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BHP Billiton Limited (ADR) (BHP), Mosaic Co (MOS): Why I’m Buying Potash Corp./Saskatchewan (USA) (POT)

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David Lee Roth left Van Halen in 1985, and the Van Halen loyal mourned his departure. Sadness turned to hand wringing, as the faithful worried the band’s trademark sound a thing of the past. Sammy Hagar’s subsequent hire did nothing to assuage their concerns, at least not immediately. But with 5150‘s subsequent release, and success, the mulleted Van Halen masses breathed relief. Van Halen’s change was merely cosmetic. The same could be said of the potash industry. Its recent history is of a cozy fraternity. Instead of competing for market share, the industry’s top players took a rational, price-centric approach to competition, ensuring tasty returns on capital and continuously increasing potash prices.

Potash Corporation Stock

But a month ago, that comfy arrangement came to a screeching halt. Or so it seems. The Russians—a key player in the scheme—announced they aren’t playing ball anymore. Instead, they intend to pursue a volume-focused strategy. The market, concerned potash players’ cush margins are at risk, handed shares in the potash crop a drubbing. But like DLH’s Van Halen dust up, things aren’t as bad as they seem. In fact, I believe the very things that made investment in potash companies fetching—a strong secular demand profile, attractive economics for incumbents, and high barriers to entry—remain intact. Potash Corp./Saskatchewan (USA) (NYSE:POT), as the industry’s leader, is poised to benefit, but with the recent dramatics, shares are a lot cheaper.

That’s why I’m buying a position equal to 3% of my Real Money Portfolio.

Potash: Delicious and Nutritious?
What’s blanketly called fertilizer is actually three market segments: potash, phosphates, and nitrogen-based fertilizers. Demand is cyclical in the short-run, tied to crop prices and, peripherally, the state of the world economy. But in the long-run, there’s a certain inevitability associated with consumption. Taking a 20 year view: Fertilizer demand is apt to move higher amid growing worldwide per capita incomes, attempts to maximize crop yields, and a trend toward higher protein consumption in emerging markets, buttressed by China and India in particular.

Potash Corp./Saskatchewan (USA) (NYSE:POT) is the world’s largest supplier of potash, controlling 20% of capacity, and one of the lowest-cost producers. For would-be competitors, barriers to entry are sizable: Worldwide potash reserves are closely held, as five producers own rights to roughly 80% of industry capacity, and greenfield mine development costs are enormous. This, alongside a communal industry-dynamic, has contributed to years of very attractive returns.

Potash Corp./Saskatchewan (USA) (NYSE:POT), the commodity, contributed almost 60% of 2012 gross profits, and despite cyclical demand, has helped the company reap high returns on capital with impressive consistency. Those successes haven’t gone unnoticed. Despite massive upfront costs, mining giant BHP Billiton Limited (ADR) (NYSE:BHP), is contemplating a large greenfield mine, which if completed, could increase industry capacity by 15-20% (more on that below).

Potash Corp./Saskatchewan (USA) (NYSE:POT) also has its paws in the other crop nutrients, phosphates and nitrogen. Phosphate market dynamics are decent, and nitrogen just meh. In aggregate, these segments are characterized by lower barriers to entry, less consolidated end-markets, and less disciplined participants. But even so, Potash Corp./Saskatchewan (USA) (NYSE:POT) still retains key advantages.

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