The best ways to invest in soft commodities

Soft commodities can be a tricky sector to get exposure to, so we asked three experts for their advice on the stocks, funds and markets to look at now. Find out why the next big investment boom could be in coffee, wheat, sugar and the other agricultural commodities...

Soft commodities can be a tricky sector to get in on, so we asked three experts for their views

Janice Warman: Soft commodities are not an area where retail investors have traditionally put their money. Should they be doing so, and if so, why?

Patrick Armstrong: I think the biggest problem small investors have in the long term is inflation. That's the thing that deteriorates the real value of assets. Commodities are obviously linked to inflation and so are a good hedge against inflation. Also, natural disasters often have negative effects on equity holdings in your portfolio and positive effects on commodities. That's the biggest benefit of commodities in a portfolio, I think, because it gives you that hedge against those extreme events.

Alex Robinson: That's what happened in Hurricane Katrina. A quarter of US unroasted coffee supplies were kept in New Orleans, so the price of coffee spiked up sharply afterwards due to concern about that. We've had people asking us how they can play disasters in the world. Agriculture might be one way; if there are more natural disasters happening, it could provide a way of protecting against it a little bit.

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Ian Henderson: The problem I have with agricultural commodities is that most of them are priced because of weather effects, or inadequate or excess planting and it's hard to think of a structural argument for most soft commodities. We're not short of agricultural land.

PA: But I think we are short of agricultural commodities, unless commodity prices rise to give people the incentive to produce them. You have the BRIC countries [Brazil, Russia, India and China], which account for 2.3 billion people in the world who are moving from zero meat as a proportion of their diet to an increasing amount of meat. Small changes matter when they involve 2.3 billion people. It takes a lot of grain to feed a chicken to make the meat. If you believe in the BRIC countries' growth, you've had the big rally in metals and energy, and the next wave is agricultural. You've got an emerging middle class, these billions of people starting to improve their diet and move towards Western tastes. So I think the structural case is there, but you've got to encourage that supply to come on stream and the only way to do that is higher prices.

JW: So you see the drivers for soft commodity demand coming from the BRIC countries?

PA: That's where the global growth is coming from. All incremental demand for every type of commodity is being driven from these BRIC countries, notably China. Then you've got the alternative energy on top of it [making fuel-ethanol and biodiesel from agricultural crops such as grain and sugar]. You've got global warming, pollution, oil at $75 a barrel and ethanol, without subsidies, at $65 a barrel, becomes economic. Of Brazil's petrol equivalent, 40% is coming from ethanol. The first Model T Ford was run on ethanol, so this isn't new technology, but it's never before been economically efficient. With oil at $75, if you're a long-term bull on oil, you should be a long-term bull on these alternative energies, which are also agricultural commodities.

IH: Personally, I don't think people's dietary habits change all that rapidly.

Cris Sholto Heaton: So you're not a believer in the argument that, for example, the Chinese population will increase their coffee consumption markedly because that's what people drink in the West?

IH: We don't drink sake because we're rich and the Japanese make sake. The fact that other people have got different cultural habits doesn't mean to say we're going to follow them.

PA: The statistics do show China is changing, though. Ten years ago, coffee wasn't consumed now it's a status symbol. It's a little bit like a Gucci bag or a Rolex watch it shows you've made it if you drink coffee. But with all these things, when you have billions of people, you don't need a 100% hit rate. Small fractions of that population have huge consequences on the global supply and demand fundamentals.

IH: I think we can take it as a given that the emerging world is having a huge effect on commodity consumption of every sort. It's not so clear to me that we've got structural imbalances for soft commodities, because my own perception is that there is plenty of

land that can be put to the plough if needs be. Why, in Europe, are we actually paying people to leave their farms fallow? Why do we have wine lakes, beef mountains and butter mountains?

AR: But they're disappearing, aren't they? Also, the EU price is much higher than the world price and the EU just dumps its excess onto the market and depresses the price there. Possibly the changes happening in the EU people being asked to put their land on set-aside are going to have an impact, so they won't have that dumping effect on the world markets and world food prices can rise up towards European levels. But even if world food prices double on sugar or wheat, for example, it's not going to stimulate the Europeans to produce any more, because they are so inelastic.

IH: But within the commodity complex, food-related commodity prices have been the weakest and that's in a period when demand for all sorts of commodities from the emerging world has been going through the roof. Why is that?

PA: I think the Chinese government has decided they're going to build infrastructure and cities and that's led to instant demand for metals copper and oil. But it's the Chinese population that has to decide to change their diets. They've got a savings rate of 55%, which is ridiculously high by Western standards, and when they start to spend which will probably be triggered by China creating some sort of social safety net to make consumers feel safe enough to spend one of the things they're going to spend on is their diet. The government has decided on the hard commodities the people have to decide on the soft commodities and they will spend at some point.

CSH: Are there any particular softs that each of you view as especially attractive?

AR: I would probably say sugar is the one most highly correlated to the oil price [sugar can be used to make ethanol as a partial substitute for petrol]. I guess that's the one that we are most bullish on at Barclays.

PA: Sugar is the most clear bull case, but unfortunately I think hedge funds are most aware of the bull case. When you look at the Merrill Lynch fund managers' surveys, sugar is always where the biggest long positions are. I like sugar, but I'm worried that a lot is priced in. With something like coffee, you don't get ethanol or biodiesel out of it, but there is more demand than supply right now and it takes six years to grow a coffee plant. So it's not like sugar, which takes three months to bring on from planting to production. Coffee takes six years, so if there is anything that happens in one of the big coffee producing nations, there's a potential price spike there. I think all the alternative energy cases are also strong sugar, soya beans, palm oil.

IH: I can't think of any soft commodity that really grabs my attention right now and I think the sugar story is a lot of hype. The whole idea of moving to bio-fuels is absurd, but somehow or other the market has bought this idea in a big way. It's not going to happen. I don't believe in this agricultural commodity story.

JW: So are you bearish on soft commodities?

IH: I'm not bearish. I just don't believe there are going to be big shortages.

PA: You don't need huge shortages to make something a reasonable

investment, though.

IH: Yes, that's fair enough.

AR: I believe that people should have diversification in their portfolios.

People shouldn't have a great deal of soft commodities in their portfolio,

but they should have some in there.

JW: But how easy is it for retail investors to get this diversification? Are there any commodity index funds or exchange-traded funds (ETFs) they can invest in?

AR: We launched something about three months ago, linked to the Goldman Sachs Commodity Index Excess Return Index. That was a six-year product and it provided 110% of the upside with a soft protection on the downside. This means that the index would have to fall by 50% before you started losing capital and it was a one-for-one fall if that barrier was breached on the downside. To my knowledge, that's the only one that's been done in the UK for retail investors. But that's a tranche-based product, so it's not available for continuous open investment.

PA: There are a number of ETFs where you can link to the Dow Jones Commodity Index, which has a bias towards agricultural commodities. But Alex's firm's product is the only one I am aware of that's a pure play on agriculture. The best way, from a self-serving perspective, is to buy a diversified target return fund, such as the one we offer. You get agricultural commodities in a portfolio context you're buying part commodities, part real estate, part equities. There's the diversification benefit of different asset classes put them together in a portfolio and you really can reduce the risk.

CSH: What other possibilities are there? How about investing in a farming company or a plantation company?

IH: It's a question of how the firms are managed. There are good forest products companies and there are less good forest products companies. There are one or two but not very many companies that have got large acreages of farmland; cotton- and sugar-producing companies.

AR: What about investing in some of the machinery companies, such as Deere & Co (NYSE:DE)? They would benefit if agricultural prices rise, because the farmer could go off and buy that new combine harvester.

IH: Absolutely, that's a very good way of playing these things.

PA: Another good way is fertilisers. If you look at potash, which isn't a

soft commodity, but it's what you use for fertiliser, you can also make the bull case on potash.

AR: What do you think of some of these food-processing companies, such as Archer-Daniels-Midland (NYSE:ADM)?

IH: They have been fantastic investments this year on the biofuels argument. There has been a lot of press about biofuels and it has certainly had a huge impact on Archer-Daniel's stock price. But I had a look, for what it's worth, in the first quarter of this year at all the sugar-producing companies and I found they were all pretty damned expensive.

PA: If you want something abstract with potential, I think one angle is biotech companies that are using genetic engineering to change the characteristics of corn. That's an area that is related to soft commodities and I know there is a lot of innovation happening there.

CSH: It's obviously still tricky for retail investors to gain exposure to softs.

Do you think more instruments will be launched to make the process easier?

PA: The potential is there under the newer FSA regulations, allowing more flexible investment strategies for retail investors. Investor appetite will determine it and I think you can make a clear case for why investor appetite should be there.

AR: As new investors start to want it, there will be funds coming out. Someone will spot that and launch a fund. It would be good if there were an open-ended fund provding exposure to agricultural prices, but there isn't. At the moment, they are limited on what they can do either pick some of those stocks themselves or get a manager like Pat, who knows what they are doing, to get involved.

PA: I think it also shows why agricultural commodities may be undervalued, as it's not easy to invest in them. They aren't something pension funds can have widespread investment in. There's potential demand we've seen that in other commodities. Agricultural commodities could be the next, because they makes just as much sense in a portfolio.

You can find out why Jim Rogers is a big fan of soft commodities and sugar in particular here: Why sugar prices have soared. And for a more general look at the soft commodities sector, click here: Should you put your money in soft commodities?

Our Panel

Patrick Armstrong

Co-head, Insight Investment Management

Ian Henderson

Manager, JPMF Natural Resources Fund, JP Morgan

Alex Robinson

Director, Barclays Capital

Star stocks for softs bulls

In addition to our panel's funds, there are a few overseas products that may appeal to softs bulls. ABN Amro offer a range of euro- and dollar-quoted certificates linked to the Rogers International Commodity Agricultural Index, which are traded on several European exchanges. Call +49 69 2690 0900 for details. Several US providers also offer funds and notes based on the Dow Jones Commodity Index, which is about 41% weighted to softs.

If you want to invest directly in softs stocks, take a look at plantation firms. Long dismissed by markets as archaic relics of the colonial era, some are being reassessed as solid moneymaking plays. One such firm is

M. P. Evans (MPE), which farms palm oil and rubber in Indonesia and cattle in Australia, making it a play on both biofuels and food. Investors have caught on since we last tipped it in January, and it now trades on a forward p/e of 25, but it seems to have a solid strategy that can justify a growth rating. Other palm-oil plays are R.E.A. Holdings (RE) and Anglo Eastern (AEP). They have less aggressive strategies, but could benefit from a sector re-rating.

Asian Citrus (ACHL) owns an expanding orange plantation in China, making it an interesting bet on the country's changing appetites.

It trades on a p/e of around six times last year's earnings (around ten times, excluding accounting gains in the fair value of its trees) and plantation output should expand by 160% in the next four years, according to Andreas Ettl of Profit Hunter.

It's not just farmers who'll benefit so should their suppliers and processors. A long-time MoneyWeek favourite is Bunge (BG), a miller, processor and fertiliser supplier. Profit growth is strong consensus forecasts are for 16% this year and its forward p/e of 13.9 looks cheap.