Investing in "Food Inc."

By Jared Levy, Editor, Smart Investing Daily

When we think of food in general, especially prepared foods, most of us don't realize the effort, enormity, complexity and cost that go into a bag of potato chips or Doritos, a fresh glass of orange juice, or the prepared cuts of poultry or meat that might be sitting prepackaged in your fridge at the moment.

Companies like Tyson Foods, Hormel, Sanderson Farms and Pilgrim's Pride, to name a few, actually grow or raise their own crops and livestock in addition to preparing and packaging and finally selling to distributors like Wal-Mart, Kroger, Safeway and other stores. They produce immense quantities of food! Tyson Foods alone produced 41.4 million chickens, 139,400 head of beef and 393,300 head of pork, per WEEK on average last year. Their profits can come under attack from higher input costs and reduced consumer spending.

Then there are other companies that don't farm, but rather purchase raw or semi-processed commodities like corn, wheat, rice, dairy, beef and poultry from a company like Archer Daniels Midland (ADM:NYSE) and then create their own packaged foods for us to consume. These companies are generally more susceptible to changes in commodity costs.

Small changes in the price of grains and meats can have massive effects on the profitability of the aforementioned companies, but also can cause adverse effects in areas you wouldn't think of... more on that in a minute.

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Why Are Prices Rising?

A Growing Problem

The world consumes on a massive scale, and it is only getting worse. According to the USDA, population growth rates in most developing countries remain above those in the rest of the world and are projected to account for 82% of world population growth by 2020. Although total growth population seems to be slowing, global demand for proteins is on the rise, causing unusual demand for some areas.

Fuel

Oil is now topping $100 a barrel and alternative fuel for the over 900 million cars on the road is needed. Whether you're in favor of alternative fuels or not, corn is expected to remain the primary feedstock for U.S. ethanol production during the next 10 years, eventually equaling 36% of total corn production in the U.S. (as per the USDA).

The EU is currently projected to run 60% of its vehicles on biodiesel by 2020.

Corn is the No. 1 crop grown here in the U.S.; we are also the world's No. 1 consumer of corn.

Weak Dollar

Many of the commodities mentioned are traded and quoted in U.S. dollars. Continued monetary easing and weaker dollar trends move prices higher. There are several scenarios that can play themselves out over time when it comes to currency. For now, a weak dollar is driving exports and prices of commodities here in the U.S. and abroad.

Natural Disaster, Disease

A fellow trader and friend used to say, "we plant the seed, nature grows the seed, we eat the seed." When nature fails to grow our seeds or inhibits us from harvesting what we have sown, there can be supply constraints. The droughts in Russia and foot-and-mouth disease in South Korea are just a few of the tragedies that can add to price pressure and food scarcity.

Commodity Price Effects on Food Companies and Other Industries

Kent Lucas discussed the need for major changes in food output and indicated the need for greater efficiency. Until that happens, there is a long road ahead for many hungry people around the world in addition to many related industries, given the inflationary outlook offered by many experts.

As food prices rise, the first blow comes to the producers and retailers of the foodstuffs because their input costs to feed their grains, cattle and chickens move higher. While this is happening, they try to keep consumer prices as low and stable as possible, which can reduce their profit margins. The same will go for the retail grocers to an extent, although they tend to adjust prices faster to account for input costs and have a different cost structure.

When higher retail prices hit the consumer, spending budgets for the lower and middle classes can be affected, hurting discretionary stocks. So watch out for the companies that only sell stuff we don't need. This sector is likely to be stifled by rising food costs.

In addition to the cost increases we are seeing here, prices all around the world are higher. In the U.K., food prices on average were 9.8% higher compared to last year.

Clothing

Clothing has not been discussed enough, in my opinion. Cotton has risen 400%, from about 50 cents to over $2.05 per pound, in about a year. Considering that it takes about 1.6 pounds of cotton to make a pair of jeans, a company like True Religion Apparel (TRLG:NASDAQ) and others like it who manufacture tens of thousands of jeans and other garments could feel those effects.

Cotton prices are expected to remain high over the next several months even with an increase in cotton planting this year.

Even polyester garments are affected by higher commodity costs; the synthetic material is derived from crude oil and liquid natural gas.

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Where Can You Profit?

Stick with the seed and fertilizer companies like Monsanto (MON:NYSE), Mosaic (MOS:NYSE), CF Industries (CF:NYSE) and Agrium, Inc. (AGU:NYSE). Their products and services will be an integral part of the "food revolution" and are an essential element in farming.

You can look to some Midwest banks with caution -- there are a couple publicly traded banks that lend to farmers in that region of the U.S., such as Marshall & Ilsley Corp. (MI:NYSE), MidWestOne Financial Group, Inc. (MOFG:NASDAQ) and Bank of the Ozarks (OZRK:NASDAQ). These banks do have exposure elsewhere, but agriculture loans are an important part of their business.

Many experts and farmers believe there is still upside to crop and farm prices, but even with prices expected to sustain themselves, we must not forget history. There was a major farm bubble in the 1970s and subsequent crash in the '80s. But back then farmers were loading up on debt and backing that debt with their farms (remember "bet the farm"?), but according to the USDA, farmers' average debt is about one-third of what it was back then.

Whatever investment you select, make sure you do your homework and never put all of your eggs (or any other commodity) in one basket.