Speculating on Drought

NEW YORK (TheStreet) -- Investors are ghoulish.

We constantly speculate on the misfortune of others. When people are dying in Libya or Bahrain, we speculate on the price of oil. When workers are laid off in China we speculate on toys and iPods. When they riot in Greece we speculate on the euro.

Well, now our people are suffering. A historic drought has hit Midwestern farmers hard, as the Des Moines Register reports.

This is a global phenomenon that's pushing up prices in India, as Reuters reports, and causing violent strikes in Indonesia, according to Bernama.

Traders are expecting another reduction in crop estimates this week (see this Reuters story) -- maybe not as bad as in past weeks, but bad enough. And if you're expecting supply help from Russia, don't. The news, as the Examiner notes, is just as bad in their grain belts as in ours.

Care to speculate? All this bad news could do wonders for your portfolio.

The game is already on. Fertilizer prices are rising, as are stocks in fertilizer companies like Potash ( POT) and Agrium ( AGU). The two commodities are closely linked, according to the Toronto Globe & Mail.

On the other hand, companies in the business of animal protein are sells, like Smithfield Foods ( SFD) and Hormel ( HRL). You might expect less selling pressure on Tyson Foods ( TSN), because chicken takes less grain to produce than pork or beef. But no luck, Tyson bought pork producer IBP a decade ago.

Here are two other ways to play this:

Buy McDonald's ( MCD). The prices paid by McDonald's will rise significantly, but so will the prices consumers pay.

As food prices rise, Americans traditionally trade down. Instead of steak, we go for hamburger. When the impact of currency fluctuations are taken out, the company's most recent "earnings miss" actually turns out to be in line with expectations at $1.39/share, as Business Insider notes.

McDonald's has a steady profit margin of 20%, a steady operating margin of nearer to 30%. The balance sheet shows as much cash as a typical quarter shows gross profit, so it can handle the shocks that a global company takes.

In short, I expect prices to rise, but that means sales will rise. And I don't expect much earnings compression from the coming food inflation. McDonald's is a buy.

ADM ( ADM), by contrast, looks like a sell. It's currently trading midway between its 52-week high and 52-week low.

ADM's business model is based on an abundance of corn and soybeans. It's the largest processor of both commodities and the largest exporter. It pioneered the use of corn for corn syrup and for ethanol, but the former is going to be less competitive with cane sugar, and production of the latter is declining quickly as corn prices rise.

The only hint I've seen of ADM trouble is this Motley Fool study questioning the validity of reported cash flow numbers. The company has a cash cushion of barely $1.25 billion, with a debt-to-assets ratio of about 25% and over $21 billion in quarterly revenue. It lacks the financial flexibility to hide bad news.

ADM is due to report earnings at the end of this month. ADM's previous earnings statement was bad, and it blamed results in ethanol and oilseeds.

The current quarter and the next quarter are bound to be worse. Yes, I can almost hear you rubbing your hands in glee.

At the time of publication, the author was long MCD.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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