Harvest profits from agricultural growth

published 2 July 2010

Despite recent claims that a food surplus makes the agricultural sector unprofitable, investors should stay in if they want to reap the rewards to come, says James McKeigue.

A new argument is doing the rounds in agricultural circles. Only two years after food shortages caused riots in several developing countries, some people are now worried that we will have too much food.

As Scott Killman notes in The Wall Street Journal, bumper crops in several regions around the world, and a mass of new acreage, mean that global grain reserves are likely to be 24% higher than two years ago, according to the UN's Food and Agriculture Organisation (FAO). That would put them at their highest levels in eight years. The fear is that, if demand falls too in the event of a double-dip recession, prices will tumble. That could hammer farmers' profits and hit demand for farm machinery and other tools.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

So is it time to get out of the sector? Not at all. Agriculture is certainly a cyclical business and soft commodity prices are extremely volatile which is one reason why we don't recommend betting on the price of individual softs as a way to gain exposure to the area. "Prices respond to changes in inventory, which are basically driven by the weather," as Tobin Gorey of JPMorgan told the Financial Times recently. But of course, this can be very changeable. "A couple of good harvests in a row seems to have left financial markets somewhat blas about the ability of the world to feed itself," says George Lee of the Eclectica Agriculture Fund.

We rely on agriculture to feed and clothe us and in some cases, even fuel our vehicles. So population growth inevitably increases demand. The number of people on earth is set to increase from 6.8 billion at present to nine billion by 2050. That's a lot of extra mouths to feed. A joint report by the OECD and the UN's FAO predicts that food demand will rise by 70% by 2050. The report also predicts a decade of higher prices. Because of the cyclical nature of the agriculture industry and price volatility, agronomists often compare prices over a ten-year range. In real (inflation-adjusted) terms, wheat and grain prices are expected to be 15% to 40% higher during the next decade than between 1997 and 2006. The cost of vegetable oil will be more than 40% higher across the same period.

On top of population growth, there's also the fact that much of the global population is also getting wealthier. And that means they eat more. We've all heard the data by now 25 years ago, the average Chinese person ate 20kg of meat a year; now it's more like 50kg. As meat replaces vegetables on the plate of more people in the developing world, more animal feed, water and land will be needed to raise livestock.

Urbanisation and a rising middle class in developing countries also shapes food demand. As people in developing countries move to large urban centres they consume more processed food, which generally includes more vegetable oils and proteins. And as per-capita income in countries rises, the cost of food falls as a proportion of people's budgets. So this means that price fluctuations are less likely to affect their eating habits.

We've already had proof of this in the past year or so. Gregory Page, CEO of US agribusiness Cargill, pointed out to the FT earlier this year that after the Asian crisis of 1997-1998, some countries lost "more than a decade" of dietary advances in a few months. However, after the last recession: "If you looked across the shopping basket of [developing] countries the diet was remarkably resilient this time, so we start from a better base than before".

The USDA predicts that demand for biofuel crops will continue to grow during the next decade, albeit at a slower rate than the last. Even if US demand grows less rapidly, the European Union is demanding that biofuels account for 10% of the transportation sector's energy use by 2020. The adoption of similar standards in Argentina and Brazil and continued support for ethanol from the US government also suggests that demand for various agricultural commodities, including fuel as well as food sugarcane in particular is set to continue.

So how can farmers meet this rising demand in the long run? An obvious response is to grow more crops. Indeed, since 2006, 82 million hectares the equivalent of a second US corn belt has been added to the world's total land under cultivation. Most of this has come from South America and former Soviet Union countries. However, the USDA estimates that crop area will only increase by 0.5% a year which will not be sufficient to meet rising demand.

Another serious cap on increasing the amount of land devoted to farming is water use. Agriculture is the world's biggest user of water, and in many countries farmers are being forced to change crops or abandon farmland as water supplies dry up. Climate change is also expected to change traditional farming areas. While there is hope that areas lost to farming because of climate change will be replaced by changes elsewhere the world, it will cause disruption to agricultural production as the industry adjusts.

Considering the limits to increasing farmland the next obvious step is to boost productivity. The post-World War II 'green revolution' improved crop yields by introducing mechanisation, selective breeding and fertiliser. But the trouble is that large-scale farms, especially in Europe and the Americas, have already adopted the techniques of the 'green revolution' and now productivity increases are slowing. Genetically Modified (GM) crops have the potential to boost yields, yet strong opposition means that only 9% of cultivable land uses GM crops.

Smallholdings could still benefit from many aspects of the 'green revolution'. But most small farmers in the developing world do not have the capital or the economies of scale to use modern agricultural machinery. Aside from economic considerations there is also an array of political and social factors that makes it unlikely that the efficiency of small farms will improve any time soon. This is frustrating, because it is one of the few parts of the industry where there is slack that could easily be turned into increased production. As Rowena Davies puts it in The Times, "the challenges facing smallholder farmers remain high. There are an estimated 1.5 billion of them on the planet, but only a tiny proportion are involved in the global food supply chain".

Another solution may come from technological advances, in the form of 'precision' farming. This is a generic term for high-tech guidance and planning systems that reduce waste of expensive inputs and boost yields. Precision farming is most commonplace in the US and EU where large farms, energy-intensive farming methods and deep pockets make the extra investment worthwhile. Satellite systems drive tractors and direct the planting, fertiliser and weeding equipment. Accurate to a few centimetres, the systems can ensure that fuel and fertiliser are used more efficiently. This is becoming increasingly important in the days of high oil prices not to mention increased environmental awareness.

Another advantage of precision farming is that it can boost yields. Precision farming systems can create more detailed pesticide, fertilisation and planting schedules that can vary according to specific factors, such as soil condition, and thus produce higher yields than the traditional 'blanket approach'. Using such techniques, says the UK Agriculture and Horticulture Development Board, can result in cost savings of up to £19 a hectare on a typical arable farm.

That's bound to be attractive to farmers who are constantly looking to trim costs, particularly amid volatile commodity prices. Better yet, as with most technological advances, as the popularity of precision farming equipment has grown its cost has come down. "It wasn't but a couple of years ago that you would pay $50,000 for a system Today you can get a complete system for $15,000 to $17,000", said Kurt Lawton from US farming website Precision Pays.

The rising popularity and growing market for precision farming equipment offers one way for investors to cash in on agricultural growth. Another is to invest in the companies making the agricultural chemicals, seeds and fertilisers, which will be used in increasing volumes to push up crop yields. In the box on page 24, we look at a few companies that are best placed to benefit from the drive to raise productivity and cut costs.

US agri-business Bunge (NYSE: BG) had a tough 2009 and was shunned by the market. Yet most of the damage done to its profits came from its fertiliser production business, which it has now sold. The rest of Bunge's business is well placed to profit from an agriculture boom. The group will now focus on processing oil seeds, grains, sugar cane and wheat. Bunge's expertise in oil seeds will prove profitable as demand soars due to rising consumption of processed food. The group also processes sugar into ethanol, which gives it exposure to the growth in biofuels indeed the FAO believes that the majority of the new feed stock used for ethanol will be sugarcane.

Bunge decided to leave the fertiliser industry to the dedicated players. While it was probably the right decision for Bunge, it doesn't mean that investors should miss out on fertiliser. PotashCorp (TSX: POT) is the largest fertiliser manufacturer, by capacity, in the world. It makes three key plant nutrients: potash, phosphate and nitrogen. The firm has large mines producing the first two, with the ability to expand capacity in favourable market conditions. Potash fertiliser consumption has risen by 30% over the past 20 years, which roughly matches the trend in food consumption in the same period. In 2009 farmers were able cut back on fertilisers, as a time-lag effect means that the positive effects can stay in the soil for a few harvests. But they will be unable to continue this practice in coming years. For example, Brazil, one of PotashCorp's key markets, cut potash imports by 48% in 2009. Imports are expected to rise in 2010 and 2011 as a result.

Precision farming is expected to play a key role in any new 'green revolution'. There are a number of dynamic smaller players, such as Trimble Navigation (Nasdaq: TRMB), making exciting advances. But, at a multiple for 2011 of 16.7, Trimble looks expensive. After a tough 2009, market leader John Deere (NYSE: DE) looks a better bet. On p/e for 2011 of 11.7, the company is good value at $55.50. Group sales fell by 19% in 2009, but crucially it still made $873m profit. Its resilience in the downturn should continue in any double-dip, while its record-breaking 2008 shows that it has upside potential as investment by farmers recovers.

Perhaps more importantly, the company has a good broad customer base. Most of its sales still go to North America, the largest market for precision farming. Yet it has still managed to double its non-North American sales in the past ten years. These now account for 37% of revenues, and heavy investment to build manufacturing plants in key growth countries like Brazil, Russia, China and India means the firm is well placed for the future.

For those who want to avoid buying individual stocks, there are a few funds in the sector. The CF Eclectica Agricultural Fund outperformed the MSCI World Index in the rises of 2007 and early 2008, yet managed to limit losses in the downside, only marginally underperforming the index. Another fund worth a look is the Sarasin AgriSar Fund. Its manager Henry Boucher has made good calls and limited the impact of the soft-commodity price dip by moving more of the fund into cash and buying a call option on the agricultural index. Boucher is confident that emerging market growth will drive agricultural stocks even if a double-dip recession strikes. He thinks agriculture is one of the best ways to play emerging markets their rise "is reflected in improved diets more than any other factor".

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the Forbes.com London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.