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Risk Assessment and the Effects of the 2012 Drought

August 11, 2012 | About:
John Emerson

John Emerson

142 followers
Most extremely successful value investors deploy a two-prong approach in selecting equities. The approach combines a top-down as well as a bottom-up approach. Such investors not only understand the fundamentals and nuances of their holdings, they also understand the economic dynamics of the industry in which their company's compete.

A value investor may be quite successful in employing a strictly bottom-up approach so long as he/she is extremely patient. That said, value recognition can generally be facilitated and return on investment enhanced, if the investor understands the micro or macro economics that affect the profits of their holdings. Additionally, such an understanding allows the investor to discern whether an earnings shortfall is terminal or temporary in nature.

One merely needs to turn the calendar back to 2008 to understand how a failure in comprehending the economic dynamics of housing-related stocks dealt many outstanding value minds a near fatal blow. In essence, when an investor does not fully appreciate the economics which may affect the profits of his holdings, he is not performing adequate risk assessment.

Additionally, most businesses are more cyclical than investors are willing to admit. For instance, consumer non-discretionary products frequently become discretionary during periods of price inflation. I may prefer eating beef rather than eggs; however if the price of beef passes a certain point then I will likely develop a much greater appreciation for the culinary merits of omelets and soufflés.

While the diehard buy and hold investor may not concern himself with temporary drops in the market price of his security; most investors would prefer to sell an equity ahead of a temporary earnings trough if they are being honest with themselves. The sale may or may not be prudent based upon the existing valuation of the investor's holding and the risk to the future profits of their various stock holdings.

Let's say I held large positions in WFC and AIG in early 2007. For arguments sake, let's further suppose that I was privy to the extreme danger that existed in the form of an impending crash in the US and world housing market. Let's also assume that I was an extremely sophisticated investor and I was aware of the extreme risk that AIG was undertaking in their derivative portfolio.

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It could easily be argued that a sale of WFC was not prudent even though the stock would dip below 10 dollars per share briefly, losing about 75% of its market cap before it recovered. On the other hand, anyone who was privy to the extreme risk which was involved in holding AIG would have been patently foolish to maintain their position.

In retrospect the aforementioned statement is crystal clear but what if an investor merely looked at the fundamentals of the two companies' heading into 2007. In terms of price to earnings and price to book ratio, AIG looks every bit as attractive as WFC.

AIG

INDUSTRY: Property & Casualty Insurance



AVG P/E


PRICE/ SALES


PRICE/ BOOK


NET PROFIT MARGIN (%)


12/11


3.5


0.65


0.42


24.1


12/10


2.1


0.09


0.39


2.6


12/09


-0.3


0.05


0.25


-16.8


12/08


-0.7


-0.51


0.07


0


12/07


26


1.22


1.29


5.4


12/06


10.2


1.39


1.54


12.4


12/05


12.9


1.38


1.72


9.6


12/04


15.1


1.49


1.79


10.2


12/03


15.6


1.84


2.07


10.2


12/02


25.1


1.93


2.14


8.8


WFC

INDUSTRY: Money Center Banks



AVG P/E


PRICE/ SALES


PRICE/ BOOK


NET PROFIT MARGIN (%)


12/11


9.9


1.81


1.03


30.4


12/10


12.8


1.91


1.29


22


12/09


13.4


1.39


1.25


14.2


12/08


42


2.39


1.26


6.8


12/07


14.6


2.58


2.09


22.9


12/06


13.8


3.4


2.62


26.1


12/05


13.5


3.25


2.59


29.5


12/04


14.3


3.54


2.78


33.5


12/03


13.8


3.52


2.9


31.9


12/02


14.7


3.19


2.61


30.9


In reality, an investment in WFC held little in the way of long term risk in early 2007; while an investment in AIG was fraught with peril. Surprisingly over five years later, Bruce Berkowitz considers AIG to be his single best investment idea in 2012. Such is the evolution of value in investing.

Looking Forward to 2013, The Effects of the 2012 Drought

The US is currently experiencing one of the worst droughts in their recorded history. The effects of the drought will be far reaching and the ramifications will be felt in numerous areas of the stock market in 2013.

The combination of an extremely low US corn yields coupled with the continuing use of corn in US ethanol production is likely to sustain historically high corn prices throughout most of 2013. High corn prices affect a multitude of US businesses including food and restaurant companies, soft drink manufactures, live stock producers, farm implement companies, ethanol producers, and virtually every rural community in the US, including rural banks.

Investors should take the following observations in account when assessing portfolio risk:

1) Crop insurance for drought minimizes losses for US farmers but frequently does not provide them with a break-even payout. Farmers who did not purchase crop insurance may be put into precarious financial positions. Banks issuing a substantial amount of mortgages in rural areas may experience difficulty in collecting mortgage payments in late 2012 and 2013.

2) Extremely low profitability for US farmers will adversely affect farm implement sales for at least the next year.

3) The cost of good sold (COGS) will increase precipitously for virtually every US restaurant in 2013. The increased input costs are likely to squeeze profits.

4) After an initial glut of slaughtered beef is cleared from the market; beef prices are nearly certain to increase dramatically in 2013 as a function of low supply and high input costs. Demand for alternative sources of protein and increased imput costs are likely to drive up the prices of all meats, poultry, eggs and dairy products.

5) Manufacturers of soft drinks and any other company which uses a significant amount of corn syrup in their products are likely in experience significant increases in their COGS in the next year.

6) Corn-produced ethanol input costs will rise precipitously in 2013. The effect may encourage US legislators to rethink current policies involving the use of corn in ethanol.

7) High corn prices will increase the COGS for every food manufacturer which uses corn in their products. This will result in diminished profit margins for such companies.

8) Companies which significantly hedged their grain-related input costs are likely to outperform companies which did not hedge their input costs in the next year.

The Drought and Investing

"Great investment ideas start with disasters". --- Bruce Berkowitz

I am not sure if the drought and its effect on corn prices will be perceived as a disaster but it certainly will affect the profits of countless companies over the next year. In the interim, investors would be advised to limit their portfolio exposure in companies whose profits will be significantly damaged by high corn prices. Specifically, businesses which hold little in the way of competitive advantage and ones which hold a high amount of debt on their balance sheets.

Investors should particularly avoid low-grade food and restaurant stocks which appear to be attractively priced on a trailing price to earnings ratio. The same is true with highly-leveraged farm implement manufacturers. These two areas will likely turn out to be the value traps of late 2012 and early 2013.

The best way to play the drought of 2012 is to wait patiently for high quality companies to drop in price as a result of earnings shortfalls created by a temporary increase in inputs costs. Should these companies drop to levels which are significantly below their intrinsic value; investors should take the opportunity to build positions.

Next year may provide value investors with an opportunity to enter the arena of food, farm, and restaurant stocks if their profits temporarily decline as a result of historically high grain prices. Successful value investors should always look ahead in the event that opportunity comes knocking at their door.

Disclosure: no position in WFC or AIG


About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

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