An Update on a Classic “Boom and Bust” Sector

There’s a classic low-risk, high-reward trading setup in one of the market‘s biggest “boom and bust” sectors.
 
The latest bust was bad. Prices fell nearly 50%. But the big-picture trend is in your favor. And the gains could be extraordinary.
 
Let me explain…
 
Since 2001, global food prices have surged over 130%. Take a look…
 

 
This chart shows two decades worth of the Food and Agriculture Organization’s (FAO) “Food Price Index.” This index measures the change in international prices of food commodities, like meat, dairy, and grains.#-ad_banner-#
 
I’m sure you’ve heard the arguments for higher food prices. Earlier this year, the global population hit the 7 billion mark for the first time ever. Food production needs to keep increasing in order to keep pace with a growing global population.
 
According to the FAO, increasing farmland area isn’t a sufficient option. Farmers must increase their crop yields. That means more fertilizer… and a long-term tailwind for fertilizer stocks.
 
But even small changes in the price of grains can send these things soaring and crashing. Last year, for example, corn and soybean prices declined 20% off their highs. That translated into a classic “bust” year for big-name fertilizer companies like Potash and Mosaic.
 
In just nine months, shares of Mosaic (MOS) plunged 47%. Potash (POT) fell 38% before bottoming in December. Both stocks have underperformed the S&P 500 by more than 25 percentage points over the past year.
 

 
But since the end of 2011, the sector’s fundamentals have started looking a little “less bad.” Corn prices are up about 7% in the past three months. Soybean prices are up 25%.
 
After a difficult run in 2011, the fertilizer market is showing some signs of life…
 
The “big three” fertilizers include potash, phosphates, and nitrogen. Since late last year, nitrogen prices have surged more than 50% in some areas. (Fertilizers are “local markets,” so prices vary from region to region.)
 
Due to high inventories, potash and phosphates haven’t had such a huge bounce. U.S. potash inventories this winter were at their highest levels since late 2009, according to Bloomberg. There are signs of improving demand, however.
 
According to Bloomberg, U.S. corn planting is off to a fast start. As of last week, 7% of crops were seeded versus the five-year average of just 2% for this time of year. That means farmers should work off their excess inventory of fertilizer over the next few months.
 
Also, less than a month ago, China signed a contract with giant Russian supplier OAO Uralkali for 400,000 metric tons of potash at a price of $470 per ton. Because China buys all of its potash in one big bulk order every year, it gets the best price. That price acts as a benchmark, so sellers are unlikely to cut deals below that price for smaller orders. In other words, that contract effectively sets a “floor” for global potash prices in the near term.
 
Of course, there are at least a dozen factors that can affect the fertilizer market: Crop prices, credit markets, farming subsidies in India… It’s a long list. But at today’s share prices, the downside is limited…
 
Over the past five years, shares of Mosaic traded with a price-to-earnings ratio anywhere between five times earnings and 65 times earnings. Potash shares went below seven times earnings near the end of 2008… and traded as high as 42 times earnings back in 2007. Right now, both stocks are trading between 11 and 12 times this year’s expected earnings.  
 
That’s not “end of the world” cheap like in 2008… but it’s close.
 
And shares of Potash are currently trading about 11% above their closing low from mid-December. Mosaic is even closer – about 6% above its lows.
 
If either stock breaks below its former low, that means shares are in the midst of a longer downtrend. But if these stocks recover just half of their losses from their 2011 highs, that would generate a 25% to 40% gain in just a few months.