- - Thursday, November 18, 2010

ANALYSIS/OPINION:

Recent headlines have favored the postelection fallout, what may or may not have been accomplished at the recently completed Group of 20 meetings and renewed concern over eurozone issues. All of these have their places in my investor mosaic, but the one I am eyeing more closely is the rise in commodity prices and not only what that means to us as investors, but also how it corresponds to concerns about low inflation.

One of the tenets of the Federal Reserves recent move to purchase another $600 billion in Treasuries was to get the U.S. on the right side of inflation. Just so we are all on the same page, I’m defining inflation as a general increase in the price levels of goods and services. What this also equates to is a reduction in the purchasing power of a U.S. dollar, or any other currency for that matter. Based on the most recent producer price index, it would seem the Feds concerns are on target.

Per the Labor Department, the core producer price index, which excludes food and energy costs, fell 0.6 percent in October after climbing a modest 0.1 percent in September. Including the far more volatile food and energy components, the October headline index rose 0.4 percent, well below economists’ expectations for a 0.8 percent increase. The culprit is widely thought to be sluggish demand.

In a normal recovery, inflation starts to rise as the economy strengthens. Although the producer price index does not show any inflation, we can find inflation aplenty in commodities. It seems that hardly a week goes by that we are not hearing about rising prices for corn, cotton, milk, fuel and other such items. While this may or may not be reflected in the official government statistics, it can be found in the recent performances of at least a few companies.

For example, when Dr Pepper Snapple Group reported its quarterly results, the management team shared that “supply chain productivity benefits were more than offset by higher packaging, ingredient and transportation costs.” United Kingdom retailers Primark and Next announced that steep rises in cotton prices are hitting their margins.

What I found more interesting was the decision Primark made not to pass on rising input prices to its customers, and that the company was prepared to take a hit to its profit margin in order to keep its prices low. As background, part of Primarks strategy is to be a price leader.

As an investor, this causes me great concern because margin pressure will impact a company’s earnings, with a likely end result being a decline in the share price. This is particularly true if Wall Street financial models have yet to factor in the rise in direct and indirect input prices.

This maelstrom — rising input prices and the cash-strapped consumer — have me skittish on brand-poor companies and retailers, while warming up to companies that serve the agricultural and mining markets as well as several others. The rises in those types of commodity prices will improve farmer incomes, which in turn bodes well for equipment upgrades of all kinds as well as related materials, such as fertilizers, as farmers look to capitalize on commodity price trends.

As such, this bodes well for the likes of Deere & Co., AGCO Corp., Agrium Inc., the Mosaic Co. and Potash Corporation of Saskatchewan Inc., among others. Deere in and of itself is forecasting a 15 percent increase in total farm income in the United States in 2010 to $81.5 billion, compared with $70.9 billion last year.

Good hunting, and always remember to do your investing homework before putting ideas into action.

Chris Versace, the thematic investor, is director of research at Think 20/20, an independent equity research and corporate-access firm in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.