Grow your profits on a farm

Farmland may be the best low-risk investment over the next decade, beating bonds, cash and property, says Jonathan Compton. Here, he explains how to take advantage by investing in farms or farming-related businesses.

Britain's farms and estates have never been cheaper.So why not take advantage by either buying a farm, or simply investing in agriculture-related businesses, says Jonathan Compton.

Until the 1980s, British pension funds and insurance companies held up to 10% of their portfolios in agriculture. Now the proportion is nil. Meanwhile, financial advisers simply ignore agriculture.

Low fees and ignorance to any contrarian investor, these are profoundly good reasons to buy. But more important is that the structural fundamentals suggest that farmland may be the best low-risk investment over the next decade, beating bonds, cash and property for sure. The driving forces include weight of money, good capital and income growth, tax breaks and subsidies, a larger population and, of course, greed. Development potential and the pleasure gained from investing in farmland are free bonuses on top.

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The weight of money argument is overwhelming. A recent report from Savills suggested that £7.5bn in cash is waiting to buy farms and estates in Britain in reaction to low cash and gilt yields, and a desire for safety. This would increase prices by half in three years. Yet interest from foreign buyers alone will ensure higher prices. Large investors in farmland don't care about borders. If they can buy 1,000 or 2,000 acres of similarly productive land at the same price, they will opt for the larger.

Historically, British farmland has been relatively expensive. That's no longer the case. In 2008, the average price of grade three (not the best) farmland increased by 21% to £4,400 per acre (€12,000 per hectare). That may look impressive, but it's nothing compared to many of our European neighbours. The price of farmland in Ireland is around €40,000 an acre, despite a bruising fall from €65,000 in 2006. Equivalent prices in Denmark, Belgium, Holland and Finland are all over €25,000, with most of west Germany at €20,000-plus. Even Italy, which is too hot or dry for many crops and livestock, has a slight premium to Britain. In short, the UK has never been cheaper on a relative basis. And that's one reason why it should attract highly mobile investment capital.

Farms produce a solid income

Of course, just because an asset is cheap does not mean it is good value. Ultimately, rising income drives the value. There are three components to this. First is the income from actual crops. In Britain grains are the main source of such income. Assume the price of milling wheat is £130 per tonne plus the arcane premium (the spread of bread milling wheat over feed prices) at, say, £30. That would give a farmer/owner a yield of around 4.5% per year. That's better than government bonds, and has happened in less than ten years since 1890.

Next are EU subsidies. Not only are they largely fixed until 2015-2019, but they will morph depending on political fashion. About 25 years ago farmers were paid to remove hedges. Now they are paid to put them back, plant trees and even to grow less wheat than before. On my small 100-hectare farm in East Anglia, last year's various payments exceeded £1,200 per hectare for doing things I would have done anyway. On a much larger farm in Lithuania where I have an interest, the EU, national, and other subsidies and grants were much lower, coming in at 'only' €300 per hectare.

At current market values this alone is equal to a yield of 4%. Whether this is morally right or not (I'm in the latter camp), it is free money and kicks the yield up to 6.5% for the owner.

Next are the enormous tax breaks on inheritance tax, capital-gains reliefs and even gifts for entrepreneurs (for more on the specifics of these, see below). For farm and woodland there are special and pragmatic income-tax rules accommodating the huge swings in prices. Value-added tax (VAT) is the bane of most businesses but not farmers. For most farm-related spending, VAT is reclaimable or, better still, large costs such as fuel are exempt from excise duties. This is why the modern farmer is as much a financial entrepreneur as a horny-handed son or daughter of the soil.

Farmland is getting scarcer

The 18th-century economist John Malthus forecast Armageddon through population growth and starvation. Since then the world's population has risen over 20 times. So far it hasn't starved because of progress, from Jethro Tull's drill to fertilisers. England produced under half a tonne of wheat per acre in 1947. Now that figure is over three tonnes. Yet such productivity gains are finite, as ultimately they impoverish the soil.

Meanwhile, population growth and changing patterns of consumption in Asia alone ensure higher food prices. By 2005, middle-class teenagers in Shanghai were just as fat as their American counterparts. A generation ago they weighed a third less. Asia wants hamburgers or protein. It takes 4kg-8kg of grain to produce 1kg of animal protein; economically, the vegetarians have the right idea. Yet only 15% of China's land mass can produce grains and this area is shrinking rapidly through erosion and industrialisation. To meet current growth patterns, China needs new farmland equal in size to Scotland annually. Instead, over the past decade, it has lost that amount every year. As a nation it must import, starve or suffer a revolution.

So why aren't farmers rich?

So why are the majority of British or other farmers not particularly well off? The answer is simply scale. We have about 300,000 active farms, averaging only 57 hectares (in the EU, only 20 hectares). That's simply too small to be viable. Only 15% of British farms are more than 100 hectares in size, yet these account for 65% of all production and even more by income. To make a good return, including paying a manager, an arable farm needs to be over 250 hectares. Given a minimum cost of £3m to include buildings and machinery, this is a high barrier to entry. Yet you can be a farm partner with family or friends to spread the cost. Banks like lending against farmland. The terms are reasonable and subsidies cover most of the interest.

Investing through farm funds is not recommended. The many fee-takers (fund manager, custodian, land agent and trustees) eat half the income return, and investors are often barred from the tax breaks or grants. But you can get access to the underlying themes that make farms profitable without actually buying a farm. Invest in farm-related equities, such as the big fertiliser, herbicide and agricultural machinery makers, all of which trade well below 2008 highs (for more on these, see below).

But don't invest in 'cheap' land overseas: it's often cheap for a reason. Complications include local laws on ownership and tax, and the distance from ports, skilled workers and good machinery. Britain, especially England, ticks every box, the more so as it is a good hedge against almost certain sterling weakness. Arable seems best, although good woodland has merit (wood is our third largest import). Retro and much against current investment fashions, farming looks the best deal around.

Jonathan Compton is managing director of Bedlam Asset Management.

The best place to shelter capital

Merryn Somerset Webb

For many people the best thing about owning a farm is not the improving business environment, not the sense of living in a rural idyll, and certainly not the "lifestyle and status" that accountants Grant Thornton say it gives you. Rather, it's the tax breaks.

The most important of these is inheritance tax (IHT) relief. If you own agricultural property and have been farming it yourself (on a day-to-day basis) for at least two years, then you can pass it on to your heirs entirely free of IHT, either on your death or in your lifetime. The definition of agricultural property is reasonably broad. It includes everything from farmhouses, cottages and buildings to woodland used for the rearing of livestock. However, there are, as ever, a few catches.

The guidance from HMRC makes it very clear that houses on farmland are only eligible for the relief if they are "character appropriate" and "proportionate in size and nature to the requirements of the farming activities conducted on the agricultural land or pasture".

So you can't buy a 20-acre plot of land occupied by a few ornamental buffalo, put up a 14-bedroom mansion with attached spa and infinity pool, then expect to pass it on tax-free. This concept was tested a few years ago on the death of David McKenna. McKenna had lived on his land since 1984 in what Thisismoney.co.uk refers to as a "rundown but attractive" Grade II-listed manor. The house was ruled to be not a farmhouse, but "primarily the residence of a rich man". Agricultural relief on IHT was denied.

Any cottages on your land that are not occupied by an agricultural worker or the widow/widower of an agricultural worker are also not normally eligible. Finally, note that even if a cottage is occupied by a farm worker, its full open market value may not be subject to tax relief. If the tax authorities judge it to have a value above and beyond just that as agricultural accommodation (as an attractive second home, perhaps), "that additional value will not attract agricultural relief".

The second catch is the 'farming it yourself' business. The taxman means it: if you contract out the actual farming to a tenant farmer under certain kinds of lease while simply doing the occasional spot of shooting yourself, you could only get IHT relief at 50%.

Still, IHT is not the only tax area out of which farmers do well. They can also claim back a good deal of VAT and they get special income-tax treatment. For example, they can average out their results between tax years, carrying forward losses to make sure that if they have only one good year in three they don't end up paying higher-rate income tax on that year.

They can also offset farm losses against their other income which will be nice for lifestyle farmers irritated that their City bonuses have been so heavily taxed. The downside is that losses can only be offset for five years the taxman is not keen on the idea that the rich might get a kick out of constantly producing losses on their farms (by buying fancier and fancier breeds of cow, quad bikes and tractors, say) simply to offset their high incomes elsewhere.

There is also some capital gains relief available. In particular, rollover relief. If you roll capital gains made on agricultural land or buildings over into more agricultural land or buildings, then you can defer the tax due on them until you sell the second lot. All this makes a farm a pretty good place to shelter capital where else can you get all the tax benefits of owning a business with almost none of the risk?

How to get exposure to farms

John Stepek

If you're not ready to make the leap and buy a farm itself, there are plenty of other ways to profit from the long-term bull case for agriculture. If you have an appetite for risk, then you can bet on crop prices directly. You can use spread-betting or less risky exchange-traded commodities to get exposure to various agricultural or 'soft' commodities. But direct investing in softs shouldn't be seen as a 'buy and hold' strategy. For one thing, in the short run, prices are heavily affected by the weather, so they are highly volatile. More importantly, as Dylan Grice of Socit Gnrale has pointed out in the past, ultimately "any commodity bull market is really just a bottleneck and human ingenuity has a good track record of unblocking the bottlenecks which have appeared in the past". In other words, rising food prices will force us to find ways to improve crop yields and bring prices back down.

So in the long run, the best way to profit is through buying the companies that are involved in helping to solve such problems. One such stock is Amiad Filtration (LSE: AFS). This water filtration group makes products for water-treatment plants and also for irrigation purposes, which is vital to increase efficiency and yields in the developing world. The stock is up around 20% since we last tipped it in October, but it's still worth buying if you don't already have a position.

In the longer run, genetically modified seeds should help boost yields. Outside of Europe, insect and herbicide-resistant GM crops are widely used. As Matt Ridley points out in Wired magazine, these are just the first generation GM crops. "In the pipeline are ones that use less nitrogen and hoard water better." We tipped GM seed producer Syngenta (NYSE: SYT) in October. It's up around 9% since hold on to it.

In the shorter term, fertiliser is also key to boosting crop yields. Prices look set to rise this year a decent American corn harvest last year should result in "strong nitrogen, potash and phosphate demand in 2010 as farmers scramble to replenish their soil nutrient levels", reports Reuters. This is one reason why analysts at merchant bank Silvia Quandt believe agricultural stocks will be "among the best performers in 2010". The group likes the look of German-listed fertiliser producer K + S (DAX: SDF) in particular. It has a price target of €56 on the stock. Rather conveniently, given the recent cold snap, the group is also Europe's biggest road salt provider.

This article was originally published in MoneyWeek magazine issue number 470 on 22 January 2009, 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.