It’s a great time to buy this controversial commodity

Palm oil is a controversial industry. But for long-term investors, now looks like a good time to buy in. Lars Henriksson explains why, and picks seven stocks to consider.

You don't have to go far in Malaysia to find palm trees. More than ten percent of the country is covered with them, all planted in neat green rows. They're a vital part of the economy, because every year the country churns out millions of tonnes of palm oil, a key ingredient in all sorts of consumer products including chocolate bars, soap and lipstick.

Record prices for the commodity in 2011 sparked a planting frenzy in Southeast Asia, and supplies ballooned. It's a cyclical industry of course, and thanks to the extra plantations and the global recession, prices have almost halved in two years, putting the squeeze on producers and sending their share prices plummeting.

Now the industry is consolidating, and companies are taking advantage of weak prices to buy up new plantations. That may be very bad news for the local environment much of the palm oil has been planted in virgin rainforest in the heart of Borneo. That has threatened several endangered species and replaced vast tracts of rainforest with low diversity monoculture. This is definitely a controversial investment something you should consider before reading on.

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But this is also a plant that is bringing a good deal of prosperity to this region. And you might be surprised to know that one in ten products at your local supermarket contain palm oil.

Three buyouts in recent months have put the focus back on palm oil stocks. And I think we'll see plenty more deals like this in the coming months. For long-term investors now looks like a good time to buy into palm oil.

Big palm oil firms are buying up swathes of land

The British founded the industry in Malaya about a century ago, leaving a legacy of excellence which remains today. Palm oil is found everywhere in supermarket products ranging from cooking oil, margarine, cereals, crisps, sweets and baked goods, to soaps, washing powders and cosmetics. It is also used in animal feedstuffs and biofuel. Major buyers include China, the EU and emerging markets.

Recently, three corporate deals in Sabah, East Malaysia, have put the focus back on palm oil stocks.

On 2 October, IOI Corporation Bhd(IOI), a leading privately-controlled palm oil company, bought a 40% stake in the Unico-Desa Plantation for 396.6 million Malaysian ringgits (about £77 million). The deal gives IOI an extra 13,660 hectares of land, which amounts to a 7.5% increase in the overall area of the company's plantations.

The land is next to IOI's existing plantations, allowing them to share resources and therefore the potential to improve yield and profitability. The company is expected to make a mandatory general offer (MGO), which can be easily financed internally as IOI doesn't have much debt. The net gearing is a mere 0.32. The purchase price works out at 73,416 ringgits per hectare.

On 27 September, Boustead Holdings Bhd (BOUS), a Malaysian conglomerate with large interests in the palm oil sector, bought a land bank of 2,410 hectares for 184.6 million ringgits from Unico, equivalent to a purchase price of 76,603 ringgits per hectare.

On 18 July, Felda Global Ventures Bhd(FELDA), the world's third-largest manager of palm oil plantations, bought Pontian United Plantations for 1.2 billion ringgits, allowing it to increase its land bank by 16,187 hectares, resulting in a purchase price of 74,798 ringgits per hectare. The company aims to expand in the region, including land acquisitions in Myanmar, Cambodia and Indonesia. It is also eying Africa.

Consumer demand in Asia will boost prices

Of course, the price of palm oil is dependent on the supply as well. On that front it appears that land is becoming dearer, particularly in Indonesia, following concerns about the environmental impact of turning rainforest into plantations. Future supply might come from Africa, but most people I talk to suggest that is far away given the problem of securing land, manpower and proper infrastructure.

Recently, the Malaysian and Indonesian governments have stepped in to try and stabilise tumbling prices. They're going to speed up biodiesel programmes to make businesses use more palm oil in certain fuels. This should provide some price support in 2014.

As a consequence existing plantation lands with yielding assets, particularly the larger plots located close to mills and ports, are set to increase in value. So if you fancy playing this theme what should you do?

Seven companies that could get bought up soon

enterprise value

The Malaysian CIMB Bank has identified seven possible candidates. Here they are with their enterprise value per hectare in brackets, all quoted in Kuala Lumpur:

Hap Seng Plantations (HAPL) 53,466 ringgits;Golden Land Berhad (GOLD), 30,972 ringgits,NPC Resources (NPC) 39,570 ringgits;Duta Land (DTL) 43,304 ringgits;Cepatwawasan (CWG) 51,098 ringgits;Kretam Holdings (KHP) 55,235 ringgits andKwantas (KWAN) 73,640 ringgits.

The industry is consolidating due to weaker palm oil prices, higher production costs linked to labour shortages and hikes in minimum wages. So I think we can expect to see more acquisitions in the coming months.

Now these are all small companies, which means that trading volume might be thin. But you have to remember, this type of company makes a tempting takeover target. So to get maximum value from them, you need patience and a long time horizon. And also remember that most Asian consumer stocks trade at high valuations, which means that the best candidates are to be found in the smaller and less liquid names. This is the game being played by the Asian investors and if you can't beat them you should join them and pursue a similar strategy.

Investing in palm oil stocks is controversial due to its environmental impact. There are two things that make these investments more appealing. First, they are mature plantations, which means there is no need to clear any new rainforest. Second, the buyers of these estates have been involved in the business for decades and have good corporate governance, which means they work towards sustainable production and treat their workers decently.

Finally, I think it is important to appreciate these corporate deals in light of the AFTA 2015 free trade agreement. To recap, the ten member countries of the Association of Southeast Asian Nations (ASEAN) with a total population of 600 million people and a combined GDP of $2.5 trillion will set up a free trade area by the end of 2015. All that will mean steadily growing consumer demand, and a huge boon for the palm oil industry.

Lars is our resident emerging markets expert, with 17 years of 'on the ground' experience hunting down profit opportunities in Asia.

Lars spent ten years living in Malaysia and Thailand, seeking out strategic opportunities, before moving to London to manage the Oracle Asia Absolute Fund.

In short, Lars has real knowledge of where the opportunities in Asia are. Sign up to his free newsletter, The New World, here.