First, we need to take care of a couple of annual housekeeping items.  Our condensed privacy policy is simple.  Employees of Quality Growth Management, Inc. shall preserve the confidentiality of information communicated by clients and prospects, contents of account statements, and actions taken in accounts.  There shall be no disclosure of client information to any party outside of Quality Growth Management, Inc., unless 1) required by law or subpoena, 2) needed by a firm that executes trades for that particular client account 3) needed by a firm that is the custodian of securities for that account, or 4) approved by the client.

All clients are invited to a review meeting and lunch.  Also, if any development in your life has changed your investment needs and objectives, please let us know.

The United States Economy     After a hugely relieving recovery year, in which our accounts significantly outperformed the S&P 500 Index, it is a propitious time to give a reasoned projection of what the year ahead might hold.  Although economic projections are tenuous at best, as the last two years have shown, an investor still needs a frame of reference with which to judge investments and changes in the investment environment.  And changes are coming.  One must expect a change in Federal Reserve Bank (Fed) policy.  In addition, the water of Federal Government policy is murky in regards to taxation, health care, financial regulation, carbon taxes, union laws, and free trade.

The executive summary is as follows:

1. Economic recovery will pick up momentum over the course of this year.
2. Inflationary pressure will correlate to the degree economic of recovery.
3. The Federal Reserve Bank will review its monetary policy, leading to a reversal of money printing.
4. U.S. Government stimulus spending will continue to boost GDP growth in the first half of this year, but further stimulus will be limited by the realities of a huge government debt.
5. People and businesses will react to the near-certain tax increases coming, at the latest, with the January 1, 2011 expiration of the Bush tax cuts by shifting economic activity from 2011 into 2010.
6. Economic recovery could very well reverse next year.
7. The long-term purchasing power of the dollar is threatened by current monetary and fiscal policies.  The recent spurt of the dollar, based on the rate of recovery of the U.S. economy and debt markets relative to elsewhere in the world, will eventually be reversed by too many dollars chasing too few goods.

The U.S. financial system is awash in cash, created by a close partnership between the Federal Reserve Bank and Federal Government.  The Fed has purchased unprecedented amounts of U.S. Treasury bonds and mortgage backed securities (almost $2 trillion!) to accompany massive levels of stimulus spending.  The action of the Federal Reserve Bank to create the loosest money in history faithfully follows Ben Bernanke’s academic history, in which he wrote numerous papers for economics journals that attribute the Great Depression to tight money.  Some of these articles are collected in his book, Essays on the Great Depression.  Readers of his book will learn what he thinks and how he will attack recessions.  As Patton said when his army surprised and defeated Rommel, “Rommel, you magnificent _______, I read your book.”  According to Dr. Bernanke, depressions and bank panics form a vicious circle, leading to an implosion of the amount of money flowing in the economy, which, in turn strangles the economy.  He feels it is the job of the Fed and Federal government to create enough money to replace that destroyed by economic malaise.  The alternative is a cascade into depression.  Money printing stops the cascade.  Over the past two years we have seen an incredible level of money creation and stimulus spending worldwide.  As a percentage of world stimulus spending, 37% and 28% can be attributed to the U.S. and China, respectively.  As the confidence of both bankers and borrowers expands, the massive amount of reserves injected into banks will lead to a resuscitation of money flow throughout the economy.  Investors will decide to take risks again, purchasing assets instead of holding cash that pays negligible rates of interest.  Gradually, asset prices will stabilize, the feeling of wealth will return, and the economy will get going again.  Right now, it appears as if Dr. Bernanke is right, and we have to credit him for a breathtaking recovery in the stock market.

Loose money has historically led to inflation.  Like recessions, a mindset and expectation is created which accentuates the actual economic direction.  Inflation over long periods of time leads to a significant decline in the purchasing power of currency.  This is an insidious, creeping type of taxation, of particular concern for those with limited retirement funding.  However, it also reduces the repayment burden of debt, a fact not lost on fiscal policy makers currently increasing the amount of Federal debt ($12.5 trillion and counting) like there is no tomorrow.  It is easier to pay off debt in depreciated dollars.  However, these policies damage the value of currency.  Devaluation of currency scares investors into moving their money into stronger currencies, thereby causing the departure of the investment capital on which long-term GDP growth depends.  In order to slow inflation, monetary policy is tightened to reduce excess liquidity, raise interest rates, and staunch the outflow of capital.  Since some of the excess liquidity has ended up in the stock market, we must be vigilant about the potential effects of the removal of this liquidity.

The economy in 2010 has numerous growth drivers that are not likely to be replicated in 2011.  1) Inventories were cut drastically in response to recession-induced expense controls.  Rebuilding started in the fourth quarter of 2009, and is boosting economic growth in 2010.  2) Stimulus spending is scheduled to end as it bumps its head against the realities of soaring public debt; this alone has contributed markedly to the current recovery in GDP growth.  3) The Fed says it will start winding down its liquidity programs, including debt purchases, in March of this year. 4) Between Fed tightening, ongoing Federal deficit funding needs, increasing loan demand from a recovering economy, and inflation concerns, interest rates should rise.  5) The huge increase in the supply of currency has already led to a recovery in commodity prices, a good indicator of future inflation.  6) We are getting plenty of warning that higher tax rates lie ahead, let alone the expiration of the Bush tax cuts.  People will drive economic activity and taxable transactions forward in order to beat the tax increases.  This is not limited to capital gains; it will include personal and corporate income, revenue recognition, acquisitions, etc.  Those holding stocks that have multiplied in value, such as Qualcomm, Monsanto, and Church & Dwight, must consider biting the capital gains tax bullet before taxes rise.  (Talk to your accountant about this.)  Essentially, a tax-timing arbitrage is going to develop that will shift forward significant GDP growth from 2011 into 2010.

So, my concern is not 2010, but 2011.  The question is whether consumer and business confidence improves sufficiently over this year to drive the economy into the headwinds cited above.  One must be concerned that if an economic pause develops, “double-dip” stories may inspire a decline in the stock market.

Opportunities   Compared to the uncertainty of economic forecasting, one can predict with confidence that companies dominating a niche of innovation, making products so attractive and respected worldwide that they create a moat around their businesses, will outperform major stock indices over the long-term.  Clearly, Qualcomm and Monsanto have an unrivalled intellectual property position in two gigantic world businesses – wireless communications and agriculture, respectively.  Literally billions of people will benefit in coming years from Qualcomm’s and Monsanto’s inventions.  Boeing’s new 787 is another example of a world-leading innovation, offering unparalleled fuel efficiency and economy of operation.  And, Apple continues to blaze the trail of user-friendly computer and Internet device technology.

Another reliable prediction is that a massive demographic shift is occurring in the world, creating an unprecedented business opportunity.  More than a billion people in less advanced economies are working to attain a higher standard of living.  This means eating chicken instead of rice, carrying a phone, accessing the Internet, driving a car, drinking a Coke, enjoying retail “luxuries” such flat panel HDTV sets, and on and on.  The expansion of the world’s consumer class is the dominant economic driver, and business opportunity, of this decade.

Steven L. Ré, CFA                                                                                            January 15, 2010

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss, and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.

Just as people and computers worldwide were connected by the huge build-out of the Internet over the past decade, machines will get their turn in the next decade.  However, there are 70 billion machines in the world compared to 7 billion humans.  The industry of connecting machines is broadly referred to by the acronym M2M, meaning machine to machine.  Growth will be driven by telematics, industrial automation, access control, point-of-sale terminals, real-time metering, home security, and home automation.  It will extend networking technology into industries such as electrical utilities, healthcare, sports, entertainment, and traffic management.  The technology is already here to replace the utility employee who reads your electrical meter every month with real-time consumption monitoring, allowing you to control home appliances from your iPhone or Blackberry.  Erecting the infrastructure to network machines will dwarf the build-out of the Internet.

How the world creates, distributes, and consumes energy is one of the most important issues facing governments today.  Solutions will use M2M to wirelessly connect users, generators, managers, and distributors of electrical power.  The energy sector is evolving from antiquated electrical systems towards becoming the Smart Grid of the future, enabling management of energy all the way from generation to consumption in businesses and homes.  A $3.4 billion portion of the U.S. $787 billion(!) “economic stimulus package” is presently being awarded to stimulate the build-out of the Smart Grid.  President Obama likens this to the development of the national highway system fifty years ago, saying the Smart Grid will lead to a “smarter, stronger, and more secure electric grid.”  The Smart Grid will connect utility companies to their customers, allowing utilities to budget and control consumption, thereby saving energy, money, and emissions.  It will allow consumers to see their energy costs in real time, enabling them to budget the level and timing of electricity demand.  It will facilitate the connection of renewable power sources, such as solar and wind.  According to the U.S. Department of Energy, if the U.S. electric grid were just 5% more efficient, the energy savings would equate to permanently eliminating the fuel and greenhouse gas emissions from 53 million cars.  In turn, this would reduce the number of new electricity generating facilities needing to be built, the cost of which comprises 33% to 50% of electrical bills.  The savings are significant.  Cisco says that the energy control system it installed for Google’s Campus achieved a 25% energy consumption reduction.  For those interested in more information about the Smart Grid, the U.S. Department of Energy’s The Smart Grid: An Introduction may be viewed here:

http://www.oe.energy.gov/DocumentsandMedia/DOE_SG_Book_Single_Pages%281%29.pdf

According to The Brattle Group, an investment of $1.5 trillion between now and 2030 will be required to build the Smart Grid alone, and that is only expected to be 20% of the M2M industry sector.  We went in search of an investment that would be a pure play on M2M.

Digi International (DGII is a leading manufacturer of electronic devices that connect, monitor, and control machines over networks.  It will be a direct beneficiary of government stimulus spending on energy conservation.

Digi’s product offerings include:

1. Sensors to collect operating information from machines, such as how much electricity each windmill in a windfarm is producing, how much liquid is in a storage tank, how much electricity a washing machine is using, or where miners are located in an underground mine.  The sensors remotely read thermostats, displays, and meters.
2. ZigBee modules – sensors, adapters, and other devices which have wireless communications built in to facilitate plug-and-play connectivity to networks.  Zigbee is a global wireless language that connects dramatically different devices so that they work together in very large networks.  It can be thought of as Bluetooth for machines.
3. Cameras to provide video surveillance from remote locations.
4. Cellular routers to network sensors to each other, to the Internet, and to computers that process collected information.
5. Gateways that allow consumers to read and control their home/business thermostat or appliances from their iPhone or Google Phone.
6. M2M network design services through the iDigi Developer Program.
7. Software to enable a network of remote devices to interface with enterprise applications.

Services that earn recurring revenues for Digi include:

1. iDigi – a turnkey two-way communications platform hosted by Digi for connecting machines.  It includes devices, software, and service that transmits information from remote sensors to home base.  It saves the information, and allows the home base to control remote devices at a tiny cost per transmission.  The “home base” can be an enterprise computer, PC, or iPhone.  It remotely reads thermostats, displays, and meters and controls the machine that is connected to the thermostat, display, or meter.
2. iTank – remotely monitors storage tanks just as we watch the gas gauge in our cars.  The level of fluid in tanks and the correct operation of attached equipment, such as pumps and valves, is monitored and transmitted to the owner of the tank, so he knows when to refill or service it.  It is more reliable and less expensive than regularly sending an employee out to check tanks.
3. ConnectPort X5 – a telematics platform for managing truck fleets using multiple wireless modes, including satellite, cellular, and WiFi.

Digi’s stock sells under book value, has no debt, makes money, and relatively few investors even know it exists.  With modest earnings growth assumed, intrinsic value is about $12.  If earnings grow in excess of 20% per year, intrinsic value is somewhat higher.  The company is inexplicably secretive about its Smart Grid business opportunities.  This behavior has damaged the stock price.  However, Digi’s devices regularly show up in pictures of Smart Grid and other M2M installations.  Digi’s revenues per utility customer should be about $15.  Government and industry want to deploy between 40 and 60 million smart electricity meters within the next several years.  Accordingly, we predict that the Smart Grid alone will be a huge business opportunity for Digi, relative to its current annual revenues of $166 million.

Steven L. Ré, CFA                                                                                 November 16, 2009

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.

 Third Quarter 2009 Update and Company Report

Inflation, the printing of money, and U.S. dollar valuation are getting frequent mention in the press these days.  Bail-outs, stimulus spending, and burgeoning government expenditures have combined with lower tax collections to set all time U.S. Government deficit and debt records.  Indeed, this money creation has saved the world from its depression scare and the U.S. economy is starting to recover, but there is a price to be paid.  It will likely have a powerful impact on investing for years to come.  We will start this discussion by explaining the process of money creation and finish by considering its impact on investment decisions.

When the federal government spends beyond its means, it must print certificates of indebtedness, better known as U.S. Treasury bonds, notes, and bills, to exchange for “money” from its lenders, the largest and most reliable of which is the Federal Reserve Bank, hereinafter referred to as the “Fed.”  The check from the Fed to pay for these certificates is not really money, just another printed piece of paper.  The Treasury, however, can take that piece of paper, deposit it, and then write its own checks (also just paper) to fund government expenditures.  Nothing tangible backs the value of the U.S. dollar, only the credibility of the financial position and fiscal policies of the U.S. Government.

In turn, the Fed calls this certificate of indebtedness an “asset.”  Remember, it is really just a piece of paper printed by the federal government promising at some point to pay debt back.  The world assumes the U.S. Government will keep that promise, as it has for decades past, despite various tumultuous periods experienced from time to time.  The Fed, in compliance with the laws that created it in 1913 and empowered it in 1935, can now use the “asset” to offset its liabilities.  The check it gave to the federal government in exchange for the certificate is called a liability, even though there is nothing of tangible value manifesting its existence.

As we said earlier, the government deposits the check from the Fed and then issues a multitude of its own checks to fund its expenses and programs.  These checks flood into the economy, ending up as deposits in commercial banks.  These deposits are considered the liabilities of the commercial banks, since they have to be paid back at the request of depositors.  At the same time, these deposits brought funds into the bank.  Funds sitting in the bank are assets of the bank, and can be lent to borrowers.  In fact, banks are allowed to lend these funds many times over and collect interest on the loans, as long as a little reserve is left behind in case some depositors want their deposit back.  If the reserve requirement is 10%, the bank must hold back 10% of total deposits, but can lend the remaining 90%.  The bank thereby can lend much more money than has been deposited, allowing many more checks to be written, which, sooner or later, end up being redeposited in commercial banks.  This creates more reserves and more loans and more deposits and more loans again, etc., driving liquidity in the economy.

In this manner, the growth of the economy is fostered and maintained.  Essentially, that one run of the government printing press ends up creating about ten times as much money in the economy.  All is copasetic as long as nothing interrupts this chain of money creation.  However, if too many depositors decide to take deposits out of the bank, or use funds as if they were real money to buy a tangible asset for cash with no loan, or put it under the mattress, or fail to make loan payments, the train of money creation gets derailed.  This slows the economy, causing other bad developments – foreclosures and depreciation of asset values.  This cumulative reverse in the creation of money, if sustained, creates a recession.  If a lot of layoffs are added into the mix, a depression could ensue.  In the past year, the Fed and federal government have teamed up to create a phenomenal amount of money.  We are now seeing that they successfully created enough money to offset the debt implosion and stop the economic decline.  That is a great relief, but it comes at a price.

Gold Bars are held in 122 compartments in the main and auxiliary vaults at the Federal Reserve Bank of New York

The 1930’s Great Depression was characterized by a significant contraction of money usage in the economy.  However, the Fed/government team did not have the power to print money then, because the value of the dollar was fixed to gold at $20.67 per ounce.  The amount of money was thereby limited to the amount of gold.  In 1933, private ownership of gold was made illegal in the U.S.; owners of gold were legally required to exchange it for money.  Eventually, the dollar’s value was entirely delinked from gold.  In 1935, the Federal Reserve Act was amended to give the Fed money creation power.  With the impediment of private ownership of gold out of the way, the Fed/government team wantonly printed money and inflation boomed, although neither the economy nor unemployment improved for another five years.  The Great Depression is colloquially attributed to a contraction of money supply.  Although the economic record from 1930 to 1934 supports that conclusion, the data from 1935 to 1940 thoroughly refutes it.

Obviously, more factors were involved.  The Smoot Hawley Tariff was imposed, which attracted international retaliation and damaged trade.  At the time, the U.S. had an export-based economy, similar to China today.  Also, taxes were repeatedly increased in a failed attempt to fund government deficits.  The top personal income tax rate rose in steps from 25% in 1932 to 79% in 1936.  Overall taxation nearly doubled as a percentage of GDP.  The tax increases never brought in the amount of revenues the government projected, but did smother several attempts by the economy to rally.  Recent re-examination of the historical record correlates policy errors, such as tariffs, government deficits, tax increases, and increased regulation, to the length and depth of the depression.  Such fiscal policies reduce the after-tax rate of return on business investment, in turn reducing the amount of capital invested or forcing it to go elsewhere in the world.  Business investment is the wellspring of future GDP growth – government spending is only a short-term panacea that borrows from future prosperity.  The U.S. government is funded by collecting taxes on income.  Since income correlates to GDP, GDP growth is crucial for paying government expenses.  When government spends beyond its means, it scares owners of capital, who know they will be expected to pay for governmental flights of fantasy.  Scaring already scared investors hindered economic recovery in the 1930’s.  We can only hope that future trade, deficit, regulatory, and tax policy will benefit from the lessons learned in the 1930’s.

As Americans, most of our assets are denominated in the U.S. Dollar.  If we look at wealth on a global basis, the value of the dollar has a lot to do with our relative wealth.  The U.S. Dollar, like anything else, is subject to the laws of supply and demand that some of us studied in Economics 101.  Essentially, if there is a larger supply of “X” as compared to “Y,” X will gradually devalue in terms of Y.  In the same period of time that the recession has significantly reduced the supply of goods, the U.S. Government/Fed team has printed a flood of U.S. Dollars to fund untested levels of government deficit spending.  Dollar printing over the past year offset the destruction of liquidity that occurred due to the recession.  As the defaults pass into history, and the consumer again gets enough nerve to take money out from under the mattress, the supply of money could very well mushroom.  And, if holders of debt want to redeem those certificates, lots of money will have to be printed to pay them.  Of course, it is easier to pay past debts back in depreciated currency, and there is a long history of politicians taking this opportunity.

The laws of economics tell us that the dollar should devalue compared to the price of goods.  The recent decline of the dollar as compared to most foreign currencies and resources is likely only the beginning of a phase of significant dollar depreciation.  As the amount Americans can buy with one dollar declines, our wealth declines.  So also declines the affordability of retirement.  So also declines the credibility of U.S. Government bonds, and the desire of foreign investors to own them.

Current U.S. economic policy gives a rational observer reason to believe that dollar depreciation will accelerate.  It appears that U.S. policy makers have knowingly made the decision to sacrifice the dollar in exchange for saving the world from a deeper recession that would have permanently destroyed a lot of debt.  In fact, much of the bailout money (Fannie Mae, Freddie Mac, and AIG) went to refund the losses of foreign investors.  Note that “bailouts” are simply the reallocation of defaulted private debt to the government, and thus to the taxpayer.  Policy makers of both political parties have fooled themselves over some years now by believing that a weaker dollar would make the U.S. more competitive.  Again, the historical record does not support that position.  Investors avoid countries with weak currencies.  Perhaps the comparative price of U.S. labor will decline, but investment capital, crucial for long-term growth, flees devaluation.  Emerging economies are experiencing strong equity and debt markets at the expense of developed markets.  Current U.S. government deficit projections include excessively optimistic assumptions for future U.S. consumer spending, not taking into account the historically unprecedented burdens being dumped on the taxpayer next year and beyond.  The U.S. economy is recovering with the help of government spending, but its continued improvement, when the crutch is removed, is uncertain.  History will tell us if the policy decisions were correct.  It is likely that a sustained economic recovery will bring inflation along with it.  Investing with the long-term expectation of inflation and low real GDP growth is the prudent course.

Our investment strategy, as discussed in previous reports, is evolving towards more dependence on the growth of emerging economies in lieu of the mature economies of the U.S. and Europe, meanwhile hedging against inflation and the decline of the U.S. dollar.  This leads us to companies that benefit from the growth of consumers in the world’s more youthful economies, such as Monsanto and Qualcomm.  We seek price opportunities to reduce holdings of companies that are dependent on U.S. economic recovery and growth, such as Lowe’s.  Companies that earn most of their revenues outside the U.S., such as Qualcomm, partially hedge against a dollar decline.  Non-U.S. companies whose stocks are denominated in foreign currencies, such as Rio Tinto, Petrobras, and Weatherford, are excellent hedges against a declining dollar.  Resource companies can outperform inflation as resource prices inflate and foreign economies grow.  Refer to our Mid-Year 2009 Report for a discussion of Chinese energy companies.  Finally, companies that grow very rapidly can offset the decline in the dollar.  We have identified domestic and foreign companies that should grow somewhat faster than inflation.  Equities in general have performed well in periods of moderate inflation.

Fixed income, the traditional safe harbor retirement investment, performs poorly in times of inflation.  Unfortunately, most retirement savings in the U.S. are invested in fixed income.  If the U.S. economy makes a strong recovery, inflation is likely to ensue.  It is unlikely that today’s low yields will make up for the decline in purchasing power of fixed income investments.  For example, the ten-year U.S. Treasury bond today yields only 3.4%.  When medium to long-term fixed income investments mature, the proceeds will buy less and have a difficult time supporting worker’s retirements.  Furthermore, Fed chairmen who wish to be remembered positively take stern measures to fight inflation.  Higher interest rates typically are used as a tool to slow inflation, but have the side-effect of damaging the market price of medium to long-term bonds.  The Fed has executed $292 billion of a $300 billion Treasury bond purchase program, designed to hold down interest rates while funding government deficits.  Treasury bond prices may be expected to decline as yields rise upon completion of the program.

Although the investment strategy of coming years will not accommodate the complacencies of the past two decades, opportunities abound for those with foresight.

Steven L. Ré, CFA                                                                                 October 14, 2009

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss, and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.

Today’s profitability story on Monsanto includes a large, but relatively short-term negative.  As powerfully proprietary as Monsanto’s seeds and traits business is, its Roundup herbicide business is a lowly common commodity business.  The export from China of glyphosate, the generic name for Roundup, has surged.  The Chinese economy has become dependent on exports.  The Chinese have increased exportation of industrial products in hopes of compensating for the recession-induced decline of consumer product exports.  The Chinese have exported so much glyphosate that the world is awash in it.  In a classic case of Economics 101, the law of supply and demand has driven the price of Roundup/glyphosate to a third of where it was a year ago.  Monsanto’s gross profit on Roundup could drop from 2009’s $2 billion to $1.2 billion in 2010.  Concurrently, seeds and traits gross profit should climb from about $4.7 billion to $5.5 billion.  That translates into a flat earnings year ahead.  This explains the underperformance of the stock so far this year, especially in light of the exceptional outperformance of most resource related stocks.  The Roundup news is well-digested by investors; Roundup’s deteriorating profits are already in the stock price.

Monsanto’s first trait, Bollgard, introduced in 1996, protects the cotton plant from insects, reducing insecticide usage by two-thirds.  Roundup resistance, a trait which allows food crops to continue to thrive when fields are sprayed with Roundup to kill weeds, was also introduced in 1996.  Roundup enables “conservation tillage,” a reduced level of the field plowing employed to destroy weeds.  Less tillage enables less tractor fuel consumption, reduces soil erosion, and conserves soil moisture.  YieldGard Corn Borer, which makes plants resistant to worms, followed in 1997.  More insect protection traits followed, along with advances in Roundup protection and traits that improve food quality.  Thanks to a Monsanto trait, transfats have been eliminated from the soy oil used to cook fast foods.  When I last wrote about Monsanto in 2007, the prospect of building three traits into one seed, in a process called “stacking,” was very exciting news.  It distanced Monsanto from its competitors.  Now, Monsanto has just received the approval for “SmartStax,” which stacks eight traits into one seed.  SmartStax is the most comprehensive package of insect prevention, weed abatement, and productivity traits ever offered in one seed.  It will expand the lead of Monsanto over its largest competitor, Pioneer Hi-Bred (owned by DuPont), potentially doubling Monsanto’s market share in corn seeds.  Although it will take several years to build up SmartStax seed production to meet demand, this will have a markedly positive impact on Monsanto’s profitability.

Eight stacked traits, as exciting as that may be, is only the tip of the iceberg.  Monsanto has an exciting trait development pipeline.  The drought tolerance trait will enable plants to thrive on half as much water, generating dramatic benefits for both the environment and the farmer.  Agriculture consumes 70% of the world’s fresh water supply.  It takes about 6,800 gallons of water to grow one day’s food for a family of four (http://www.rivers.gov/waterfacts.html.)  While dramatically addressing the problem of water shortages, this trait will also tackle a large agricultural expense and the leading risk of crop loss.  For example, corn requires 20 to 27 inches of water per season, at a cost of approximately $5 per acre-inch.  Another important trait is nitrogen utilization.  Nitrogen fertilizer is very costly for the farmer and for the environment.  Nitrogen accumulation is a problem in water supplies located in farming areas and heavily populated areas.  The nitrogen utilization trait permits plants to thrive even when fertilizer usage is reduced as much as 70%, saving both the environment and the farmer’s pocketbook. Finally, in line with its objective of doubling crop productivity by 2030, Monsanto has disclosed, without giving specifics, that certain yield-driving traits in the development pipeline will lead to productivity gains that dwarf its previous accomplishments.

The company is in the exceptionally unique and prosperous position in the business world of having created an ecosystem whose vitality compounds on itself.  Monsanto increases the yield per acre of corn, soybeans, cotton, and vegetables by countering the damage from insect pests, weeds, and other constraints on growth.  This increases the amount of food grown per acre, in turn leading to increased profitability for farmers.  This drives Monsanto’s seed market share, as farmers choose the highest yielding seeds.  Monsanto is compensated as the farmer’s partner, receiving a one-quarter to one-third share of the incremental increase in farm profitability.  Therefore, Monsanto’s revenue follows the equation:

World crop acreage x Monsanto market share x number of plants per acre x traits per plant x productivity increase per trait

The coming traits of drought resistance, nitrogen utilization and increased yield are particularly interesting for Monsanto shareholders, first because of farm value, but also because these traits increase all of these factors at once: the number of arable acres, Monsanto’s market share, the number of plants a given amount of acreage can support, the number of traits stacked into one seed, and farm profitability.

The emergence of Monsanto’s seeds and traits business over the past five years grew profitability from about $1.00 per share to this year’s estimated $4.40.  Once we are past the Roundup adjustment of the coming year, double-digit earnings growth should resume.  I believe that analyst estimates for the fiscal years 2009 to 2013 of $4.40, $4.40, $5.06, $5.82, and $6.69, respectively, are conservative.  Intrinsic value exceeds the current stock price.

Food is the ultimate resource and inflation hedge.  Returning to Economics 101, the gushing supply of U.S. dollars compared to the relatively flat supply of food should create a feast of food price inflation when the economy recovers.  Monsanto should be a fine dollar hedge in such an environment.  Also, food demand will be driven for many years by world population growth and the increased demand for meat in the diet of the world’s burgeoning middle class.  Monsanto is in the unique position of being the ultimate investment in the progress of agriculture.  Dominance in the technology of this huge worldwide business gives the company virtually unparalleled long-term investment visibility in an uncertain world.  The current stock price understates the opportunity.

Steven L. Ré, CFA                                                                                            August 19, 2009

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss, and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.