctuate in price the way that fertilizer does. If farmers have twice as much capital, John Deere (NYSE:DE) isn’t just going to double its tractor price — its competitors will step in and undercut it in the marketplace. But fertilizer producers do have the flexibility to raise their prices. As a result, if our fictional farmer’s income doubles, more of that increase is going to go into fertilizer than into equipment. The end result is that fertilizer prices will rise substantially.

Furthermore, fertilizer producers’ profits are leveraged to the fertilizer price. If potash prices double, then Potash Corp.’s net income will rise much more than this.

This makes fertilizer companies very compelling if you believe that grain prices will continue to rise. Given that the world’s demand for food is rising, and given the constraints that limited farm land put on food supply, prices will almost certainly rise. If you accept this premise, then fertilizer prices will rise as well, making Potash Corp. a compelling investment.

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