Potash physics... What goes down must come up

What goes up must come down.

That's what we learn from a very early age. It's that little thing called gravity. Amazingly, there are many facets of gravity that physicists still do not understand.… but that is definitely for a completely different kind of post.

For our purposes it is important to realize that some things that go down do not stay down and in fact must eventually go up. Try putting a piece of balsa wood (or any pure wood) at the bottom of a pool. It won't take long before you see it drifting somewhere along the surface. This can also be explained by physics. Balsa wood is less dense than the water on which it floats. The wood moves until equilibrium is reached.

In the long run the same thing applies to stocks... not that they must go up... but that they must reach what they are fundamentally worth. Dow Theory is a foundation upon which much of technical analysis is built. Note that technical analysis usually integrates with fundamentals in the long run. A key assumption of Dow Theory is stated as follows (source:stockcharts.com)

The manipulation of the primary (long-term) trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present. Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors.

Dow theory was aimed at markets as a whole rather than at individual stocks. However, while it may not apply to smaller, more thinly-traded stocks, the larger a stock is the more likely the model applies. When we extend this further to a group of stocks, such as the whole basket of potash stocks, the theory begins to hold even more water. If one goes back several years they will see clearly that the agriculture stocks, and potash stocks in particular, are on a long-term up trend.

Recently many of the agriculture names have been sharply sold off. Some of the reasons cited include falling grain prices, the drop in the prices of other commodities such as oil and natural gas, and many more. After the large run up in agriculture stocks some investors may be questioning whether a bubble has formed and much lower stock prices are ahead.

First, I want to say that I have been bearish on the global economy for quite some time. I did a fairly in depth post on this in March that looked at the views of Soros, Buffett, Jim Rogers, and more. (top posts... in a picture and a word...) It provided an understanding of the market and potentially helped many of the readers of the ‘Rose’ from being long too many (or any) stocks when the market turned in the beginning of the summer. I have claimed for a long time that the global demand for oil, while high, does not support the extremely elevated prices we have seen this year. A major global slowdown will likely further decrease, to an extent, demand for certain other commodities as well. However, as an analyst finally had the guts to say, not all commodities are created equal.

I invite anyone who owns or has short interest in the big 3 potash names (POT, MOS, and AGU) to visit the websites of both MOS and POT. There you will find conference after conference about the global food crisis and about the substantial global imbalance between potash supply/demand. There simply isn’t enough supply and won’t be for the foreseeable future. This is the case even if the world undergoes a global economic slowdown.

The main reason for this is simple. Have you been watching the Olympics? Does China look like the backwards nation that you remember from only a few years ago? Did you get the sense that Communist Party will scrap industrialization and move the country back to the poor, agrarian ways anytime soon?

All of those people, billions of people, in BRIC and other emerging countries throughout the world, want to live the middle class dream. Along with this comes the basic desire to eat more nutritional food and,moreover, to eat more meat. Lots and lots more meat. The odds are that they will also eat more. How much food will need to be produced when China and other countries with enormous populations realize that they could be eating ‘Fourth Meal’?

Additionally we have growing populations, among other factors, that only exacerbate the problem.

It is true that what we see on TV masks most of the real China. Most of the country is still very backwards. However, unless there the government gets overthrown (which at some point is a possibility) the backwards nature of China and other emerging markets makes the case for the potash fertilizers even more bullish. Billions of people are in line to demand better and more food going forward.

Potash is, as they say in chemistry, the limiting reagant… it is the chemical that is essential to make the emerging countries’ farm crops grow at optimal levels. According to Doyle, the Potash Corp. CEO, potash is under applied when compared to the amount used and proven in the US to produce at the highest level. BRIC countries have a lot of catching up to do when it comes to maximizing crop yields. I could go on and on and on.

There simply isn’t enough potash in the world. The majority of it is in Canada and is controlled by POT and then by MOS and AGU. It would take years and years to develop the infrastructure necessary to develop the reserves that the big three in Canada own. We call this a HUGE barrier to entry.

Let’s look briefly at fundamentals. We have companies like MOS and POT trading at FY PE ratios well under 15 and forward PE ratios well under 10. Yahoo finance has a 5 year growth rate of around 10% for the big 3. I’m not sure what computer they’re using to come up with these numbers… maybe the one that is calculating the gold medal winners in the Olympics?

More realistic is about 25% a year at an absolute minimum and perhaps upwards of 40% a year. The real PEG ratios are under .5…

The biggest threat to potash stocks in the intermediate term is that the stock will not follow fundamentals. In fact, I would be so bold as to say that the only threat is the market itself. If things become poor enough everything may sell off and be de-leveraged. It is also possible, on the flip side, that if the dollar starts losing it’s recent gains and more and more stocks become earnings time-bombs that the big money will flock to stocks such as these as a safe haven. Call it a bank, if you will.

It has also been shown, even without panic selling, that this is a market that only slightly cares about fundamentals. This market depends on what the big money feels like doing next. The big firms have shown over and over again that if the fundamentals don’t build the case for what they want to do they will simply do it anyway and find a way to justify it. There was question after question about demand destruction on the last POT conference call. When Doyle repeated that there was simply none in sight and guided higher the stock was downgraded at one point and then sold off. It looked to me like they had decided before the earnings release that they were going to take profits. Regardless. Also, I would have to believe that the large open interest on the August puts played a role.

Now we have oil inventories that are higher than even the most outlandish estimates and we have GS saying that we are starting to see a return to the fundamentals that drive oil prices higher. What I heard was oil and commodities are on the way back up very soon.

The charts will have to confirm this of course. So far they really look like they are basing and awaiting a move over 108 in MOS and above the 180 area in POT. The big houses will do whatever they want in the short-term and I do not reside in their temple.

I can say this though, about the potash stocks. I think I see a whole bunch of wood trying to rise from the bottom of the pool right about now.

"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice.