Harvest bumper profits from agriculture

For most of us, sugar is not a scarce commodity. Walk into any high-street caf and they're literally giving it away.

Yet in the last month, Thai shoppers have taken to hoarding the stuff. Last year, Portugal's stores also suffered a run on sugar when supplies fell. In both cases the regulated local market was caught out by the spiralling price of the commodity.

Of course, it's not just sugar. Prices of most soft commodities have risen sharply since the second half of 2010. The UN's Food and Agriculture Organisation's (FAO) food price index tracks the wholesale cost of 55 'softs'. It hit a record 231 points in December, surpassing levels last seen in the 2008 food crisis.

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So why are prices rising? In the short term, damage from extreme weather accounts for some of the gains. Last year, a combination of severe drought and fierce fires in Russia and Ukraine both major wheat exporters destroyed much of their production. Meanwhile, flooding in India and Pakistan increased their need for imports. The outlook for this year isn't any better. Australia's wheat and sugar exports have been disrupted by a near-Biblical series of weather events from floods to cyclones and fires.

A severe drought in the northern plains of China is threatening the country's wheat belt, bad news given that it's the world's biggest producer. Across the globe in southwest America, cold is the problem, with a big freeze threatening the harvest. "We are in the hands of Mother Nature," FAO senior economist Abdolreza Abbassian told Bloomberg. If weather patterns don't return to normal, "we have to draw further on our stocks, and that would mean even higher prices".

Extreme weather is nothing new, but it is becoming more frequent. Many weather events, such as the floods in Australia, are linked to El Nio and La Nia. These are climate patterns involving changes to water and atmospheric temperatures that start in the Pacific Ocean but have a global effect. Again, El Nio and La Nia are not new evidence suggests that they may have occurred as far back as 10,000 years ago. But scientists agree that El Nio events have become more frequent and severe, and also that the planet on average is heating up.

For 34 years, according to Nasa, running annual temperatures have come in above the 20th-century average. The debate over the precise causes of climate change and increasing instances of extreme weather events is not one we intend to get into here. But it's telling to note that the people who end up picking up the bill from these events the insurers are taking it very seriously. In a joint study with the Met Office, the Association of British Insurers found that even in temperate Britain, floods and wind storms are becoming more common as global temperatures rise. It warned that insurance would become "more expensive and harder to obtain".

It's not just the weather

Bouts of bad weather wouldn't matter so much if we had plenty of slack in the system. But we don't. Growing demand means that any hit to supply matters, which makes food prices extra-sensitive to weather-related disruption. One factor pushing up demand, as we've noted before, is the growing population. The FAO predicts that food demand will rise by 70% by 2050, as the number of people on the planet hits nine billion, from just under seven billion now. It's hard to predict population growth with any real accuracy. As people get wealthier and healthier they have every incentive to cut down on the number of children they have. But this may not be a solution, because as people become better off, they also eat more.

Obesity is no longer solely a Western disease. The spread of processed food and urban lifestyles mean that obesity is on the rise in emerging markets, such as Brazil and Egypt. And increased spending power for citizens of developing economies means that even those who eat healthily are eating more resource-intensive foods.

A quarter of a century ago, the average Chinese person ate 20kg of meat a year; now it's more like 50kg. As meat replaces vegetables on plates around the developing world, more land, feed and water will be needed to raise livestock. Adopting more efficient husbandry methods would help, but "even in countries like India, where cultural factors may limit the growth of meat consumption, we will see changing dietary habits as consumers shift to richer, more complex foods", says David Field of the Carmingnac Commodities Fund.

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Pressure on food prices is not just down to the need to fill people's plates. Soft commodities are also used to make clothes and fuel. Crops grown for these purposes take up space that could otherwise be used for growing food crops. Thanks to heavy government subsidy and despite the upheaval of the 2008/2009 recession the US ethanol industry has flourished and is expected to account for almost 40% of America's corn harvest in 2011. Indeed, the United States Department of Agriculture (USDA) predicts that demand for biofuels in general will continue to grow as governments around the world, including Argentina, Brazil and the EU, encourage its use through tough regulations. Meanwhile, emerging-market demand for more, and higher-quality clothes, has pushed cotton prices to levels not seen since the American Civil War.

Politics and food prices

Speculation, politics and regulation also have a massive influence on prices. Many blame Ben Bernanke, or more specifically the loose monetary policy pursued by the Federal Reserve, for high commodity prices. The theory goes that extra liquidity last November the Fed decided to print $600bn under its second quantitative easing programme (QE2) has resulted in more money chasing farm produce and key inputs such as oil and fertiliser, thereby pushing up food prices. Unsurprisingly, Bernanke has denied that he is to blame for food-price inflation, noting that "emerging markets have all the tools they need to address excess demand in those countries".

But it seems hard to believe that investment demand has had absolutely no impact on food prices. A commodity bull-run since 2000 has encouraged more people to invest in commodities. New investment vehicles, such as exchange-traded funds (ETFs), have also made commodities more accessible to retail investors. And the inflationary effect of loose monetary policy can be self-perpetuating, as investors often turn to commodities to protect themselves from inflation.

However, while politicians might like to blame speculators and often do for high commodity prices, their own policies are often far more damaging. Food is a key political issue and the attempts of governments around the world to control its supply and cost has created an inefficient patchwork of agreements, regulations and price levels. Europe and America all for free trade when it comes to other countries provide subsidies to their farmers while using restrictions and tariffs to protect them from rival imports.

As food becomes more expensive, we can only expect more damaging intervention. Food prices were not the sole driver behind the recent Tunisian and Egyptian revolutions. But it was no coincidence that as protestors gathered in Tunis and Cairo, neighbouring governments began to stockpile food supplies, pushing up international prices.

"If you are in one of these countries and seeing what is happening next door, that one of the catalysts has been higher food inflation, you are going to try to bring prices down. The way to do that is to import more," Hussein Allidina, head of commodities research at Morgan Stanley told the FT. Many analysts believe that only the fact that the price of rice a staple for three billion people in the developing world remains stable, has prevented unrest from spreading to countries in Asia.

The solutions and where to invest

The obvious solution to rising demand is to grow more food. Farmers have already reacted to higher prices by planting more crops. Since 2006 more than 82 million hectares the equivalent of a second US corn belt has been added to the world's total land under cultivation. That's impressive, but it is unlikely to continue. Much of this was 'low-hanging fruit' from the former Soviet Union countries and South America. The USDA estimates that crop area will only rise by 0.5% per year from now on.

The next step is to improve productivity. Humans have a good track record on this score Malthusian predictions that population growth would outstrip food supply have always been proved wrong. When food prices rise, farmers eventually manage to boost production. The last big increase in productivity came via the post-war 'green revolution'. That involved using fuel, fertiliser and machinery to modernise farming. Most large-scale farms have already adopted these techniques, but many of the developing world's 1.5 billion smallholdings could still benefit from modernisation. That has been slow to happen. But economic and political pressures may make it more likely.

As for large farms, they are now on the brink of a new agricultural revolution. For example, some though not all genetically modified (GM) seeds have been proved to increase crop yields. At present only 9% of cultivable land uses GM technology. Another solution may come from 'precision farming' the use of high-tech guidance and planning systems to increase yields and efficiency. Satellite systems drive tractors and direct the planting, fertiliser and weeding equipment. More accurate than traditional equipment, precision farming pays for itself by bringing down fuel costs and maximising yields through more detailed pesticide, fertilisation and planting schedules.

The other solution would be to free up trade. Some countries are better at growing certain crops than others free trade would enable farmers to exploit their comparative advantages and boost global output. It is unlikely that the Gordian knot of food trade agreements, tariffs, quotas and subsidies will ever be undone. But there are signs that the current crisis may encourage some liberalisation the European Commission's agricultural committee recently proposed suspending import duties on feed, wheat and barley while cutting the tariff for sugar imports.

Even without regulatory change, the USDA estimates that trade in key crops, such as rice, soybean, cotton and wheat, will rise by 20% or more in the next decade. That will lead to huge investment the FAO reckons $50bn a year in the developing world alone in agricultural storage, processing and transport infrastructure.

Of course, all of this will take time. While the agriculture industry is responding to these challenges, "commodities and inflation expectations will rise and fall, but long-term average prices will be elevated for the duration", says Hugo Rogers, manager of Thames River. We look at the best ways to profit below.

The best investments to buy now

One company that profits from higher food prices and disruption to the global food chain is US agri-business Bunge (NYSE: BG). The firm buys, sells, transports and stores grains and oilseeds and recently released better-than-expected results. As Javier Blas notes in the FT, Bunge and its main competitors, Archer Daniels Midland, Cargill, and Louis Dreyfus, "dominate global flows of agricultural commodities". When bad crops, export bans or booming demand affect orders, "buyers turn to global traders". The stock has risen 45% since we tipped it in July and we would advise holding on if you bought then. However, it now trades on a forward multiple of 11.4, compared to eight back then, so if you are looking to enter the sector now, then Archer Daniels Midland may offer a cheaper way in.

Archer Daniels Midland (NYSE: ADM) has a strong position in milling quality wheat and looks set to benefit from the reductions caused by flooding to the Australian wheat crop. Deutsche Bank analyst Christina McGlone notes that it will also benefit from depletion of European stocks and the "emergence of new trade patterns" as buyers react to the extreme weather. The firm trades on a multiple of 10.6.

Another of our July tips that has performed strongly is PotashCorp (TSX: POT), the largest fertiliser manufacturer, by capacity, in the world. The stock is up 115% since we recommended it. Some of the momentum came from mining giant BHP Billiton's attempted takeover bid and we would advise taking profits now. PotashCorp is a great company and could well go further, but its p/e of 50 looks frothy and there are cheaper ways to play rising food prices.

One way in is farm equipment. Last time out we tipped tractor-maker John Deere (NYSE: DE) and precision farming experts Trimble Navigation (Nasdaq: TRMB). Since then their shares have climbed 39% and 78% respectively. If you bought then you may want to hold on for further gains. But for any new entrants, rival tractor-maker Agco (NYSE: AGCO) looks a better bet. Agco is a distant third-place in the American tractor market yet managed to double its US profits last year as US agriculture boomed. The firm is now moving more production units from France to America, where Gabelli & Co analyst Heiko Ihle believes they "can make a meaningful dent in the market". Moreover, financial magazine Barron's backs the firm as a "play on emerging-market agriculture". Agco is dominant in Brazil and India and has a strong position in Africa. It trades on a forward p/e of 14.

If you want to avoid the risk of buying individual stocks there are a few funds in the sector. Both the CF Ecletica Agricultural Fund (020-7792 6400), run by George Lee, and Henry Boucher's Sarasin Agrisar Fund (020-7038 7005) have performed well since we tipped them last. Another good bet is the Thames River Water and Agriculture Absolute Return Fund (020-7360 3587). Fund manager Hugo Rogers believes that agricultural production faces several long-term challenges: "Grain inventories and water tables have been falling for decades. In India, 40% of vegetables are wasted and 30% of grain produced in Brazil rots. And still the global average farm size is less than one hectare." So he selects companies that he thinks are best placed to provide the solutions, investing in firms involved in seed technology, water efficiency, infrastructure, biotech and ingredients. You can buy any of these three funds through a fund supermarket to reduce fees.

This article was originally published in MoneyWeek magazine issue number 525 on 18 February 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.