Something's up Down on the Farm

Say hello to food inflation. Prices of corn, soybeans, wheat, meat and dairy products are surging. As a result, investors have bid up agricultural stocks, such as Monsanto and Potash of Saskatchewan, to lofty heights usually associated with technology growth stocks.

Fueling the surge are two fundamental changes that are elevating worldwide consumption of grains, sugar and oilseeds. One is burgeoning demand for ethanol and biodiesel in the U.S., Brazil and Europe that has created a whole new market for crops. Almost 20% of the U.S. corn crop is now going into the gas tank, for example, and that's projected to double within just five years.

The second new source of demand is the changing diet of consumers in emerging markets. Oliver Kratz, manager of DWS Global Thematic fund, notes that when a population achieves a per-capita income of $3,000 to $5,000, its demand for meat and dairy products sharply increases. Hundreds of millions of citizens of China, India, Brazil and Southeast Asia are passing this income threshold and upgrading to richer diets larded with more meat and dairy.

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Essentially, as their incomes increase, consumers in developing countries substitute meat for basic meals such as rice and tortillas. That dietary shift compounds the demand for animal-feed ingredients, such as corn and soybeans, because it takes 8 pounds of feed to produce a pound of beef, 4 to 5 pounds to produce a pound of pork, and so forth. It's no wonder China -- where the change in diet is most dramatic -- has tripled imports of soybeans to 30 million tons over the past five years.

Farmers have reason to be cheerful. Farm income in the U.S. is rising at a rate of 10% a year, according to Standard & Poor's. The shifts in global demand, plus growing populations, shrinking arable land and tight supplies of water, all augur well for grain farmers in the U.S., Brazil and Argentina. But if you're not a farmer, how can you invest in agribusiness? Here are a half-dozen stock and fund ideas for long-term investors.

Agribusiness bets

Broadly speaking, you can invest either in agribusiness companies, which supply farmers, or food companies, which sell to consumers. As crop prices and farm incomes rise, farmers have more cash to spend on supplies such as seed, fertilizer and equipment -- especially those items that raise productivity as measured by crop yield per acre.

A big beneficiary is the world's largest maker of farm equipment and machinery, the venerable Deere & Co. (symbol DE) Founded in 1837, Deere is growing like spring grass. It has the fullest lineup of tractors, combines and harvesters, a strong global dealer network and a powerful brand name. The company controls half the North American agricultural-equipment market, has more than doubled its dividend since 2004 and has bought back $3.5 billion of its stock.

Monsanto (MON) is the 800-pound gorilla of the genetically modified seed business. Its high-tech seeds achieve the highest crop yields and are the most resistant to drought, weeds and pests. Corn, soybean, cotton, canola, fruit and vegetable farmers don't mind paying higher prices for Monsanto seeds. Shares of the St. Louis-based company have had an enormous run the past few years, but Rick Helm, manager of Cohen & Steers Dividend Value, still sees value because he thinks Monsanto can sustain annual earnings growth of 20% to 25% for several more years.

Food providers

As hundreds of millions of Chinese, Indians and Brazilians ascend to the middle class, they will consume more packaged, convenience and fast-food products. So the challenge for food companies today is not drumming up demand, but maintaining profit margins as prices steadily rise for ingredients such as wheat, corn, vegetable oils and milk.

That's one reason Tom Russo, who manages nearly $4 billion for Gardner Russo & Gardner, favors food companies with powerful brands. Nestlé (NSRGY), for example, has the brand strength to pass rising costs on to consumers. Russo likes the way the world's largest food company (brands include Nescafé, Nestea and Perrier) has invested heavily to promote and distribute its brands in developing nations, where it generates one-third of its revenues. If you deduct the value of Nestlé's large stakes in L'Oréal and Alcon from the stock's market value, the shares sell at a reasonable 14 to 15 times estimated 2007 earnings, says Russo.

Another good play on the changing diet of emerging nations is Yum Brands (YUM), which operates and franchises restaurants, including KFC and Pizza Hut. Yum is the fast-food leader in China, where it's opening a restaurant a day, on average. Twenty-three percent of Yum's operating profits are generated in China, and revenues there continue to compound by at least 20% a year -- quite a contrast with Yum's performance in the stagnant U.S. market. Yum's overall return on equity is a towering 60%, and the company has been returning about 5% a year to shareholders through aggressive share repurchases and growing dividends.

If you prefer to invest through funds, one managed fund with a fine long-term record is Fidelity Select Consumer Staples (FDFAX). Along with international food stocks, such as Nestlé and Unilever, this portfolio holds beverage companies, such as Coca-Cola and Heineken, and cigarette makers, such as British American Tobacco. Robert Lee, the fund's manager since 2004, says one of his chief themes is finding companies that benefit from the dramatically changing palates of populous developing countries. Over the past ten years to September 4, the fund returned 9% annualized, an average of two percentage points a year ahead of Standard & Poor's 500-stock index.

Or consider an exchange-traded fund available from Van Eck Global -- Market Vectors-Agribusiness (MOO). Launched in September, this ETF is interesting because it tracks a diverse global index of 40 agriculture businesses, including Komatsu (the Deere of Japan) and IOI Corp., a leading Malaysian producer of palm oil.