Stirrings in the corn fields

When Fidel Castro roused himself from his sickbed last year to write an article criticizing George Bush's unhealthy enthusiasm for ethanol, for once he had a point. Along with other critics of America's ethanol drive, Mr. Castro warned against the “sinister idea of converting food into fuel”.

America's use of corn to make ethanol biofuel, which can then be blended with gasoline to reduce the country's dependence on foreign oil, had driven up the price of corn. As more land was used to grow corn rather than other food crops, such as soy, their prices also rose. And since corn is used as animal feed, the price of meat went up, too. The food supply, in other words, was being diverted to feed America's hungry cars.

But corn-based ethanol, the sort produced in America, is neither cheap nor green. It requires almost as much energy to produce (more, say some studies) as it releases when it is burned. And the subsidies on it cost taxpayers, according to the International Institute for Sustainable Development, somewhere between $5.5 billion and $7.3 billion a year.

Ethanol made from sugar cane, by contrast, is good. It produces far more energy than is needed to grow it, and Brazil – the main producer of sugar ethanol – has plenty of land available on which to grow sugar without necessarily reducing food production or encroaching on rainforests. Other developing countries with tropical climates, such as India, the Philippines and even Cuba, could prosper by producing sugar ethanol and selling it to Americans to fuel their cars.

Even so, ethanol investors binged on the corn-based fuel in 2005 and 2006. But with the bankruptcy of VeraSun Energy, the biggest listed U.S. ethanol producer, they might want to reconsider. It is the latest grim news for a sector where listed companies have lost 80% to 90% of their market value over the past two years and, ironically, for an industry savaged by rising corn costs, VeraSun shows that falling corn prices are one of the biggest short-term threats.

Like some rivals, VeraSun took out hedges to protect against rising prices after corn hit a record price of $8 a bushel in June. Yet those hedges backfired as bushel prices went on to halve, leaving the company strapped for cash. For others also, the recent pullback in corn prices has offered little respite. As recession fears have grown, ethanol prices have plunged in tandem with corn prices, so depriving producers of any hoped-for boost to margins.

Eventually, demand will improve. The amount of ethanol to be blended into gasoline in the U.S. is set to quadruple by 2022 because of government mandates. With annual sales running at about $20 billion, the supply glut that has pushed down ethanol prices should ease by 2010 or 2011 as demand catches up. But in the long run, low barriers to entry – all it takes to become a producer is a field of corn and a simple still – means gains will be fleeting. New producers will compete away margins, leaving the biggest buyers of ethanol – the refiners who blend it into gasoline – able to dictate prices. The likely result is prices that are sufficient to keep ethanol plants ticking over, but barely profitable. All the more reason for investors to stay away.

Procter & Gamble (Ticker: PG)

Warren Buffett likes this stock. Should you?

In the corner of a meeting room next to the bosses’ office at the headquarters of Procter & Gamble (Ticker: PG), a large sculpture of a woman in a hat watches over proceedings with a serene smile. She is, it seems, at the center of all the group’s decisions. Founded in 1837 by William Procter, a candle maker, and James Gamble, who made soap, PG is the world’s biggest consumer goods company. It probably knows more about consumer marketing than any other firm on earth. Interestingly, many people at PG do not use the word “consumer”. Nor might they ask if a “customer” or “shopper” would buy a putative new product. They are more likely to ask: “Would ‘she’ buy it?”

Women have long accounted for four-fifths of PG’s customers. Over the years, the way PG sells to them has changed dramatically. In the 1930s it sponsored radio shows – the original soap operas – to encourage women (usually housewives) to buy its detergent. Now radio has been surpassed by television and the Internet as a means of promotion; and “she” has become ever more independent, demanding and fickle. The variety of products on offer has exploded, not just from makers of branded goods, like PG, but also from the big supermarket chains that now dominate the retail end of the business and sell their own labels alongside the big brands.

The consumer goods giant is spending lots to find out what she actually wants. Staff from its Customer and Market Knowledge division tour the world and spend entire days with women to observe how they shop, clean, eat, apply their make-up or put diapers on their babies. They try to understand how a woman reacts in the first three to seven seconds after she sees an item in a shop (the “First Moment of Truth”, in PG-speak) and when she tries it at home (the “Second Moment of Truth”).

At first PG struggled in the new world of empowered she-consumers. In 2000, after a big drop in profits, its share price took a tumble. Alan Lafley, a company veteran, took over that year (PG is a great believer in promoting from within). The company he leads has such a reputation for insularity that employees are known as “proctoids”, but Mr. Lafley has been trying to open up more to the outside world and to streamline PG’s notorious bureaucracy. He also needed a clear strategy for the company’s growth. That, he concluded, lay in investing more in the power of brands: the strongest brands, he reasoned, would be sought out by consumers everywhere.

Mr. Lafley began with the acquisition of Clairol, a hair-dye company, in November 2001. Two years later he paid $6.9 billion for Wella, a family-owned German beauty firm. But the biggest deal, in January 2005, was the $57 billion purchase of a company known for serving men rather than women: Gillette, which controls three quarters of the world market for razors and shaving foam. Has the huge Gillette purchase paid off? Mr. Lafley admits that he took a big risk. Four out of five mergers don’t work out, he says, and big deals fail more often than small ones. But he has a list of five reasons why mergers fail. On all counts he says PG is now doing fine.

And though PG gave a nod to the stormy economic winds yesterday as first-quarter numbers were released, it accepted only the merest widening of targets for the year ahead. While companies unable to predict the near future have characterized the reporting season, PG cut the lower end of its profits guidance by less than 1%. The group forecasts to produce earnings per share somewhere between $4.15 and $4.25 next summer.

Yet in spite of barely a raised eyebrow on the bridge, every sinew must be straining below decks. Input prices have fallen dramatically in recent months, but the time lag before manufacturers feel the benefit means PG still faces a $2.7 billion cost headwind this year. Currency volatility also makes life difficult – from boosting sales, PG now expects foreign exchange effects to take 1-2 percentage points off top-line growth this year.

At the same time consumers are “de-loading the pantry”, running down stocks of items such as batteries or razors, and waiting longer to buy replacements. (And there is no need to shave every day if you are not going to work.) A widening price gap between PG’s premium products and private label goods has also prompted greater trading down. How consumption patterns in emerging markets will change as rates of growth slow also remains unknown.

But the group is a master cost-cutter. Stripping out expenses related to selling, overheads and administration, moderated most of the hit to margins from commodities in the first quarter. Big, solid and diversified, PG should chug safely on. At $63.08, on a forward p/e of 14.88, the shares offer solid value.

Plum Creek Timber (Ticker: PCL)

Branching out

“He plants trees to benefit another generation” said Caecilius, a Roman comic poet. The sentiment remains admirable, but modern investors are putting money into trees to reap benefits in the nearer term. A growing number of rich individuals, endowments and pension funds are including timber as a “hard asset” in portfolios.

No wonder. Average annual returns on timber – meaning managed preserves that are eventually harvested – have outstripped those from leading global stock indices, property, oil and gold for the past decade. Worldwide, timber has attracted more than $20 billion of investment from institutional investors. Advocates say managed timber reserves are good for the environment too, preserving biodiversity on lands that might otherwise be logged recklessly.

Trees typically take decades to mature, making them especially appealing to institutions, such as pension funds, which are looking for investments to offset long-term liabilities. Returns are not correlated with those on stocks, and yields are predictable. There are risks, of course. Foremost among them is potential exposure to any general economic downturn, which would tend to cut demand for wood, pulp and paper.

Investors not inclined to buy actual trees might want to take a look at Seattle-based Plum Creek Timber (Ticker: PCL), one of only three timber real estate investment trusts and the largest private timberland owner in the U.S. On Monday it reported earnings per share for the third quarter 18% above the previous year. Trouble is PCL’s shares, which rose 20% this year to a record high in mid-September, have since reversed sharply, shedding more than two-fifths of their value, though today the stock jumped $7.53 to $38.28.

Timberland values, rising from about $1,100 to more than $1,700 an acre in the past seven years, have helped support share prices in spite of weak demand for logs thanks to the housing slump. But Plum Creek, with 8 million acres across 18 states, can call off the lumberjacks. Similar to petroleum producers, timber companies reduce output when pricing dips. But unlike the black stuff, trees continue to grow, adding about 5% to 7% a year in value. With southern sawlog prices down 18% year on year this quarter, for example, Plum Creek reduced its harvest by 13%.

Meanwhile, the reduction in activity at lumber mills means less residue for paper makers, boosting demand in Plum Creek’s (admittedly lower margin) pulpwood business. Investors fear that a slowing economy will dent demand there also. There are worries, too, that land values may have peaked and the credit crisis could hamper land sales, and therefore cash flow.

The latter looks overblown. Plum Creek did temper its outlook for real estate sales – which for the first three quarters of the year only accounted for about a fifth of revenues – and has in the past cut its generous dividend. But the company has been paying down debt and continues to buy back shares, now trading at about half net asset value, arguing that this is a cheap way to increase its holdings of timberland. Investors, too, should consider a stroll in the woods.

Oil in troubled waters

Using fancy charts and slides, potted histories and personal anecdotes, drillers for oil and natural gas claim that astonishing breakthroughs are transforming their business, particularly where it concerns the oil industry’s final frontier – deep water exploration. Until recently, however, many geologists were convinced that offshore oil would be found only in shallow waters. The sorts of rock conducive to petroleum accumulation, they argued, would be found only in ancient river deltas and other formations close to shore. That view has been debunked – oil majors are now betting that enormous amounts of oil are trapped under the ocean off Brazil, West Africa and the Gulf of Mexico.

That’s good for oilfield services companies. During a gold rush, it’s often the people selling shovels rather than the prospectors themselves who wind up making the most money. The oilfield services companies that are integral to energy production did extremely well during the black gold rush of the past few years, but now the demand for their implements – and more importantly the amount they can charge for them – are set to drop. While that will hurt profits, investors seem to have fled from the sector indiscriminately, confusing the rotten fundamentals of oil and gas producers with the more mixed picture at service companies that have lost two-thirds of their value.

Take industry leader Schlumberger (Ticker: SLB). Earnings per share increased nearly sevenfold over the past five years, yet earnings should not decline to 2003 levels even if oil prices might. The big oil fields needed to keep global output steady are in increasingly challenging and inhospitable spots that require Schlumberger’s technology and expertise.

Even in less dramatic settings, such as onshore natural gas production, the need for services like pressure pumping has increased as unconventional wells take up the slack of fading traditional reservoirs. The pace at which new wells must be drilled has increased too, particularly for gas, even if oil prices continue to fall. Analysts at Tudor, Pickering & Holt calculate that marginal gas wells are no longer profitable in many key areas, meaning gas prices – and hence drilling activity – could rebound soon.

Even if hydrocarbon prices continue to slump, four leading U.S. service companies – Schlumberger, Halliburton (Ticker: HAL), Baker Hughes (Ticker: BHI) and Weatherford International (Ticker: WFT), along with our portfolio holding Oceaneering International (Ticker: OII) – trade at under 7 times next year’s net earnings on average and sport a free cash flow yield of 9%. Some weaker players will struggle with a drop in prices and demand, but the larger companies appear well placed to emerge stronger the next time picks and shovels are sold at a premium.