Back to the land

Potential investors in the agricultural sector had much to think about lately. Last year was one of the most interesting in the last 20 for the agriculture complex as it saw one of the strongest bull markets quickly followed by one of the sharpest declines. 

Against a backdrop of economic slowdown has this wide-ranging sector bounced back and where are institutional investors finding opportunities? 

Investing in agriculture is a sure-fire way for investors to diversify their portfolio because the driving factors are different to those behind other asset classes. Typically, however, allocations are small and a pension fund might invest between 5% and 10% of its portfolio to commodities and less than 5% of this to agriculture.

Mercer principal and senior investment consultant Crispin Lace explained why this is the case: “If you think of it as a growth portfolio then 5% to 10% might look at agricultural farmland or forestry. Particularly in the UK, most clients are thinking about hedging their risks and controlling them with bigger bond or liability-matching portfolios.”

One pension fund that sees opportunity in forestland is CalPERS, who has approximately US$123m invested in timberland at present across the US, Brazil, Australia and Guatemala. The fund’s target allocation is 1% of the total portfolio ($1.7bn) and to date has invested over $1.2bn in this asset class. 

Timberland is positively correlated with inflation and negatively correlated with most other asset classes. Statistics from CalPERS spanning 1960-2006 show timberland has a correlation of -0.18 with the S&P500 and -0.31 with long-term corporate bonds, while the correlation with inflation is 0.4. 

Robeco product specialist, global equities, Joroen Afink agreed that the agriculture complex in general is a good inflation hedge but through investing in equities rather than timberland.

Afink said: “In an inflationary environment, exposure to a portfolio of agriculture-related equities can be attractive due to their correlation with rising soft commodity prices. In China, some 65% of inflation is food related, while in the West it is about 50%. Investing in agribusiness offers protection against inflation, although some companies such as food processors do benefit from lower prices.”

Opportunities

Global population growth shows no sign of slowing down and, as Credit Agricole Asset Management Funds Global Agriculture fund manager Nicolas Fragneau pointed out, the global population will inevitably increase.

“There are 6.5 billion people on this Earth and according to the UN there will be around nine billion by 2050,” said Fragneau. “We need to grow agricultural yield and develop the sector because these extra people will need to be fed.”

Another big factor is the changing diet in most countries. “Meat consumption in China has multiplied by 2.5 in the last 25 years. It requires 7kg of grain to produce 1kg of beef so you get a multiplying effect on crops and the quantity of grain required,” added Fragneau.

This places further pressure on agricultural products and demand will increase over the coming decade. Investments, therefore, will not just be into land but other related sectors such as seed, machinery and fertilisers and experts believe it is important to seize opportunities in technology and industry that support the land.

One approach that is currying favour with investment consultants is “thematic” investing. A thematic fund is typically a multi-asset fund that invests as part of one theme. So in the case of agriculture, it might invest in land directly, but also in shares in Matthew Ferguson tractors, for example. It might invest long and short in companies associated with the sector in one way or another and the infrastructure around it.

 Hewitt Associates consultant Tim Currell explained this is a key strategy when actively seeking fund managers. 

“We are trying to identify funds that do not just focus on a narrow opportunity within agriculture,” said Currell. “A good way to get an active manager to get value from a theme over the medium to long term is to allow them to invest in commodities, infrastructure and equities, giving them a broader palette to choose from.”

Harvest time

A good example of agricultural fundamentals affecting commodity prices was seen in the dramatic swing from an appalling global harvest in 2007 to a record shattering harvest in 2008. The extreme difference between these two harvests led to a swift drop off in commodity prices in 2008 and confused a lot of investors. 

“That is largely to do with a poor world harvest in 2007 with problems in many of the significant producing parts of the world against a record harvest in 2008,” said Bidwells head of Agribusiness Richard Warburton.

“Prices started softening in our opinion with investors and markets taking a view on the difference between the two years rather than the market turmoil the world entered into.”

More volatility is inevitable but the consensus is that average soft commodity prices over the next 10 years will be a good deal higher than those of the past decade. Warburton believed short term movements are important for sentiment but farmland/farming is a long term play. 

Unpredictable events in agricultural fundamentals are, of course, unavoidable but farming strategies can offer some protection against this through the tactical planting of crops. 

Permanent crops include the likes of vineyards and orchards that sit in the ground for a long time and supply a reliable crop each year. From an investment point of view, this consistent yield from year to year provides a stable return.

Row crops, by contrast, change each year so farmers can vary the use of land depending on what the demand is in the market place. This gives more flexibility to exploit changes in commodity pricing.

“These [row crops] follow a bit more of a cycle in line with GDP growth and commodity growth. It provides a bit of diversification because the cycles tend to be out of kilter with the equity cycle,” said Lace.

“In a time of crisis correlation tends to get quite high in the short term. And if you are in the illiquid part of it – farmland and permanent crops – you can still get quite low correlation with other investment opportunities.” 

Commodities, equities or both?

As S&P’s Commodities Indices vice president Eric Kolts affirmed, commodities are a relatively new asset class. This, he said, explains why commodity indexes, such as the S&P GSCI parent index, appeal to new entrants.

“As a whole commodities as an asset class is a new concept – around five or six years old,” said Kolts. “Whenever you have a new asset class new entrants are going to gravitate towards an index-based product because you are basically buying the market with an index, so indexes have been very popular.”

Commodities are useful in a portfolio because the returns of commodities indexes are time mismatched to the returns of equities and bonds. Commodity prices rise during certain points in the economic business cycle at a different time to when equity and bond prices rise. Over the past year and a half these have moved together but traditionally it is a non-correlation.

The Ceres Agricultural Fund invests in an actively managed portfolio of exchange-traded agricultural commodity contracts and derivatives. The objective of the portfolio is to capture the alpha in the commodity space because of the huge volatility it believes is present.

Ceres Agricultural Fund senior portfolio manager Chady Achkar said: “Commodities markets in the last two years are increasingly driven by economic news and in the current situation with all the bail out plans our traders are waiting on the sidelines for the smoke to settle before taking real positions in the market.”

Despite commodities’ shaky performance towards the tail end of last year, the S&P GSCI Agriculture Index snapped back in December, increasing 7.78% on the month reducing the total 2008 loss to 28.88%, showing that there is potential for a surge in 2009.

As Kolts said, an index made up of commodity equities is going to perform more like an equity index and not like a commodity index. 

“When you buy an index of equities of commodities you are buying the balance sheet of the company – the assets it owns, management expertise or lack of, the debt of the company – which is very different to buying something that is tracking a commodities futures price where you are gaining or losing from the movement of the commodity price.”

Indeed with an exploding global population, increasing urbanisation and changing dietary requirements placing greater demand on farmland, it seems anything that increases agricultural production in the future will be welcomed by savvy investors. 

Agricultural commodities may not have had the best time over the past year but, as Warburton believes, the outlook is positive. “In 2009 prices will creep back up and they are already up 30% from before Christmas,” he said.