2 Safe Ways To Play The Commodities Boom

Dear Fellow Investor,

This report couldn’t reach you at a more critical juncture.

You read the papers. We have unrest in the Middle East. Europe’s debt problems just won’t go away. The U.S. has reached its debt ceiling of $US14.3 trillion. And the Chinese government is stomping on the economic brakes in an attempt to curb rampant inflation.

It’s no secret Australia is riding on the back of the Great Chinese Dragon. Such dependence has threats, but also massive opportunities.

And speaking of opportunities, none seems bigger than China’s long-term insatiable appetite for oil and other natural resources.

In our view, it’s a long-term super-trend that should be played.

You may know Tim Hanson. Tim’s one of The Motley Fool’s top analysts.

Based out of our headquarters near Washington D.C. , Tim recently flew down under to confirm what he believed to be world’s “Last BIG Resource play.” We think you’ll find his report a fascinating and hopefully profitable read.

But it turns out he was only half right.

It’s the other half that could make us rich. We’ll explain that other half just ahead and tell you exactly how we plan to play it. But first the facts…

Asia is growing like mad — and just getting started.

The IMF expects the region’s economy to grow 50% in the next five years. At which time it “will account for more than a third of global output and rival the economies of Europe and America.”

By 2030, Asia’s output will SURPASS the entire Group of Seven major industrial economies, predicts Anoop Singh, director of IMF’s Asia and Pacific Department.

Clearly, as Barron’s points out, “The driver of global economic growth has moved east.” You can’t ignore it any longer.

Asia’s hunger for natural resources is insatiable — and accelerating.

China accounts for nearly half the coal consumed in the world and recently surpassed the U.S. as the world’s largest consumer of oil. It’s also the leading consumer of iron ore, zinc, and steel.

The U.S. Energy Information Administration estimates that Asian countries will DOUBLE their consumption of coal by 2035, driven by massive growth in China and India. The demand for iron ore, oil, gas, and copper are also on the rise.

Ominous for the U.S. and Europe, this is great news for Australia, perfectly situated and flush with natural resources.

Few sources can feed this hunger, but one thing is for sure — Australia’s resources are staggering!

We rank No. 1 in demonstrated reserves for zinc, nickel, lead, thorium, tantalum, and mineral sands — and in the top six for coal, copper, gold, iron ore, manganese, and uranium.

Our total exports have grown 8% annually since 1989. While exports to China and India are growing at a sizzling 18%-19% clip, also according to the IMF. China’s share is expected to jump from about 22% today to 33% by 2015, Barron’s reports.

The implications and opportunities appear staggering.

But it gets even better. You may know most of the brokers here concentrate their efforts, and their research, on the top 20, 50 or 100 ASX quoted companies.

And frankly, we don’t blame them. It’s the big end of town where the bankers and the brokers can make a decent crust. We’re talking about companies worth billions of dollars, like BHP BillitonCommonwealth Bank, Woolworths and Telstra, just to name a few.

We’re very happy to leave them to it. Because what we call this systemic “anomaly” has made identifying overlooked, undervalued opportunities on the Australian stock market much easier than it should be — giving individual investors willing to do their homework a massive leg up on the big institutional money.

Commodity super-cycle is back in full swing — Financial Times

The commodities boom of 2003-2008 has been called the most notable in a century. Legendary investor Jim Rogers famously characterised the period as a “commodity super-cycle” — and is convinced we are nearer the beginning than the end.

Frankly, we largely agree. After a dramatic but short-lived pullback in 2008, demand for many commodities raced back to all-time highs in 2010 — much earlier than expected, the Financial Times reports.

For the first time in history, China is importing coal to drive its electric power plants. And four decades into its so-called Green Revolution, India is quietly importing ever greater amounts of staples from beans to lentils to cooking oil.

Only once in the past 30 years has the demand for oil grown at a faster rate, while the demand for commodities ranging from copper to corn also recently hit new highs.

Regardless of whether Rogers is correct that global supply of critical commodities will struggle to keep pace with demand, one thing is certain: It won’t be for lack of trying on behalf of the world’s low-cost commodity producers.

While Tim was on the ground here in Australia, mining giant BHP Billiton announced plans to spend $80 billion to increase production over the next five years — almost four times more than it spent over the past five years.

Rival Rio Tinto is also on an investment spree, having earmarked billions more for projects to meet growing demand for iron ore, aluminium, and other materials.

Whether that’s good news or bad news for shareholders isn’t clear. It’s also not our concern. We have a different – and we’d argue, safer and potentially more profitable — way to play the commodity super-cycle.

Let’s face it: Investing in commodities is a defeatist bet. Even in a super-cycle, increased demand for a commodity invariably triggers higher prices and a scramble to generate more supply.

The greater the demand, the greater the technology and brainpower brought to bear to meet it. Riding that bear of a cycle while trying to outwit the speculators in the trading pits is a tough way to make a buck.

That’s why we think you’d do better to avoid commodities at this stage in the cycle and consider investing instead in sound businesses like BHP Billiton and Rio Tinto that create value through sound management and innovation.

But there may be an even better solution.

In our view, increased capital spending and the supply it will invariably spawn will come back to bite the major mining and exploration companies. Why on Earth would we take on that risk at today’s valuations?

Especially when we can invest in one overlooked group of companies that could stand to profit even more from the tightening supply/demand imbalance — AND could continue to make money over nearly the entire course of the commodity super cycle.

You see, rather than take on the risk and expense of trying to feed China’s insatiable hunger for resources — these nimble, capital-light companies supply the “picks and shovels” the major mining operations rely on to do the heavy lifting.

Not only are these businesses less capital extensive and less exposed to geopolitical risk, they benefit from rising prices, while cyclical declines have a muted effect on their business — so long, that is, as it remains profitable for miners to continue digging stuff out of the ground.

Moreover, because they are starting from a smaller base — Rio Tinto and BHP Billiton are already valued at over $140 billion and $240 billion, respectively — these companies could offer us MUCH more headroom to possibly double or triple our investments or more.

In fact, we recently discovered that one extremely well-run company in particular is already profiting from Asia’s insatiable hunger for resources. Yet a combination of factors has conspired to hand us an opportunity to get in at what looks like bargain-basement prices.

We’ll tell you more about this amazing company, its diversified business lines, and compelling growth opportunities just ahead.

But first, let’s address the profitable “other half” of the equation we mentioned earlier — the systemic anomaly that makes this opportunity so potentially lucrative right now.

More stocks than there are analysts to cover them” – Tim Hanson

When meeting with investors, we’re often asked to explain how we identify great companies.

Firstly, we focus a decent amount of our attention on emerging markets.

Not only do emerging economies provide outsized opportunities to innovative companies… but a relative lack of analyst coverage and a tendency for investors to avoid hard work make finding value in some of these stocks just that little bit easier.

As we mentioned earlier, in Australia, the institutional focus on large-cap names is quite pronounced. This is at least partly due to a superannuation system that encourages the concentration of individual assets into massive, low-cost super-funds.

Unable to take positions in small or even mid-sized opportunities, the managers and analysts who support these funds (and more than one executive Tim Hanson met with actually called them “lazy”) have even less incentive to wander off the beaten path in search of undervalued stocks.

This is music to our ears!

One result is that Australian mega-caps — companies like BHP Billiton and Rio Tinto — are typically fully valued. That’s not to say that they can’t move higher — only that the upside appears limited.

The flipside is that a surprising chunk of the rest of the ASX market — including what could be the best business and investment opportunities — goes almost entirely uncovered and unexplored.

This is a dream come true for people like us — and for you, too. It’s also why we focus on smaller, underfollowed Australian names.

We mentioned above Tim Hanson’s recent trip to Australia. He and his crack team of analysts visited a host of companies, including Westpac, the ASX and Billabong, just to mention a few of the more familiar names.

His report is called “The Last BIG Resource Play — 2 lower-risk shortcuts to help you profit in a world of global strife and insatiable hunger.” We’ve arranged for Motley Fool Australia readers to get FREE access to this special report.

Enjoy, with our compliments.

The Last BIG Resource Play

Dear Australian Fools,

There’s a reason I chose to sit in seat 42K on our flight from Brisbane to Sydney. It was a window seat, and I was hoping to catch a glimpse of the Opera House and the harbour from above as we made our descent. Unfortunately, I ended up being on the wrong side of the plane for that, but it was fortuitous that my neighbour on the aisle was an Australian Parliamentary staffer. We got to chatting, and when we landed an hour later, I had a better understanding of what’s going on in Australian politics.

But perhaps the most interesting part of our conversation was when he asked what I was doing so far from home. We’d been in Australia for a few days by this point, so we’d already developed our elevator pitch. I told him that I was an equities analyst and that we were traveling around the country in search of promising investment ideas. “Australia,” I said, “offers an opportunity to tag along on the Chinese and Indian growth stories but gives us the corporate governance of a well-developed market — a pretty attractive combination given our recent experiences in China.” His agreeable response? “That’s the plan.”

Although both China and India are raising their interest rates (and potentially slowing their economic growth as a result), there’s no doubt in our minds that if the countries are to get to where they want to be in 10 to 20 years, they need to consume a lot more stuff. This stuff includes iron ore for steelmakers, coal for power plants, copper for electrical infrastructure, wheat for food companies, and much more. And what all this stuff has in common is that it’s abundant in Australia but relatively rare in China and India. In other words, it’s not hard to see that Australia is a promising long-term market.

The Australian government recognises this important opportunity to fuel Asia’s growth and become more prosperous as a result, and it’s taking steps to help. Of course, political opposition and some editorial page writers are concerned that the government’s recently bloated budget and Australia’s bubbly housing market could lead to an economic downturn if China’s thirst for resources falls off — but we think those are short-term risks, not long-term game-changers. Furthermore, we believe that the two stocks featured in this special report have been overlooked by Australian investors, so their prices more than compensate us for taking those risks.

One of the companies is out of favour with Australian investors because it’s run by a New Zealander and has done big business in China, so it’s been shunned by the good-ol’-boy banker and broker network in Australia. The other is a small agricultural play that’s been overlooked precisely because it’s small. Given the way institutions invest in the Australian market, all of the coverage is concentrated on the country’s top 100 companies — creating pockets of opportunity among smaller caps.
Put it all together, and we believe these two companies are worthy of your consideration.

Industrea (ASX: IDL)

Recent Share Price: $1.10
Market Cap: $417 million
Industry: Capital Goods
Risk Rating: Aggressive

No matter where you look today, you’re likely to find aggressive growth forecasts for the mining industry. While we were in Australia, for example, mining giant BHP Billiton said it would spend $80 billion over five years to increase production — that’s two and a half times what it spent during the past five years. But BHP isn’t the only miner hoping to coax more stuff out of the ground, so prices for commodities such as coal and iron ore could drop as mining capacity grows.

Why The Attraction?

Plans by miners in Australia and China to increase production will drive growth for all three of Industrea’s businesses. The opportunity to sell equipment in China and earn recurring service revenue is particularly promising given China’s need to mine coal safely and efficiently.

That reality could make mining companies less profitable in the future — and therefore slightly riskier investments than they are at today’s prices. But declining commodities prices should have no effect on mining-services companies, such as Brisbane’s Industrea (ASX: IDL), as long as it’s still profitable for their customers — the mining companies — to dig stuff out of the ground.

The Business

Industrea operates three businesses: mining services, which companies such as BHP Billiton hire on contract to mine their properties; diesel equipment, which makes flame-proof vehicles used in underground mining; and technology, which makes critical safety equipment used in underground mining and sells the industry-standard system for removing dangerous gases from underground mines.

All three are solid businesses, but they don’t always grow at the same rate. Diesel equipment sales had a great year in 2010 thanks to demand in China, and now, Australia-based mining services and technology are driving Industrea’s growth in 2011.

Some analysts are confounded by this cyclicality, but the company’s recent performance proves that it’s capable of producing steady growth in a variety of operating environments. Furthermore, as Industrea sells more diesel equipment and safety equipment, the company becomes more stable — CEO Robin Levison told us that Industrea makes about $15 per year in ongoing maintenance revenue for every $100 of new equipment it sells.

The Numbers

Revenue is divided roughly 60%/40% between Australia and China, with a very small amount of sales in Latin America. Industrea’s mining-services business accounts for about half of sales, technology one-third, and diesel equipment the rest.

Given China’s plans to modernise and consolidate its coal industry while reducing mining fatalities, both we and Industrea expect equipment sales in China to become a bigger part of the business.

The company is catering to this demand by building new, lower-priced flame-proof vehicles for the Chinese market, which will be priced competitively with Chinese vehicles but are safer.

The sale of those lower-priced vehicles in China will probably drag on Industrea’s very profitable margins — all three business segments currently have a better than 20% operating margin — but the company expects to make up the difference on volume.

All told, Industrea’s shares are priced as if annual revenue will grow just 6% over the next decade. But given the company’s and analysts’ expectations of 12% growth for this year alone and China’s long-term need for more and better mining equipment, that 6% baked into today’s price seems more than achievable.

The Foolish Bottom Line

Before coming to Australia, we thought that Industrea’s stock seemed too cheap and that we were simply overlooking something wrong with the company.

But what we learned is that Australian analysts don’t like the company because it underperformed expectations in 2009 and because they think that the CEO, a New Zealander, is too brash. They’re not all that happy with the company’s 2010 decision to raise capital, either.

Our analysis, though, led us to a different conclusion. This is a niche business with significant growth opportunities and a track record for rewarding shareholders. We’ll be watching Industrea’s profit margin and the way the company manages its balance sheet, but in the meantime, this could be a compelling way to profit from the rising demand for commodities in emerging Asia.

PrimeAg Australia Limited (ASX: PAG)

Recent Stock Price: $1.10
Market Cap: $161 million
Industry: Food Beverage & Tobacco

Risk Rating: Aggressive

Up until recently, commodity prices this year have run up faster than Usain Bolt. Oil gets most of the attention, but staples such as wheat, sugar, and cotton have had even more extreme price increases.

Some of that was because of unpredictable weather, but recurring bouts of rising commodity prices will become more common. That’s because the world’s population is expected to grow from just under 7 billion now to more than 9 billion by 2050, and the competing demands for land and water will reduce our ability to increase production.

Why The Attraction?

The rising global population and booming emerging economies create an increasing need for food and clothing. Australia’s infrastructure and proximity to emerging Asia allow it to increase its exports of grain and cotton to the fast-growing region.

With fewer than 23 million inhabitants, a surplus of commodities, and ports on every coast, Australia is perfectly situated to meet Asia’s growing demand for food. The country exports about 60% of its agricultural products, and so does PrimeAg Australia Limited (ASX: PAG), a multi-farm operator in Eastern Australia.

We expect the company to ride the commodities growth trend, but because its first few years of production were plagued by droughts and flooding, its share price arguably doesn’t reflect its true potential.

The Business

PrimeAg’s chairman and co-founder, Peter Corish, who’s been in the agriculture business for 37 years, helped launch the company in 2007 to capitalise on the growing demand for agricultural commodities.

PrimeAg now owns more than 92,000 acres in Queensland and New South Wales for production, as well as water rights that give it access to an average of 17.7 billion gallons annually for irrigation.

These cropping and grazing operations are spread across five farm hubs, which allow PrimeAg to keep its production costs low by sharing equipment and labour within each hub. Its biggest sellers are cotton and wheat, though it also sells smaller amounts of chickpeas, sorghum, and cattle.

Management has the experience necessary to successfully navigate the ups and downs of farm production. Industry veteran Corish was the former president of Australia’s National Farmers Federation and controls 3% of PrimeAg’s shares. CEO John Stewart brings more than 20 years of agribusiness experience to the table and grew grain and cotton in two of PrimeAg’s hubs.

In their capable hands, PrimeAg has three primary opportunities to increase its sales and profit in the next few years. The first is by continuing to improve production and yields on its existing properties. It can also use its $10 million net cash balance to buy underperforming properties and improve them. Finally, PrimeAg can integrate other farms into its hubs and operate them for a fee.

Management has already committed to making regular improvements to its farms each year and is actively looking for farms to acquire or partner with.

PrimeAg have recently been going through a tumultuous time as they try to double down on their investment thesis of undervalued agricultural assets. Neither their shotgun capital raising of funds from institutions nor their non-renounceable share offer were popular. However, their new Agri-Fund will provide a steady income stream.

The Numbers

Australia’s droughts over the past decade and the low grain prices after the global financial crisis kept PrimeAg from turning a profit in its first two full years of operation.

But before the floods hit Australia this January, PrimeAg said it was cash flow positive for the first half of its fiscal year. Although the floods have reduced its profit outlook for the second half, the company should remain profitable, and its aquifers are now full enough to allow it to increase production. (The persistent drought conditions had emptied the aquifers in previous years and limited irrigation and yield in the past two.)

PrimeAg shares sell for less than book value, and we estimate that the company’s normalised price-to-earnings ratio will be 12 to 14 (based on its planned production for 2011 and slightly lower wheat and cotton pricing). We believe the shares are worth a premium to book value, giving investors the opportunity for decent upside potential.

The Foolish Bottom Line

As the world’s population increases and more grain is grown for fuel, supplies of basic foods will likely grow tighter. PrimeAg should benefit from these trends as it helps meet Asia’s rising demand for wheat and cotton. Its share price doesn’t appear to account for this potential, giving investors an opportunity to tap into the Asian growth story through PrimeAg’s shares.

Invest well,

Tim Hanson
Motley Fool’s Head of Global Equities

Take Stock

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All figures as at August 8th 2011.

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