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.
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 blasé about the ability of the world to feed itself,” says George Lee of the Eclectica Agriculture Fund.
But it only takes a few dud years to push supplies back down again. Indeed, bad weather in China has forced the nation – the second-largest consumer of corn in the world – to import cargoes of corn from the US this year “for the first time in a decade”, says Lee.
Also, Lee notes, with more bearish sentiment in the sector, “agriculture appears to be benefiting from the absence of the speculative froth which has been present over the last couple of years”. That has also seen stock prices come back to more attractive levels for investors. And that’s good news. Because in the longer run, consumption of agricultural products is only set to keep rising.
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.
For investors this last trend is good news because it helps to insulate certain soft commodities, such as vegetable oils, from an economic downturn.
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 combination of a rising population and better living standards does not just affect food crops. All those extra people will also need more, and higher-quality, clothes. The US Department of Agriculture (USDA) predicts that trade in cotton will increase 22% by 2019.
Using food as fuel
Another huge strain on agricultural resources and infrastructure is the demand from biofuels. Corn and sugarcane are the main feed stocks for ethanol, while rapeseed and soybean are used for biodiesel. Some governments are experimenting with using alternative feed stocks for biofuel, yet even this policy affects prices as it restricts the land available for other crops.
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.
How to meet rising demand
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.
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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”.
So what methods do remain for boosting productivity? Trade is one answer. Certain countries are better at producing certain crops than others. They must exploit their comparative advantages if global production is to increase overall. The USDA estimates that trade in key crops like rice, soybean, cotton and wheat will rise by 20% or more during the next decade.
What does this mean? Well, it will place an enormous strain on the existing agricultural storage, processing and transport infrastructure. The FAO predicts that $50bn a year will need to be spent on infrastructure in the developing world alone.
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.
Three firms that will do well in the ‘green revolution’
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 has strong positions in established agricultural powerhouses such as the US and Brazil and a presence in the growing markets of Eastern Europe and Asia. This geographical spread is complemented by storage, processing and transport facilities – which means it should benefit from increased demand for improved agricultural infrastructure, as trade in soft commodities continues to grow.
The group looks cheap on a p/e of 8.6 for 2011 and its current share price of $50.05 is well below its five-year average. On top of that, the board has committed to using some of its $1bn cash pile to buy back 10% of its own stock.
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.
The importance of fertiliser to agriculture makes an investment in PotashCorp an investment in the whole sector. At CAD$92.34, the firm is trading near its 52-week low. Its multiple of 11.7 for 2011 is higher than peers such as Agrium, but the scale of PotashCorp and its extensive reach means that it will benefit from all aspects of the global push for productivity.
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”.
• This article was originally published in MoneyWeek magazine issue number 493 on 2 July 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don’t miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.