Planting an Idea for 2013

 | Dec 20, 2012 | 1:30 PM EST  | Comments
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Value investors always like to refer in investing in good or great businesses. But what does good or great actually mean? Rather than speculate, Warren Buffett, who is perhaps the best investor in the world, has defined high-quality businesses through his words and investment over his 60-plus year career. Buffett likes to refer to competitive advantage, or that set of characteristics that set a business or industry apart from the competition. For example, Coca-Cola (KO) fits the bill. Payment network providers Visa V and MasterCard (MC) also qualify as high-quality business due to the recurring revenue streams created by their near duopoly in credit market. Another form of competitive advantage includes being a low-cost provider: Think GEICO insurance and Wal-Mart (WMT).

One industry that I also believe possesses durable competitive advantages is the fertilizer industry, which has underperformed in 2012. The long-term prospects for fertilizer demand look very bright. Investors who buy these stocks during cyclical dips are likely to do well over time.

Let's consider the unique characteristics of the fertilizer industry. First, fertilizer is an absolute prerequisite to maximizing food yield per acre of land. The cost spent to fertilize is almost always a fraction of the additional revenues generated by the incremental yield obtained. In fact, the risk of not applying fertilizer and risking producing unhealthy crops far outweighs the alternative. The last thing a farmer wants is to spend months tilling fields only to risk growing a poor crop.

Second, fertilizer has no commercial substitute on a large scale. A backyard gardener can compost waste, but a commercial farmer needs the three essential fertilizers: potassium (potash), nitrogen and phosphorous. Oil has natural gas but fertilizer has no commercial substitutes.

Third, nearly 80% of the world's fertilizer supply is controlled by fewer than 10 global companies. So if I were to offer anyone $20 billion or $50 billion to go out and develop a fertilizer operation from scratch to compete in the industry, it could not be done. The only way to do it would be by going out and buying existing inventory and mines. Fourth, the industry has a relatively good degree of pricing power. If fertilizer prices fall far enough, the producers can simply curtail production in order to arrive at a market cost that at least meets the marginal cost of production. Having the lowest input costs strengthens the pricing power.

And for investors, you don't have look far and wide to find the best fertilizer investment opportunities. Three of most dominant players are Potash (POT), the biggest and most diversified, Mosaic (MOS), and CF Industries (CF). Year-to-date, Potash shares are down 8%, while Mosaic shares are up 5%. CF Industries, on the other hand, is up 33% in 2012. Nitrogen, CF's principle product, relies on natural gas as its primary raw ingredient. As natural gas prices of have declined, CF's margins and profits have swelled.

In 2012 fertilizer prices have dropped along with volume. One of the key short term determinants of fertilizer demand is the price of corn: rising corn prices increase farming profits which in turn increase purchase of fertilizer. Corn prices have been declining in 2012 due to forecasts that sowings are set to swell next year.

But fertilizer may be one of the best ways to play China and increased food consumption in the rest of emerging world. Potash and Mosaic are two very high quality businesses with lagging valuations. I wouldn't yet qualify them as bargains, but the shares have done nothing for more than a year. If corn prices continue to slip and valuations sink further, fertilizer companies could be attractive places to plant capital in 2013.

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