There's a grain shortage - here's how to profit

The rampant rally since March has driven up prices across the board. Last week, my colleague David Stevenson had to have a real trawl around to find any remaining sectors on the stock market that looked cheap. He found one (Here's where to find the cheapest stocks on the market), but it wasn't an easy job.

In the wider investment universe, there's the same problem. From corporate bonds to oil to copper to government debt, the price of everything has been driven higher. If you care even remotely about fundamentals, it's getting harder to find value out there.

But one market looks as though it's been left behind in the big bounce agricultural commodities. And there are plenty of good reasons why it should recover and rise much higher...

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Why grain prices should rise

Agricultural commodities grains specifically have been left behind somewhat in the 'Rally in Everything' as Dylan Grice of Socit Gnrale puts it. Individual 'softs' such as sugar have done well for reasons specific to that market. But grains have pretty much halved since summer 2008, and recovered only a little, whereas global stock markets have rebounded strongly.

Yet the fundamental concerns that helped to drive softs higher in the first place are still intact. China is still an agricultural cul-de-sac it has 22% of the world's population and just 7% of its arable land and 8% of its water. Worse still, China's supply of arable land is falling, as increasing amounts are lost to industrialisation.

Meanwhile, as the country gets richer, its people will want more protein in their diets. That means even more pressure on the grain supply, because raising livestock to turn into meat is more grain-intensive than a low-meat diet.

And of course, China's not the only place where the global population is growing. Even although we've had a couple of very good years harvest-wise, global grain inventories remain near record lows.

What it comes down to is the simplest story in the world. Supply looks vulnerable, and there's no reason to expect demand to decrease. Therefore, prices - if we're looking across the board, rather than at individual grains - should rise.

There are a wide range of exchange-traded funds (ETFs) that allow you to take advantage of this, by simply tracking the price of various groups of grains (or even individual ones if you feel particularly strongly about a single one). But you should be aware of a few things before you pile in.

• Why UK property prices are going to fall 50%
• When it will be time to get back in and buy up half price property

Speculating on the commodities market

As we've pointed out several times before, buying directly into a commodity is not investment it's pure speculation. Commodities pay no dividends. Therefore you are buying them in the belief that you will be able to sell them at a higher price at some point in the future.

That's not to say there's anything wrong with speculating on the commodities market. But it is important to go into such a trade with your eyes open. Commodities are certainly not a buy-and-hold investment so if you buy, you should have a good idea of when and at what price you are aiming to sell.

Just to go off topic for a second, I realise many of you will be asking how gold fits into all this. Gold is a slightly special case in that you don't buy gold to bet on supply / demand imbalances. You buy it because it's historically performed well in times of fear over the ability of paper currencies to maintain their value. I would regard gold as a financial insurance policy and wealth preserver. Of course you can take bets on the price of gold going up or down, but there are also sound reasons for holding on to a chunk as part of your portfolio.

Anyway, getting back to soft commodities, Grice makes a good, related point. Ultimately, "any commodity bull market is really just a bottleneck and human ingenuity has a good track record of unblocking the bottlenecks which have appeared in the past."

Necessity is the mother of invention. If the alternative is going hungry, cold or without transport, then we have little choice but to find technological solutions or substitutes or efficiency improvements to reduce our dependence on commodities as they are used up. In other words, rising commodity prices sew the seeds of their own destruction, which is another good reason why you should have price targets before you take direct exposure to any commodity.

An alternative investment to buying directly into softs

The good news however, is that this also means that you don't have to buy into commodities themselves to take advantage of any shortages. You can instead buy into the companies who are working to fix the problem to get rid of the bottleneck and profit from their progress in doing so. For example, if part of the problem is inefficient use of water, then companies that can help farmers irrigate their fields more efficiently should profit. Then there are areas such as genetic modification, or fertiliser and farm machinery providers.

My colleague Eoin Gleeson looks at the most promising areas to invest in, including irrigation and third-generation biofuels, in the current issue of MoneyWeek: Is the drought over for agriculture stocks? If you're not already a subscriber to MoneyWeek magazine, subscribe to MoneyWeek magazine.

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