Global demographics are driving agricultural returns for both financial and real assets, writes Martin Steward
For the agri-bulls, it's simple arithmetic: there are going to be more and more people on a planet that isn't getting any bigger. They also have a nice line in slogans: "The secular drivers come down to the three Fs," says Jonathan Blake, the global resources manager running Baring Asset Management's recently-launched, equities-based Global Agriculture fund: "Food, feed and fuel."
More people means more food. But more people with more wealth also means more consumption of meat - which in turn means greater demand for animal feed: producing a tonne of beef takes seven tonnes of grain, not to mention an astonishing 7,000 tonnes of water, the overwhelming limiting factor for agriculture. This is now compounded by the growing use of food crops as biofuels.
As well as these secular drivers, investors are also helped by the fact that, in the shorter-term, agricultural-commodity prices are influenced by factors like the weather, natural disasters, politics and disease, that bear little relation to economics. During the recession in the early 1990s, demand for all agricultural commodities except coffee increased.
Which is not to say that an exposure via commodity futures would be a smooth ride. Although last year's correction - attributable as much to record-breaking harvests as to financial speculation - did not take prices below their averages for 2007, that is no comfort if you went in at the top and are now nursing 50% losses. For long-term investors, perhaps a better way to smooth out that exposure to the secular trends is own the farms that produce the commodities. For a start, you get real estate exposure which has shown decades of remarkably robust, inflation-busting returns (the NCREIF Farmland index has suffered only one quarterly loss since launching in 1992 - 0.01% in 4Q 2001; while US Department of Agriculture figures suggest that during the high-inflation periods of 1944-1947 and 1975-1981 farmland returns exceeded US CPI by 2% and 6.6% respectively).
"We find that the closest comparison is an inflation-linked bond without the default risk," says Stefan Leibold, head of business strategy with AgroYield, a Stuttgart-based manager with a fund that owns farms in Romania and plans expansion into Serbia, Moldova, Russia and Ukraine. "This is a great long-term asset - Churches and royal families have been investing since the Middle Ages."
That real estate appreciation might represent as much as 70% of total returns, against 30% from operating yields. But what you do on that land gives you a lot of influence over the risk/return profile of that capital appreciation.
"Dairy generates constant cash flow and is very similar to the model of buying an office and renting it out," says Detlef Schoen, managing director with Hamburg's Aquila Capital, whose AC Agri Opportunity fund is being raised to invest in dairy, beef-cattle, sugar-cane and row-crops farms in Brazil, Australia and New Zealand. "It's a cash cow, if you'll pardon the pun, offering about 12% net IRR per year, 3% of which comes from land appreciation. What we do - buying dilapidated, over-grazed farms with a lot of bush attached and getting it back into production - is more like buying a car park, demolishing it and building a new office tower. For beef production, that means a target annual IRR of 25%, with 5% from appreciation. Each one would suit a different risk appetite."
Geographical exposures also offer diversification. The land market is extremely varied: from the UK, where the average holding coming to market is likely to be less than 120ha at $20,000 (€14,403)/ha; through South America, where you can pick up 10,000ha at $2,000/ha, along with a bit of tenure risk; to Central and Eastern Europe, where you can get land for about $4,000/ha but have to do without freehold rights.
The consensus is that pretty much all the yield improvement possible in North America and Western Europe has been squeezed out; but Schoen reckons large tracts of Russia and Ukraine "could easily double their yields"; and Latin America and Africa represent the largest reserves of untapped farmable real estate.
"You have to choose you location very carefully," warns Gary Vaughan-Smith, CEO of SilverStreet Capital, whose Silverlands fund will launch later this year to invest in Central Africa. "This is prime land at very low prices, but for every 100km you are away from the market you make 15% less profit; every 0.5km you are away from the water source loses another 15%; and it costs $2.5m to lay 70km of powerline, so you can't do that without government support."
Like Africa, Brazil is also about low prices for prime land - as well as the advantage of a huge aquifer and sandy soils that make irrigation much easier. Eastern Europe is a multi-faceted convergence play. A wave of German, Dutch and Danish farmers are selling their existing businesses and taking their yield-boosting experience further east - the model on which AgroYield is building.
"Romania has low political risk assuming it stays in the EU," says Leibold. "There is no export duty, and a political objective of fostering agriculture in the new Member States means we are subsidised up to 50% for investment in equipment."
Subsidies introduce a new kind of political risk to the more obvious ones present in Russia and Ukraine - especially when governments are hunting around for spending cuts. And whereas Brazil under irrigation is as reliable as a greenhouse, a wheat crop in Kazakhstan's climate will be a disaster three years out of five but a monstrous success in the other two.
The best idea is to diversify globally and by production - some pastoral meat production in Australia; some diversified crops in Brazil; cereals in Eastern Europe; something high-yielding in Central Africa. This will also help long-term investors manage the risks of climate change, which could be considerable.
Overall the squeeze on supply - of food, and of the land to produce the food - seems like a surefire driver of returns. But is land really the greatest beneficiary?
Farming remains the world's most fragmented industry, with 30% of farmers still living on their land - but this is set to change rapidly as consolidation is forced by an urbanising population that is willing to sell and governments looking for food security and farming conglomerates looking to buy. New economies of scale enable the improvements in yields that will help limit the growing population/land imbalance, but those economies of scale are required precisely because yield improvements add capex to what is already a capital-intensive industry: as an investor, why sit on the buy-side of that equation with the farmer, rather than with the companies selling them seeds, fertilizer, machinery, irrigation equipment and services?
"The more leveraged opportunity is equities," says Hugo Rogers, who manages the Thames River Water & Agriculture fund. "A company with a solution that improves yields will see its order books increase by multiples - and improving irrigation or animal husbandry are multi-decade, not just seasonal, trends."
Rogers is talking his own book, but even the farmers recognise the benefits of diversifying along the value chain. Leibold sees storage capability as one of the keys to working in the variable climate of Eastern Europe, and he eventually wants to get into the trading business, too. Vaughan-Smith points out that buying a mill is a cost-effective way to add 50% on top of a 30% yield from a wheat crop; and that providing microfinance for subsistence farmers sustains a market for seed and fertiliser producers that his Africa fund is planning to buy.
Inputs, finance, storage, processing: one can already see how diverse the opportunity can be. The very basic need for greater yield for a growing population is clearly an opportunity for fertiliser companies like Mosaic and Incitec Pivot; crop-protection firms like United Phosphorous or Makhteshim; or those specialising in farm professionalisation such as SLC Agricola or Indofood Agri. More and better machinery from the likes of John Deere, Agco, or Kubota also helps - indeed, it becomes a must-have as populations in developing economies urbanise.
"Without crop protection, some experts say that the amount of land for food production would have to treble," says Gertjan van der Geer, a senior investment manager with Pictet Asset Management who runs its new Agriculture fund. "As farm workers move to the cities mechanisation is the only solution for farm owners; and that trend to move away from the centres of production, and to spend more on non-local foods, makes supply chain services more important than ever."
Storage, transportation and trade businesses like Bunge or America Latina Logistica might be expected to benefit, but also food-testing and traceability specialists like Neogen or SGS Group.
"If you take a cargo of soybeans from Brazil to Europe it has to be GM-free," says Sarasin & Partners' deputy CIO Henry Boucher, manager of the AgriSar fund. "It gets tested on the farm, in the port, on the ship and again when it gets to its destination - so food-testing is a nice little geared play on the volume of trade."
Once crops get to their destination, processing companies like Corn Products or Tate & Lyle take over, and ultimately distribution and retail names like Tesco could be included in the universe. For Pictet, 50% of revenues must be agri-related and branded food manufacturers and retail are out, leaving about 280 companies worth $480bn; Sarasin has no explicit selection criteria and estimates its universe to consist of 500 stocks; while Barings imposes the 50% of revenues rule, it runs a ‘farm-to-fork' strategy looking at about 350 names.
Those universes are self-evidently quite diverse, and present trades pitting one part of the value chain against another: for instance, rising commodity prices are good for the producer but bad for the processor, and vice versa - so dampening some of that commodity volatility is relatively straightforward.
The farmers have a simple counterargument, of course: "When prices are rising we think it is wise to be invested in the limited factor of production - and that means the land," as Leibold puts it. "You can't increase the supply of land, but you can build a second plant to make combine harvesters."
It is certainly a point worth remembering - but it should also be noted that the equity funds are not without listed opportunities in farming itself: firms like Sanderson Farms, Indofood Agri, China Green and SLC Agricola own large landbanks, as do listed palm oil producers. The Pictet fund allocates 20% of its portfolio to farming stocks: "We expect that to grow because we think it is a very attractive part of this industry," says Van der Geer. "At the moment you pay about the same price for the average farm-professionalisation company as you do for the MSCI World index - the land assets are essentially free."
Reza Vishkai, head of alternatives with Insight Investment, is not so sure. He argues that very few large listed companies give significant land exposure: "You end up going further up the value chain, an exposure that is much more closely correlated with broader equity markets."
While undoubtedly true, it should not be overstated. The agriculture universe is only about 1.5% of the MSCI World index, its fundamentals stack up very well in comparison at the moment, and over the longer term it seems that the de-correlation of agriculture from economic growth trends does translate into the equities. And of course, it is possible to improve a fund's correlation characteristics with good knowledge of the industries.
"It's very tempting to try and play agriculture by buying the big North American fertiliser companies - like the index products that have sprung up," says Boucher. "The chemicals-based yield-enhancement practices that characterise that market are probably not the best way to make money out of it for the long-term, but the focus of the market there means that I can buy a great chocolate producer in Indonesia that no-one knows about."
The same goes for commodity-market correlation. A fertiliser company is very clearly reliant on natural gas prices; but in general energy prices represent only about 20% of farm input costs, while benefits can accrue from the biofuels substitution effect pushing up softs prices. The diversity of the value chain helps, too: a grains farmer obviously doesn't like to see grain prices fall, but a pork producer like Smithfields does.
Equities are a leveraged play on farming - and so, despite the diversification available, returns are likely to be more volatile than from the farms themselves. The last 12 months will have made that clear to any investor. But a broadly-diversified exposure to the big trends around food, feed and fuel certainly has much to recommend it.
"You can't have the listed-equity level of liquidity without paying for it in volatility," says Schoen. "If you want to add an element of stability then you should not invest in agri-equities but in farmland: but other than that, the investment case is in place, the same mega-trend is supporting both cases."