The case for agriculture exposure in investment portfolios remains convincing. The middle class growth in emerging economies and the associated increased protein consumption is one of the major positive factors as is the declining supply of readily available arable land per person. Locally, the recently announced Free Trade Agreement with China and other Asian countries provides a further boost with tariffs for a range of agricultural commodities reduced over time. Over the very long-term agriculture in many countries has offered attractive pre-tax returns and strong diversification benefits showing little correlation with equities and bonds.
However, the real issue for the sector is the implementation, i.e. finding appropriate investment vehicles that can take advantage of what appears to be an attractive thematic. The poor performance of numerous high fee, tax driven agricultural and timber schemes has badly tainted the experience of many Australian retail investors. Also, some of Australian Securities Exchange (ASX)-listed agricultural vehicles have also not covered themselves in glory. Even some larger unlisted institutional vehicles, at least local ones, have struggled in recent years with extended droughts weighing on returns. In any case such funds have not been available to smaller investors.
Agricultural investment is normally lumped into one of three broad categories.
- Annual/Row crops such as wheat/corn;
- Permanent crops such as olives/grapes; and
- Livestock such as sheep and cattle.
Each of these categories and even different agricultural commodities within the same category can have quite different economic characteristics. Further, there are a multitude of other factors such as land quality, farmer skills, access to capital, weather, input and commodity price movements that will impact the economic returns achievable from each.
However, the general perception from an investment perspective is that the operating profitability from many agriculture businesses is poor, is quite volatile and is subject to a range of uncontrollable factors such as commodity prices and weather. Hence, significant/consistent land price increases are required (but by no means certain) to make overall acceptable returns.
It is hard not to have some sympathy with this view but perhaps we are painting too negative a picture that is based on history and focused only on near-term. It is true that historic operating returns averaging between two to five per cent don't seem that attractive given the risks involved. However, this neglects the benefits that come from rising land prices over time. At least over the long-term these are more reliable than investors give them credit for.
Land prices are typically treated as a speculative element in the overall performance, but well located and managed farm land can become more productive over time as well as benefiting from general inflation. In some cases land closer to urban areas can benefit from redevelopment.
A more objective assessment of the opportunities in agricultural investment suggests the following points are relevant.
- Long-term historic pre-tax returns from agriculture have been attractive in many areas of the world including Australia with returns made up of modest but solid operating returns together with land price increases. We note, however, that Australian land prices have lagged in recent years.
- The attractive feature of these investments is their diversification benefits, i.e. little or no correlation to equity and bonds as well as an inflation hedging element that comes from exposure to commodity and land prices. Hence, these investments are usually lumped in the "real returns" category.
- That recent trend in low operating/income returns reflect a particularly tough environment of adverse weather, high input costs and political factors that should not be projected forward, especially given today's attractive fundamentals.
- Outside pure leasing arrangement most types of agriculture investments should always be viewed as a package of returns reflecting low to modest (but volatile) operating profitability and long-term growth in land prices. This combination has, over the long-term, produced pre-tax performance in the high single digit to low teen returns (without gearing) and is quite attractive compared to current cash returns.
- Lower risk approaches to invest in agriculture such as leasing land to farmers are available, at least to large/institutional investors.
So far the evidence seems to be that land prices do best in the more reliable agricultural regions, particularly after a run of good years where local farmers are willing to plough profits into neighbouring land and bankers are also more accommodating. According to TIA CREF this explains the relative boom in agricultural land prices in the US
However, another explanation for the boom in agricultural land returns, particularly in recent years in parts of the US, has been the increased investment by institutional investors. The argument suggests that institutional investors do not need the same returns as owner farmers because of the diversification benefits that agriculture brings to their portfolios. As such they can justify even lower operating returns; this change in valuation has driven up land values.
To the extent this view is true the increased institutional (although mainly overseas) and large ultra-high net worth investor interest in Australian farmland recently suggests a period of higher land prices and higher returns is likely. Of course, there will be plenty of shorter term noise relating to commodity prices, input costs and weather around any path to higher land prices and improved returns. A continued low interest rate environment is also likely to be supportive.
The big limited resource in many areas of Australian agriculture has been water. However, geographically diversified exposures that can invest in water infrastructure are well placed to manage the challenges around this issue.
Leasing arrangements, particularly relating to cropping, provide a lower risk approach to investment although this is typically mainly available to institutional investors.
Listed companies and funds have been the most common vehicles for retail investors to gain exposure to agriculture. Their experience has been very mixed.
Apart from poor returns and share price performance in a number of cases, the perception is that listed funds don't provide as much diversification benefits because the broad sharemarket heavily influence their prices. This is true to some extent although eventually the fundamentals do come through (both good and bad).
One view of some large private agricultural investors is that agriculture should never be listed because investors do not have the patience to take the very long-term view needed or an understanding of the complex ongoing challenges facing agricultural investment.
A key example was Prime Ag. Listed at $2 to a mainly institutional shareholder base in late 2007 the shares quickly drifted to under $1, a 50 per cent discount to NAV. After a number of years of poor returns the fund faced considerable shareholder pressure and was wound up and sold to unlisted institutional funds and large private investors. Interestingly the fund did provide solid returns for those that bought in at these lower levels when it was most hated even as some asset values were written down.
The perception of all listed agricultural businesses as continually poor investments is perhaps unfairly earned and excessively backward looking. One can point to a number of companies that have performed exceptionally well in recent years even if their long-term history is mixed. Select Harvests (SHV) which is focused on a range of permanent crops is one such strong performer over recent years. Even historically poorly performing Australian Agricultural Company (ASX Code AAC) is finally trading above its Net Asset Backing for the first time in many years as investors bet on a robust future for beef prices and volumes and AAC embarks on a more vertically integrated model with its own processing facility.
And there are now some new if somewhat less pure types of listed vehicles available. Blue Sky Alternatives Access Fund (ASX code BAF) listed earlier this year and has some exposure to water rights/trading and agricultural land and cotton farming. The jury remains out whether investors will embrace these types of vehicles.
Australia's large funds have been notoriously reluctant to invest in agriculture but foreign investors and wealthy individuals are increasingly active. I recently attended an institutional breakfast of one the world's larger institutional agricultural managers. Only a handful of asset consultants and investors turned up and only a couple have invested in agriculture. This attitude may change but I would expect only very slowly. Meanwhile Andrew Forrest and Gina Rinehart are ploughing some of their wealth into beef properties in Australia's north and Wesfarmers chief, Richard Goyder recently announced they were interested in getting into the primary production space.
Obviously these days it is relatively easy for retail investors to gain exposure to a range of agricultural commodity prices. The problem is that over the very long-term spot commodity prices tend to go down, at least in real terms. But one can still do well in shorter time frames and depending on the forward price structure of the commodities a roll yield can be earned (for commodities in backwardation) that adds to return. There are a number of ETFs or funds that provide either passive or enhanced passive exposure to agricultural (and broader) commodities. While these provide some exposure to agricultural commodity prices and benefit from supply shocks and growing demand without the operational risk discussed above they also don't provide exposure to productivity growth or land prices. Nevertheless, they can be a valuable diversifier and partial inflation hedge.
Managed futures is also a strategy that will provide some exposure to both rising and falling commodity prices (including agriculture) depending on how they are trending but agricultural prices tend to be a relatively small part of such programs. There are also a small number of relative value hedge funds that aim to exploit pricing anomalies in the agricultural commodities space. However, all of these strategies are quite different to a core strategy of owning agricultural land and businesses.
Agriculture is an investment theme that does make sense in many portfolios from both a diversification perspective and because the long term fundamentals in a range of areas are attractive. The fact that agricultural returns (especially land returns) in Australia have lagged many countries in recent years and especially compared to the US suggests Australia may have some catching up to do. Increased institutional (at least overseas investors) and ultra-high net worth local and overseas interest could be the catalyst for this to happen.
The problem for retail investors is twofold in that local institutions that run their superannuation monies have been very reluctant participants in this area and that they have very limited ways to gain exposure to it directly, particularly in liquid form. Of course, many investors that have been disappointed by this sector before will not feel they are missing out on anything, at least until attractive returns are pointed out in the future. However as discussed above there are some factors that suggest the opportunities this time are very real even if the access to these are limited.
Dominic McCormick is Chief Investment Officer at Select Asset Management Australia.