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Praveen Chawla
Praveen Chawla
Articles (76) 

Food Inflation: The 1st, 2nd and 3rd Derivative Effects

Rising food inflation is having a positive effect on a whole series of downstream industries

August 31, 2020 | About:

Food prices have spiked during the Covid-19 pandemic as a result of consumers buying more groceries as they spend more time at home. Supply issues have also contributed to this trend.

The pandemic has had a strong impact on grocery prices since February. The Bureau of Economic Analysis tracks personal consumption expenditures to help measure inflation. The chart of Consumer Price Index for Food and Beverages in the U.S. shows that food and beverage inflation has dramatically increased since the start of the pandemic.

This demand and supply shock is having a profound effect on not only the grocery industry, which is closest to consumers (which I call the first-order derivative stocks) but also the more downstream industries like food suppliers (i.e., packaged foods, meat suppliers), which I call second-order derivative stocks. Further down the line are third-order derivative stocks like fertilizer and farm equipment stocks.

First derivative stocks

The pandemic has positively afftected directly related food stocks like grocery store operators Kroger (NYSE:KR) and Walmart (WMT). Apart from increased demand, these companies now have pricing power and cash flows have improved dramatically, as illustrated by Kroger's stock and cash flow from operations chart.

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This phenomenon may have more room to run and the massive stimulus and money printing by central banks around the world will keep food inflation on the boil. I am long on Kroger and have a personal target of $50 per share on the stock. I am also bullish on other grocers, including Walmart, Ahold (AHODF), Loblaws(TSX:L) and Sprouts (SFM).

While the grocers have responded strongly to demand and price inflation, stocks further down the "food chain" are still a bit weak. Regardless, there are still opportunities to be found in the second and third derivative stocks.

Second derivative stocks

Food producers are further down the food inflation chain, and I think of them as second derivatives benefiting from the trend. My favorite in this category is erstwhile beaten-down packaged food names such as Kraft-Heinz (NASDAQ:KHC), which is a major holding of Warren Buffett's Berkshire Hathaway (BRK.A)(BRK.B). While stocks like Kraft Heinz have started to respond, due to consumers stocking up their pantries, they are not as far ahead of the curve as grocers. I am long Kraft Heinz and have a medium-term target of $50.

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Third derivative stocks

Third derivative stocks are further down the line. They include producers of farm equipment, seeds, pesticides and fertilizers.

In particular, I like Canada-based Nutrien Ltd. (NYSE:NTR), the world's largest fertilizer company. Nutrien was formed by a merger between Agrium and Potash Corp. in 2018. Fertilizer stocks have been depressed for several years due to industry overcapacity and low prices. As money from food inflation starts to percolate down to farmers and then to fertilizer companies, these names should respond strongly in the year ahead. Farm equipment names like Deere (DE) are already hitting new all-time highs as investors front run in anticipation. However, fertilizer stocks have not yet responded much. I believe they will benefit soon enough. These are global companies and food inflation is a global phenomenon. Food inflation is China and India is running in the high single digits. I have a $60 target on Nutrien, which is already realizing a lot of benefits from the merger in 2018 as can be seen below in its dramatic improvement in cash from operations. However, the share price does not yet reflect this improvement.

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In conclusion

When a huge external shock like a global pandemic hits the world economy, it causes a series of cascading after-effects. The government then responded with a massive monetary and fiscal stimulus. The pandemic devastated whole industries like restaurant, travel and hospitality, but had the opposite effect on technology and food. While investors were quick to recognize the effect of the pandemic and stimulus on tech, they are a little slow on the uptake for old industries like food. I think therein still lies an opportunity when we think about first, second and third-order effects.

Disclosure: The author is long Kroger, Kraft Heinz and Nutrien.

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About the author:

Praveen Chawla
I am a full-time investor now, investing my own money. I spent most of my working life in the pharmaceutical industry.

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