How to Invest in Food Stocks

We currently have over 7 billion people in the world. Every one of us -- without exception -- needs food to live. That makes the food industry one of the most reliable in the world. 

Companies involved in the food chain -- everyone who touches an item from the farm to the table -- are diverse. When it comes to investing in food stocks, it's vital to understand what specific role a company plays in the food chain and how the company can defend itself against competition in the long run.

Image source: Getty Images.

As you'll see, while the business of food is very stable, the ability to defend one's position is much more complicated. Let's review what those different sub-industries are and what you need to know before investing in food stocks.

Industry overview

Think about the path of a soybean for a minute. A seed is provided by one company to a farmer. That farmer plants it and -- a few months later with the help of some machinery -- harvests it. It is then sent to a food processor who will later provide the processed soy to make something we're all familiar with, like soy milk. The company that makes that soy milk then ships it to a grocery store or restaurant -- at which point you, the end user, will finally purchase and ingest it.

Imagine the trip of this tiny soybean, and multiply it times trillions of similar products around the world and you get an idea for how vast and complicated our global food chain is. Within that chain, are a handful of sub-industries that all contribute to getting food created and onto your plate:

• Farms
• Farming machinery
• Food processors
• Diversified food producers
• Specialized food producers
• Distributors
• Grocery stores
• Restaurants
• Delivery services

In each section, we'll cover what that industry actually does, who the biggest players are, and what metrics are most important to watch. 

Farms

When we think of farms, we often think about family run operations that are as far from publicly traded conglomerates as possible. And indeed, around the world, most farms are small operations. Even in the United States, 97% of farms are family-owned. 

This means that most of the actual food producers don't have stocks you can purchase on the open markets. That being said, some companies do own large swaths of land they can use to make the raw materials that make our food. For instance, BrasilAgro (LND -1.22%) buys farms in Brazil for sugar cane, cattle ranching, and grains. It applies the latest agricultural technology to make these farms more productive.

Companies such as this are small and represent a tiny portion of the overall food market. If you are interested in investing here, the two most important factors to watch are total production capabilities (how much of the given crop can the company produce) and the underlying price of the commodity. If a company sells sugar cane, for instance, then it will benefit when global sugar cane prices rise.

Agricultural chemicals

While the actual producers of food are wildly diverse, they all need similar products to help their crops grow -- seeds, fertilizers, pesticides, and insecticides among them. When these products are made by larger companies, they are usually cheaper -- costs can be spread out across a wider customer base -- and significant investments are made in research and development.

The industry has undergone dramatic changes in the last twenty years. In the past, chemicals to manage pests and provide nutrients were the focus. And while those products are still very important, the advent of genetically modified organisms (GMOs) has changed the landscape dramatically.

Now, chemical companies can offer seeds that are specifically engineered to withstand treatment from that same company's pest-control products. That acts as a double-win for the chemical company: once farmers buy the seeds, they are also locked into buying the herbicide, pesticide, or insecticide that the seeds are designed to be resistant to.

The biggest players have recently gone through a round of mergers and acquisitions. Bayer acquired Monsanto -- maker of Round-Up and leader in the GMO niche, in 2018. Dow Chemical and DuPont combined forces in 2015 to form DowDupont -- though the company will soon be splitting up. And Swiss chemical company Syngenta was bought out by ChemChina in 2016.

The industry isn't without its critics: a small number of companies control an outsized portion of cash crop seeds. The long-term effects of GMOs are hotly debated -- with no definitive answer yet clear. And government regulations -- which can vary widely depending on where a company is operating -- can be heavy-handed.

In the end, the company with patents on the products that appear to be the most valuable holds the most enviable position in the industry. This can be a tricky proposition for investors, though: different pests and patents arise every year. Being able to choose which will be the dominant one over the next 12 months -- let alone the next 12 years -- can be very difficult.

Farming machinery

Along with the use of chemical fertilizers and pest control, improved farming machinery is one of the other big reasons we can manage to feed so many mouths today. What used to take weeks and an army of pickers to harvest now only requires a single human and a few hours in a field with a combine.

By far the most well-known name in this sphere is Deere & Company -- more commonly known as "John Deere." The company's green tractors are so ubiquitous in middle America that kids of all ages have miniature versions in the toy boxes at home. In 2018, the company pulled in over $37 billion in sales.

If you are thinking of investing in this niche, there are a number of factors to consider. From a macroeconomic perspective, the price of commodities like corn and grain are important. When the prices for these products are high enough, farmers have incentive to upgrade their farming equipment. But when times are tough, they are more willing to wait a year or two before making a big purchase.

On a company-specific level, brand and market share are paramount. For instance, Forbes declared that Deere is a Top 100 Global Brand, one of only two heavy machinery companies to make the list. Not only is that brand value important, but the network of distributors (read: market share) that have personal relationships with local farmers can make all the difference. 

Such things can be tough to measure. But unless you're investing in a company that's got a disruptive new agricultural machine that's protected by an ironclad patent, I think your best bet is to invest in the company's with the greatest market share and brand value within their specific niche.

Food processors

Once all of the world's key cash crops have been harvested -- namely wheat, corn, barley, soy, and oats -- they need to be processed. Most people, for instance, don't go out and pick wheat and then grind it into flour to be used to make bread. Instead, we count on major food processors to take the raw food material from farmers and turn it into ingredients we can use.

The biggest players in this realm are Archer Daniels Midland, Bunge, and Fresh Del Monte. ADM tends to focus on oilseeds, ethanol, and sweeteners. Bunge produces much the same, but has a specific focus on sugars sourced from Brazil. And Del Monte is a popular name for sourcing and processing fruits primarily from Central and South America.

The biggest competitive advantage most of these companies have is their physical scale. It costs lots of money to collect, transport, and process all of these raw food materials. The more customers a company has -- and the more built out its infrastructure -- the costs can be spread out across all clients. This helps lead to lower overall costs.

That being said, because the largest players all typically have enough scale to compete on price, the two most important metrics to watch in the industry are revenue growth and margins. Revenue growth will tell you if a company is maintaining, gaining, or losing market share -- while profit margins reveal if the company is able to gain any share profitably.

Diversified food producers

Now we enter the realm of names that you're probably more familiar with. When food processors are done putting food through their machines and making usable ingredients, they send them off to food producers.

You'll see tons of products at the grocery store from the nation's top diversified food producers. Oscar Meyer hot dogs, Heinz ketchup and mustard, and Philadelphia cream cheese all come from Kraft Heinz; Oreos, Ritz Crackers, and Trident gum from Mondelez; and Gerber baby food, Lean Quisine, and Haagen-Dazs are all owned by Nestle.

By far the most important metrics to watch with such companies is the organic growth of sales. I say "organic" because these conglomerates often times buy up small, fast growing, and increasingly popular brands. When they are rolled into the product suite, the addition of these new brands can make sales appear to grow markedly. 

But what really matters is whether existing brands are continuing to resonate with customers. Organic revenue growth filters out the effects of new -- or divested -- brands from a company's performance. 

We'll dive deeper into this below in the "Trends" section, but the relative strength of brands is the key differentiator for these companies. And with millennials now making up a huge swath of consumers globally, the gravity of having a strong brand is not what it used to be.

Specialized food producers

Specialized food producers aren't all that different from the diversified ones. They tend to be smaller and have a more narrow focus. The most popular and well-known of such companies includes Hershey (chocolate), Lifeway Foods (kefir), Post Holdings (breakfast cereals), and Lamb Weston (potatoes).

All of the same dynamics covered above are at play here: Organic revenue growth is the key metric to watch, while brand value provides the most long-term protection from competition. Because most of these companies have fewer product offerings, they tend to have brand values that are somewhat more defensible -- though still under assault by changing demographics of millennials. 

Distribution

When your fruits come from California, your grains from the Dakotas, your steak from Texas, and your frozen and packaged goods from Pennsylvania, someone needs to coordinate transporting all of that food around the country (and world). That's where the nation's top food distributors come into play.

This industry is dominated by two stalwarts: Sysco and US Foods -- though United Natural Foods has carved out a niche in servicing natural and organic-focused organizations. Sysco and US Foods were actually in talks to merge back in 2015, but the federal government prohibited the merger based on the combined market shares of the two companies.

Entrenched players have have a two-fold advantage: it is prohibitively expensive to build out a transportation network specifically for food, which introduces high barriers to entry. Furthermore, once companies like Sysco and US Foods reach a certain size, they can spread fix costs out over a larger base, giving it a pricing advantage.

There are two metrics worth watching. "Case volume" tells you if the amount of stuff the company is distributing is growing. And "inflation" is an industry term for whether companies are getting paid incrementally more for moving those cases.

One key thing to watch is the encroachment of Amazon.com (AMZN 0.01%) into this industry. The company already has the distribution chops to match Sysco and US Foods' scale, and the purchase of Whole Foods in 2017 was a strong indication Amazon could be looking to disrupt food distribution.

Grocery stores

Those distributors drop food off at two types of locations: grocery stores and restaurants. We'll deal with the former here.

If there's one thing to know about this niche, it's that there's been massive consolidation among grocery stores. A number of formerly publicly traded grocers -- like Safeway and The Fresh Market -- have been taken private. And what's left has been gobbled up by Amazon (Whole Foods) and Kroger. 

The main driver of all of this is the simple fact that just about anyone can procure and sell groceries -- there are very few moats in the business. Over the past decade, in fact, none other than Walmart (WMT 1.09%) has become the most prolific seller of groceries. Target also has an important grocery division that helps draw customers into its stores. And Costco's business is heavily reliant on shoppers coming to buy groceries in bulk.

What all of this means is that the biggest players -- Costco, Walmart, Amazon, and Target -- have taken a lot of business away from the more traditional niche players.

If you're thinking of investing in this space, comparable store sales -- or comps -- is the most important metric to watch. This tells you how much stores are able to grow sales from year to year -- while factoring out the effects of new store locations.

Restaurants

Next we have restaurants. This includes a wide-array of establishments, from heavy-weight fast food joints like McDonald's to fast-casual locations like Chipotle Mexican Grill, to high-end sit-down restaurants like Ruth's Hospitality Group's Ruth's Chris steakhouses.

The moats at such locations are very narrow -- anyone can start up a restaurant and offer goods for relatively cheap. The ability to introduce high switching-costs via loyalty programs and rewards help create stickier client bases. And partnering with food delivery programs (more on them in the next section) has also helped juice returns.

The most successful restaurant stocks are the ones that seem to "hit" on an under-appreciated consumer demand at scale -- like Chipotle has done over the past ten years. Predicting what those under-appreciated demands are before hand, however, is exceedingly difficult. Chipotle itself serves as a case in point, as reception to the company's attempts to branch out to pizza, burger, and Asian fusion joints has been lukewarm.

As with grocery stores, the most important metric to watch are comps. And within that designation, you should see how much comps growth comes from increased prices and how much comes from increased traffic in the store. In general, you want increased traffic to lead the way, as it shows a restaurant gaining favor with more and more customers.

Delivery services

Finally, we have a niche that probably wouldn't have been included 10 years ago: food delivery. If you want something from the aforementioned restaurants, but don't want to go out to get it, you now have a bevy of options to get it to your door.

This market is dominated by four big players: GrubHub, Uber's UberEats, as well as privately held DoorDash and Postmates. In theory, these businesses should have a very wide moat around them: as more customers visit GrubHub, for instance, to find their next meal, more restaurants will be motivated to list on the site, which further draws in more customers. It's the virtuous cycle of a network effect.

In reality, though, things haven't played out exactly as you'd expect. Because food delivery tends to be a city-by-city business (an Austin, Texas, customer doesn't care how many New York City delis are on GrubHub), there are different companies benefiting from these network effects in different cities. Furthermore, there's nothing to stop a restaurant from listing on more than one service -- or from customers picking and choosing from who has the lowest delivery rates.

If you're looking to invest in this realm, the three most important metrics to watch are growth in active customers, growth in restaurants served, and the company's take rate. While the first two are self-explanatory, the take rate represents the amount of cash delivery companies keep from each delivery. The higher, the better.

Trends in the food industry

As already alluded to, there are several major factors that are reshaping the food industry. Three in particular stick out:

• The growing desire for natural and organic food: Starting sometime around the release of SuperSize Me, Americans have been increasingly focused on natural and organic goods. While grocery stores have already made this pivot, the trend has serious implications for chemical companies (consumers don't want lots of chemicals), food processors and restaurants (consumers want healthy food).
• The importance of e-commerce: Of all retail industries, food was once thought to be the most resistant to e-commerce. This makes sense: Food is perishable, and buying in-store seems advantageous. But with improved technology and customer familiarity with delivery services, those who can deliver groceries to your doorstep as quickly and safely as possible could benefit enormously.
• Millennials shifting trends: As former hedge fund manager Mike Alkin outlined in a January 2018 speech, millennials are now the largest buying demographic in America. They tend to want three things from their packaged goods: that they are organic (when possible), that they come from small producers, and that they come from local producers. This means the power of a company's brand -- once the Holy Grail of food retail -- has diminished enormously, and power is shifting to local producers that don't have publicly available shares.

Over the next decade, it will be important to consider all three of these large demographic trends before making any long-term investments in the food industry.

The largest food players

As you can see below, the world's 10 largest food stocks are dominated by familiar names. 

DATA SOURCE: YAHOO! FINANCE. DATA ACCURATE AS OF JULY 16, 2019.

Amazon and Walmart might seem like odd additions to a list such as this. But as we know from above, food plays an integral role in each one's business models. Not only that, but as the aforementioned e-commerce trends continue to intensify, the companies with the largest fulfillment infrastructure (read: Amazon and Walmart) will be some of the biggest winners.

Top food stocks to buy

Here's the thing to remember about the food industry: It is vast and trillions of dollars are spent on it every day. It is also incredibly reliable -- we will always need food to eat. These two things might make it seem like the food industry is a great place of an investment. 

But that's not necessarily the case. Anyone can grow food. Anyone can transport food. Anyone can cook food up and offer it to others. That's great news for you and me -- the competitive forces of capitalism drive the costs of food down. 

That's not, however, a great thing for food companies. Without any discernible moats to extract outsize profits, increases in sales are almost always met with increases in spending. That's why the only two companies I feel comfortable recommending as "food stocks to buy" are Amazon and Walmart. 

Walmart has turned its brick-and-mortar operations into efficient places to pick up pre-ordered goods. And its history of moving groceries makes it an excellent pick to help bring the goods to your door. Amazon's specialty is large-scale distribution. The purchase of Whole Foods means that company can afford to invest massively in helping move food -- in bulk -- across the country and the world.

That type of distribution scale will be hard if not impossible to match, leading me to believe that there are the only two food stocks with enough of a moat that I'd be willing to invest in.

Final word on food stocks

It's important to remember that there's a huge difference between a reliable business and a good investment. Food companies have reliable demand -- people always need to eat. But because almost anyone can grow or make food, only a company with a moat makes a good investment. Keep that in mind as you're investigating options in food stocks -- and you should be richly rewarded over the long run.