The Poor Investor

Investigatory Value Investing

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Coffee Industry Outlook

Recently I wrote an article regarding finding investments during market peaks.  In that article I discussed some coffee stocks and made an argument for being bullish on coffee over the long-term.  However, I was unable to go into the coffee market in as much detail as I would have liked.  In this article I will attempt to fill in some of the gaps that existed regarding coffee in the last article.

Coffee prices have had a massive drop over the last year (Figure 1).  This was fueled by a few major variables.  For one, according to the Public Ledger, global coffee production is up 50% since 1993.  The simple fact of the matter is that global supply was greater than global demand.  This resulted in a surplus of 10m bags in 2013 and 5m bags in 2014.  Also, commodity prices and the dollar are inversely related to one another.  According to the Wall Street Journal, “The dollar’s rise to a near 10-year high against the Brazilian currency added to selling pressure for arabica coffee and sugar.”  Being that coffee is measured in US dollars, as the dollar rose coffee prices fell.

Drop in Coffee Prices

Figure 1

However, this does not mean that demand is falling.  In fact, in nearly every country measured, total consumption has been increasing steadily since 2003.  Asian countries are especially on the rise with plenty of room to grow in China, as its per-capita consumption of coffee remains extremely low (Figure 2).   According to the China Coffee Association Beijing, on average a person in China drinks about 5 cups of coffee a year, which is well staggeringly below the world average of 240 cups per year.  The number of coffee drinkers there is growing at a rate of about 15% a year as younger generations of Chinese are preferring coffee over tea more and more.

Per Capita Coffee Consumption Low in China

Figure 2

Developing countries are experiencing a burgeoning of the middle-class and hence spending is growing overall (Figure 3).  There is no shortage of articles linking middle-class growth to increased coffee consumption (here are a few examples: 1, 2, 3, 4, 5).  As a luxury good, as incomes rise so too does coffee consumption.  Also, people want to experience things that are new to them and the appeal of America’s “Starbucks culture” is alluring to those in other countries.  Starbucks estimates it will double its stores in EMEA, Japan, China and other non-US countries by FY19.  The US and surrounding region will grow 25%.  This will grow its current 21,000 store count to 30,000 stores.  Starbucks is banking on the trend of increased coffee consumption.  Forecasts by the Public Ledger also show global demand will outstrip global supply over the long-term by 10m bags in 2023, with supply struggling to keep up with demand as early as 2016.  Also, as the knowledge of the health benefits of coffee drinking becomes more and more widespread, so too will coffee consumption.  This is a long-term bet, not only on coffee, but on the rise of standard of living worldwide.

Burgeoning Middle Class Spending

Figure 3

While I don’t advocate trading on near-term information, things are also looking up for coffee prices near-term.  Coffee prices trade inversely to stocks of coffee (Figure 4).  World stocks of coffee will be used during 2015 to meet the demand that has not been produced.  As this supply runs low, coffee prices will rise.  It’s not a matter of “if” just a matter of “when,” as the International Coffee Council states, “this cannot be maintained indefinitely, and will put pressure on prices.”

Coffee Price Versus Stocks

Figure 4

Long-term investors in coffee, be it through an index, such as iPath Pure Beta Coffee ETN (CAFE), or individual stocks, such as Coffee Holding Co. (JVA), are likely to find success.

Disclosure: Long JVA 

Bottom Digging During Market Tops

The S&P 500 has nearly tripled from a 2009 low of 735 to 2113 currently.  Just as a rising tide lifts all ships, so too does a rising stock market lift all stocks.  At greedy times like these, investors should be fearful and reexamine their portfolios.

…if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.  -Warren Buffett

Now, I’m not saying the market has reached its peak (though some do make compelling arguments).  I am not a market timer and I’ve written about the folly of forecasting in the past; I’m merely saying a prudent investor should not let greed get the better of him.  The following strategy is one that is more likely to be applicable during market highs as investors are more likely to have a preponderance of stocks trading at prices much higher than their actual values (aka, the rising tide theory mentioned above).

So what to do?  Well, I believe the prudent investor should lock in gains on stocks pushing well beyond their valuations (close to 52-week or all-time highs) and replace them with stocks trading at reasonable valuations.  Mr. Market is offering attractive prices for your stocks, let him have them.

But then we’re left with the problem of finding alternative investments.  As markets keep pushing higher and higher, investors are often left scratching their heads wondering where to find value.  Admittedly, this can be challenging, however, opportunities do still exist.

One place to look as stocks reach all-time highs are stocks reaching new 52-week lows.  Some noteworthy examples include PriceSmart, SodaStream, Turtle Beach Corp., and Fossil.  PriceSmart is the Sam’s Club of Central America and the Caribbean.  It’s trading at a small discount to its sales, has high insider ownership, and has consistently grown sales, 15% on average, over the past ten years.  At its current price of $17.07 after-market, SodaStream trades at a large discount to sales (72% of sales) and is nearly trading at its book value of $16.59.  Turtle Beach has near-total domination in the gaming headphone market with 50% of both the UK and US markets.  It trades at 60% of sales (which it looks to nearly double sales this year) and is led by smart management with a solid near-term plan, and patents, to enter industries such as health, automotive, TV and mobile.   I’ve already written my take on Fossil, you can read it here.

The next place to look is at overlooked stocks (often smaller capitalization, less than $100m) in industries where there is a low supply of investment opportunities.  One such industry is the coffee industry.

Now, before going into individual companies, let me preface this discussion by first noting some interesting dynamics at place in this market.  For one, coffee consumption is not nearly what it used to be.  In fact, in 1946 consumers drank 46.4 gallons of coffee per person (Figure 1).  Today, even with a coffee shop on every corner, consumers drink less than half as much at only 20-25 gallons of coffee per year as coffee was replaced predominantly by soda.  As consumers become more health-conscious, pop consumption should decrease and coffee, as a viable, healthy alternative, should have an increased level of consumption.  Secondly, there is a shift taking place where high-quality shade-grown coffee (high cost to grow) is being overtaken by the rise of poorer quality shade-free coffee (cheaper to grow).  This makes coffee plants much more susceptible to climate change and topsoil erosion.  As climate change concerns begin to grow, the downfall we’ve seen in coffee prices from $300 in 2011 to a current 52-week low of $140 is not likely to last.

Figure 1

Figure 1

Now, opportunities in this market surely exist in the form of large companies.  There is, of course, Green Mountain Coffee Roasters and Starbucks, but investors in those companies will soon bail when they see these companies for what they are—overvalued.  Starbucks trades at an all-time high ($94.30) and the highest price-to-sales ratio it has ever seen in the last ten years of 4.12.  Starbucks also trades inversely to coffee prices.  Green Mountain Coffee Roasters ($124.10) shares trade even higher at a price-to-sales of 4.31 and, like Starbucks, it is also inversely correlated to coffee prices.  As coffee prices rise investors will bail on these two companies (and valuations will come back down to earth).

So when investors bail, where will they look?  On the conservative end is Coffee Holding Co., trading at 28% of its total sales.  This company is well-managed by its owners, experienced coffee industry veterans, who have a 10% stake in the company’s shares.  They also support and believe in sustainable practices.  These beliefs lead to production of higher quality coffee (shade grown) that is not as susceptible to soil erosion and climate change.  Furthermore, as experienced coffee experts, they are well-hedged against fluctuating prices.  On the risky end is Jammin Java, better known by its Marley Coffee, which is trying to force itself to turn things around before it does a complete nose-dive.  If company-estimated year-end sales are to be believed, the company trades at a 10% discount to expected year-end sales.  However, this company is only for high-risk-oriented individuals who don’t mind getting cleaned out if things turn south.

Then, there’s the oil industry.  I don’t think I need to go into this a whole lot as many have already witnessed the price collapse at the pumps, so suffice it to say that there are many opportunities to be had in this sector, both large cap and small, and everything in between.  (Check out Cale Smith’s recent notes about the oil price phenomenon).  I’m pretty sure you could throw 10 darts at oil stocks right now and make at least 8 solid investments.

Another interesting idea is James O’Shaughnessy’s strategy of looking for stocks that he calls Reasonable Runaways.  These are stocks that have a high relative strength, greater than $150m in market cap and trade at a price-to-sales ratio less than 1.  I’ve modified this strategy a little bit by including companies that have large amounts of cash in excess of debt.  Some notable examples include FreightCar America Inc., BeBe Stores, Men’s Wearhouse, LSI Industries and FujiFilm Holdings.  While I have not had time to look into each of these companies it doesn’t matter— the theory of the Reasonable Runaways strategy is one of investor agnosticism.  The theory says that you are buying $1 worth of sales for less than a dollar (low P/S) just as investors are realizing the company is undervalued (high relative strength).  You simply run the screen, buy agnostically, and diversify your portfolio by giving equal weight to the top 20 or so companies with the highest price appreciations.  Sell after a year then repeat the process.  Since 1951 this strategy had a compound annual growth rate of over 18%.

While the S&P 500 may have reached its top, your portfolio doesn’t have to top-out.  You can simply shift your current best performers to companies that offer greater opportunity and more attractive valuations.  Employing several different search techniques, such as those mentioned above, can get you on the right track to optimizing your portfolio towards value and thus reducing your overall risk by increasing your margin of safety.  But don’t forget to hold on to a fair amount of just in case cash for when the market does plummet.  You’ll want to have that cash in your back pocket to snatch up undervalued companies when the falling tide lowers all the ships again and more opportunities abound.

Disclosure: Long Coffee Holding Company (JVA) and Fossil (FOSL)

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