Two weeks ago I did a quick tour through the Midwest, visiting some of the holdings in the global agricultural unit investment trust on which we serve as advisors. Archer Daniels Midland (ADM) was one of those stops.

As many know, the company is involved with the procurement, processing, transportation, storing and selling of agricultural commodities and products. To begin with some good news about ADM, let's review some of the financials; in the first nine months of fiscal 2008 sales are up 51%, gross profit up 20%, net earnings up 18% and earnings per share up 21% in the same period as fiscal 2007. On the other side of the ledger, looking at the balance sheet we find that short term debt increased to $4.9 billion in March '08 from just $468 million in June '07. In an environment of rising rates, investors should be wary of a company that takes on such a staggering increase in debt that must be rolled over in a short period of time.

Like many in the agricultural services space, the company is subject to the volatility of the underlying commodities it supports. If not properly hedged, the company will suffer from earnings and margin compression. ADM relies heavily on making very profitable trades in order to grow its earnings.  Despite the successful financial start of the year, the stock has provided an anemic advance of only 1%. The subpar return for the company that is known as the "Super Market to the World" is partly because it must also be a master trader and speculator in order to ensure profitable earnings growth.

In fact, it is difficult to overestimate how important trading is to the future prospects of the company. ADM's subsidiary ADM Investors Services Inc. is a futures clearing firm and a part of the company's agricultural services division. This division was responsible for a seven-fold increase in profits from $46 to $366 million in the last quarter. There is no doubt that services have been successful as of late and are key to the company's future, but can investors' bank on their continued outperformance?

After taking a tour of their processing facilities, it was a shock to enter the firm's corporate headquarters. It seemed as if I went from a corn field to the middle of a Wall Street in the space of a few feet.  ADM's trading floor seemed to rival N.Y.S.E. (or, perhaps more appropriately, the Chicago Mercantile Exchange) in technology and size. What this army of traders is doing is attempting to arbitrage prices-selling commodities to end users and then sourcing them from producers at a discount. However, it is far easier to put on profitable hedges during periods of low volatility as opposed to periods of big price swings.  Lately, the moves in commodity prices have been sharp and severe.

ADM exemplifies the problem that occurs when a company is not the producer at the margin. Companies like Monsanto (MON), FMC Corp. (FMC) and Potash (POT) can set the price of their respective commodities and easily expand margins in today's environment. Whereas companies like Corn Products (CPO) and Archer Daniels Midland must seek to either pass along their higher input costs to the end user or hedge against them by speculating in the market.

Make no mistake, ADM has shown a steady increase in earnings and share price over the years and should be included in most broad portfolios that seek exposure to the agricultural commodity space.  In addition, ADM is the country's second largest producer of ethanol and plans to increase production by nearly 50% in just three years, which-despite the wrong-headedness of our ethanol policies-could could be a key driver to boost future earnings and revenue growth.

However, to get the most bang for the buck, investors looking to buy individual stocks should first seek companies that have the most leverage to rising commodity prices and do not have to concern themselves with hedging for a living.

Disclosure: Long ADM, MON, FMC, POT and CPO.

• Cambrex Corporation Q2 2008 Earnings Call Transcript  »
• Metabolix, Inc. Q2 2008 Earnings Call Transcript  »
• Sterling Construction Company, Inc. Q2 2008 Earnings Call Transcript  »
• Infrastructure Is Making News  »
• BlueLinx Holdings, Inc. Q2 2008 Earnings Call Transcript  »

Michael Pento

• Bio & more articles

• Delta Global Advisors
• Mid-Week Reality Check Podcast