INSTITUTIONAL INVESTMENT:
THE CHANGING FACE OF AGRICULTURE.

The Trend:

In the last decade a new trend has been gaining momentum. Financiers and equity investors are cottoning on to a new investment horizon that promises superior returns and strong capital preservation in an inflationary environment.  However this investment horizon has existed for millennia, in fact it is one of the oldest economic activities known to man: Primary Agriculture.

Traditionally capital markets and “the farm” have had no interaction with one another with the overwhelming majority of farms being owned and managed by private families (often passed down through multiple-generations), however with the new generation unwilling to carry on farming or unable due to rising land prices and the increased financial burden of capital investment required to keep apace with modern farming techniques[1], for the first time the family farm is now open for business to the broader market.

Why Agriculture

So what are the “pull factors” for investors?

Growing demand for agriculture has created an incentive for investors to enter the sector including increased demand for food commodities due to a growing population, increased purchasing power of populations in some emerging economies and increased demand for renewable energy sources (i.e. biofuels), which has created competition for scares arable land.

Supply is also disrupted due to resource scarcity (particularly arable land and water) caused by urbanization, environmental degradation and climate change. Even although prices have stabilized from their historic highs of July 2008, the stabilization of prices is still above historical levels which indicates that the shift in long term demand and supply factors is causing a structural shift in agricultural prices[2].

The mixture of high demand and short supply provide a solid hypothesis for investment into primary agriculture. So far the investment results seem to validate this hypothesis.

In the United States, farmland has shown exceptional annual returns of around 12 % over the past 20 years and in the United Kingdom agricultural land investments have out-performed most major asset classes over the past decade (although tax incentives have distorted the market performance to some extent)[3].

Likewise in South Africa farmland has beaten the FTSE/JSE all share, the MSCI world equity and IPD real estate indices from 1999 to 2009 measured over three, five and ten years.  Where most equities have produced relatively low returns with high volatility over the past ten years, farmland has produced high returns with moderate volatility[4].

Furthermore farmland investments have consistently exhibited negative correlation with stocks and high correlation with inflation meaning agricultural assets seem to provide investors with an investment that acts as a hedge against inflation, has low correlations with traditional asset classes and is less impacted by economic slowdowns.

The returns from primary agriculture are made up of two components; cash return on property and indirect return on the asset or capital gain. The strong appreciation of land coupled with competitive cash returns (partially due to high commodity prices) have provided investors with an attractive risk-return combination.

However notwithstanding the favorable investment opportunities in agriculture, the nature of the sector means that there are certain inherent risks namely: production risk, market risk and financial risk.

Variability in the quantity and quality of production remains a fundamental risk for agriculture due to climate, weather and disease. Likewise price volatility of the farm output and the costs of inputs (fertilizer, fuel etc) can eliminate the profitability of the farm in any given season.

The cyclical nature of farming also provides inherent financial risk especially when coupled with price and production uncertainty.  Agriculture requires a suite of capital needs from short-term trade finance, to long-term investment into capital-intensive machinery and goods, which may amortize over a period of several years. Agricultural production cycles also have long time lags between financing needs and revenue from sales, which puts pressure on cash flow however working capital finance options still remain very limited[5].

Institutional Investment in Agriculture

To combat these inherent risks the trend has been to organize agricultural investments into a portfolio through institutional investment funds. In this way investors can reduce their risk by diversifying investments through pooled investment assets that can facilitate better access to markets, additional capital, improved price and risk mitigation strategies as well as diversify the land across climatic zones growing a diverse range of commodities.

Although still lagging behind infrastructure and real estate, agricultural investment funds have increased exponentially with US investment topping $15 billion.

The burning question then becomes, what are the implications (if any) of increased institutional investment into agriculture? Especially considering the sensitive political issues surrounding agriculture, particularly as it relates to food security and government interventions.

Politics aside, one should at least be curious at the outcomes that are likely to result from the “take over” by the market of large farmland holdings and how this could effect the way agriculture operates?

What does the future hold

In the classic finance text on value investing  “The Intelligent Investor” by Benjamin Graham[6], the author warns about the consequences of the institutionalization of stocks, which leaves investors a step removed from ownership, relying on managers to be “faithful stewards in fulfilling the responsibilities of good corporate citizenship”.  Although this is not necessarily negative, it will depend on the mandate under which the institutional fund operates and to what extent that mandate fits the operational needs of agriculture.

The greater impact is likely to come from the continuous trading mentality of the market, which constantly values and revalues investments on an ongoing basis negating the age old tried and tested investment principle of patience: to invest in an opportunity with inherent value and reap optimal returns from growth over the long term.

Agriculture in its very nature is a long term, growth orientated investment. This requires a style and patience that is not often practiced in equity markets which typically seek high liquidity and quick returns. One of the main growth factors in agriculture is the use of modern precision farming techniques to improve efficiencies and output, however this requires significant initial financial outlay, which in the long run results in substantial increase in production and value.

Production improvements to farmland of certain commodities (like horticulture) require long wait periods before the capital improvements bear fruit due to the fact that new orchards and varieties only come into full production several years after they are planted. Moreover operating revenues are cyclical in nature and are influenced by a number of factors including weather, input costs, and commodity prices.  The underlying fundamentals suggest that revenues will trend upwards over time. However investors need to be long-term horizon orientated to realize this value.

Although some agricultural investments avoid involvement in the actual farming operations and only seek return from the appreciation in the value of the land and rental incomes, one cannot divorce the value of land and the profitability of the farming operations. Long term value of land (and rental incomes) are dependent on the profitability of farming operations which are operated on that land and therefore will be linked to the long term fundamentals outlined above.

One also needs to consider that where there is a split between investors with an interest in the farmland and farm operators, the leasing model poses an inherent tension between maximizing short-term returns and maintaining the productivity of the land over the long term. Farm operators are incentivized to maximize their returns over the period of their lease, which could lead to over-intensive farming at the expense of the long-term quality of the land.

Probably the most worrying trend lies in the exponential growth in the value of land. Whist this is good for investors, as pointed out by Benjamin Graham, market trading is often only one step from investment to speculation. Against the backdrop of increasing food demand and scarcity of farmland, land values are increasingly expected to rise giving way to speculation which will ultimately lead to instability[7].

Conclusion

Whilst the proliferation of institutional investment in agriculture certainly creates enormous opportunity for investors and has the potential to increase stability in production through dedicated management teams that can optimize production and obtain economies of scale, one must be mindful that agriculture requires a long term approach, significant up front capital, dedicated management and consistency.   A market approach, which seeks to maximize returns in the short term and expects high annual increases in value without looking at the long-term trends, will not do well for the investor or the agricultural sector and is more likely to create an environment for increased speculation and volatility.


[1] The Economist “Investing in Agriculture: Barbarians at the farm gate” (January 03 2015.)

[2] The Food and Agricultural Organization of the United Nations (FAO) “Agricultural Investment funds for developing countries” Miller et al (Rome 2010).

[3] The Economist  as above.

[4] UFF Agri Asset Management “Benefits of agricultural asset classes in management investment portfolio: Illustrative case: South African farmlands” (February 2013).

[5] Macquarie agricultural funds management “The case for investing in Agriculture”.

[6] Benjamin Graham “The Intelligent Investor: The classic text on value investing”  Collins Business (2002).

[7] Macquarie agricultural funds management as above