Back during the gold rush of the 1800s, there were two ways to make money...
The companies that made and sold the picks and shovels often proved much better investments than speculating on the gold mines themselves.
Fast-forward a few decades, to the Texas oil boom, and the adage proved true again -- especially for Howard Hughes.
Hughes realized that the real money was in making the drillbits used in drilling for oil rather than actually drilling for oil. He would go on to become the richest man in the world for a time.
Today, there's a modern-day boom in farming.
The global demand for food is at levels never before seen. Global population growth and the use of crops as renewable fuels are all contributing to the demand.
What was true in the previous booms hasn't changed -- it's often more profitable to own the materials that farmers need to grow crops rather than speculating on the crops themselves. Crops are dependent on weather, and natural disasters can wipe out a full year's work in a matter of minutes.
In my view, the best way to invest in the global farm boom is through fertilizer companies. After all, there is only so much arable land. Getting the most out of each acre means using fertilizer, which ideally is applied every year to boost crop growth and keep yields high.
The most attractive company in the fertilizer space is CF Industries Holdings (NYSE: CF), which makes and distributes nitrogen and phosphate fertilizer products worldwide. The $12.3 billion company sells its products to cooperatives and independent fertilizer distributors through its internal marketing and sales force.
CF Industries has a highly profitable business, boasting an operating margin of over 40% and a return on equity of almost 32%. It's also well-positioned for the long term: It is reinvesting in its business and expects to increase its nitrogen production capacity by 25% by 2016.
CF also has a sophisticated national network to deliver its products to its customers: more than 80 in-market storage and distribution locations, over 5,000 rail cars, ammonia pipeline access, and 100,000-plus tons of barge capacity. That amounts to a big competitive advantage.
For instance, in the first quarter, CF had a large amount of ammonia in inventory, but the company was able to move it to customers in regions where weather was conducive to ammonia use. The result was a 73% increase in shipments from the same quarter last year.
Shares look to be quite undervalued. CF Industries' stock has had an impressive run over the past couple of years, but it's now down 10% from its 52-week high earlier this year. Even with the surge in its stock price, the company trades at less than 10 times next year's earnings and 2.7 times sales. Its enterprise value-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio is only 4.8.
The company has attracted the attention of activist investor Dan Loeb and his Third Point hedge fund, which has a $250 million position. Hedge fund billionaire David E. Shaw also owns a nearly quarter-billion-dollar stake in CF Industries.
In the first quarter, CF Industries Holdings sold its phosphate business for $1.1 billion after taxes. The company returned a portion of this cash to its shareholders by repurchasing 3.2 million shares for $794 million.
CF Industries sports a dividend yield of 1.6%, but that's only a 9% payout of earnings, meaning there's plenty of room to increase its payout. In fact, Loeb may have been attracted to CF Industries for its potential to increase its payouts to shareholders.
Risks to Consider: CF Industries relies on natural gas as an input for the production of fertilizer, so rising natural gas prices would weigh on margins and boost overall manufacturing costs. However, CF Industries does have a hedging program in place to lessen the impact of a spike.
Action to Take --> Buy CF Industries with a price target of $310 a share, for upside of 27% from current levels. This would put shares trading at 3.3 times book value, which is in line with the industry, and 12 times next year's earnings, which is in line with CF's historical average.