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Commodity Prices Are Surging -- These Stocks Could Be In Trouble

Friday, May 09, 2014 8:30 AM

Your caffeine buzz is about to get a whole lot more expensive.

Coffee prices have been quickly rising, as seen by the iPath Pure Beta Coffee ETN (NYSE: CAFE), which has risen 80% in the past six months. Blame it on poor growing conditions, which have reduced crop yields.

The price of coffee should also concern you if own shares of any coffee chains. Some such as Starbucks (Nasdaq: SBUX) have been wise enough to hedge their exposure through long-term hedging contracts, while others such as Dunkin' Brands (Nasdaq: DNKN) lacked that foresight.

Understanding how commodity prices and hedging strategies will impact your investment is an underappreciated topic. Indeed commodity prices -- and companies' ability to hedge against sudden spikes -- can explain why earnings forecasts steadily rise and fall.

For example, consider cotton. That commodity has been on a tear recently, but Hanesbrands (NYSE: HBI), one of the world's largest buyers of cotton, has locked in more than 95% of its cotton needs for the next year at prices that now look like a bargain. That foresight explains why this stock is at all-time highs -- despite surging cotton prices.

Other consumers of cotton such as Gap Inc. (NYSE: GPS) and other retailers aren't nearly as aggressive with their hedging strategies. That means they'll either have to raise prices to preserve margins... or simply absorb the higher expenses.

Airline carriers also have differing hedging strategies. Southwest Airlines (NYSE: LUV), for example, tends to lock in prices for more than half of its jet fuel needs, while American Airlines Group (NYSE: AAL) maintains a no-hedging policy. If jet fuel prices rise, American would likely lag behind the sector. (You can find each carrier's hedging strategy in its 10-K and other filings.)

Restaurants To Feel The Pain
Perhaps no industry feels the impact of changing commodity prices as the dining chains, which are exposed to price swings for both proteins and vegetables. Analysts at Citigroup recently met with experts at the Doane Group and found that the prices for a basket of commodities -- including corn, soybeans, wheat, beef, pork, poultry and dairy -- are expected to rise sharply this year. Doane's agricultural specialists see 15% to 20% price hikes for beef, pork and cheese in particular.

Of all the burger chains, Burger King (NYSE: BKW) has the greatest exposure to beef (19% of product costs). Pizza chains such as Domino's (NYSE: DPZ), with 35% of its food costs tied to cheese, are ill-equipped to handle rising dairy costs.

Some companies take radical steps in the face of rising commodity prices. As avocado prices have surged, Chipotle Mexican Grill (NYSE: CMG) is weighing whether to stop selling guacamole. Will that impact traffic? It's hard to know, but the move appears wise considering that Chipotle is already pushing through steady price increases and can ill afford to deliver a guacamole sticker shock.

To be sure, falling commodity prices can deliver a profit tailwind. Corn prices, for example, have slumped over the past few years, boosting the economics of ethanol as a fuel source. That has helped shares of ADM (NYSE: ADM) to surge more than 50% since November 2012.

Risks to Consider: Import demand in China, coupled with growing conditions in South America and North America are the key factors behind commodity price swings.

Action to Take --> I don't recommend buying or selling specific stocks based purely on a presumed move in commodity prices -- but I do suggest considering commodity trends as a factor in your broader buy or sell decisions. For example, if you see that oil prices are beginning to rise, you should check to see whether the airline stocks you own are properly hedged.

P.S. China's imports of one special commodity set a new record in 2013. Our top analyst just came back from a trip to Asia with an inside scoop -- along with two top picks that could deliver 218% gains to early investors. To find out all the details, go here.

David Sterman 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.