For the past couple of weeks, I have been closely following the record heat and drought weather conditions across the United States and their possible implications for investors.
A June 29 article of mine describes the upside potential in two stocks that will benefit from the heat and drought, Potash (NYSE: POT) and Lindsay Corp. (NYSE: LNN), which is already up about 7.0% since the article was published.[ad#Google Adsense 336×280-IA]But I’m not the only one who’s been bullish on the agricultural space right now.
Everybody on Wall Street is now screaming, “Buy, buy, buy!” stocks in the sector.
And that’s exactly why you should be worried about the remaining upside potential for some stocks in the sector.
In fact, one stock in particular might be ready to surprise the market on the downside.
Here’s the story…
While prices for grain commodities have shot up 25% during the past few weeks, the market is assuming the higher prices will likely translate to higher revenue for everyone in the agricultural industry. What the market does not understand is that the rise in prices is because of a supply problem, not necessarily because of healthy demand in the market.
The Food & Agricultural Organization (FAO) recently revised down estimates for global corn production by 7% and reiterated estimates for a decrease in wheat production by 3.2% from last year. The organization also revised its estimate for global grain demand to just 1.8% during the past year, about 0.3% lower than previously estimated.
Bottom line: Grain prices are increasing, but it is not because of a healthy market. Sluggish demand and decreased production might support prices for a while, but these two will not put money into farmer’s pockets.
Combine this with increased costs for everything from fertilizer to energy in the past year, and profits are being squeezed thin for U.S. farmers. This means farmers will likely not be buying new equipment this year.
And this could spell big trouble for investors in one of the most well-known, iconic brands in the agricultural space.
Shares of Deere & Co. (NYSE: DE) have jumped more than 10% since June lows, while, its competitor, Caterpillar (NYSE: CAT), is down 4.4% during the same period. This leads me to believe investors are betting on strong performance in Deere’s sales of agricultural equipment, since about 73% of the company’s revenue comes from its agricultural and turf division.
But the stock’s fundamentals tell me a different story.
Deere is already relatively expensive at 11.5 times trailing earnings compared with the 10.3 industry average. Any disappointing news could send that valuation down sharply. Moreover, the company’s operating and net margins are at industry averages, at about 7 cents for every dollar of revenue, only half that of value plays like Joy Global (NYSE: JOY), a mine equipment provider that makes about 13 cents for every dollar of revenue.
Analysts covering Deere are expecting a 37% earnings increase in third quarter to $2.32 per share, well above the $1.69 per share made during the same quarter last year. This will be a high bar to hurdle given that year-over-year earnings growth has decreased during the last four quarters and only averaged 25% during the period.
When sentiment in a stock gets so strong that analysts start ignoring financial trends, a hard reality is usually not far behind. And the stock’s current fundamentals do not seem to justify its higher relative valuation against peers.
Risks to Consider: The shares have come off their highs due to global economic uncertainty and could rally along with the market if stimulus measures in China start to support growth. If this happens, then other stocks in the industry will rally as well and may be better plays on valuation.
Action to Take –> Investors in Deere & Co. (NYSE: DE) have enjoyed a healthy rebound from 52-week lows and are up almost 30% since last October. Though the stock has boomed with commodities and posted a 31% annualized gain during the past three years, right now may be the best time to sell — before the Wall Street crowd realizes that the hefty revenue expectations will not materialize.
— Joseph Hogue
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Joseph Hogue does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.