Appetite grows for equities with an agricultural twist

A macro-economic outlook of growing world population, changing diets and scarcity of arable land, as well as positive correlation with inflation, make agriculture an attractive asset class for long-term investors.

Global population is projected to rise from 7.3bn today to 9.6bn by 2050, with most of this growth expected to come from less developed regions, according to the UN Population Division. The expanding middle class in emerging economies, particularly in Asia and Africa, and the dramatic demographic shift from rural areas to urban conglomerations are fuelling bigger consumption of animal protein and processed foods. 

Coupled with the growing use of biofuels as alternative energy sources, these trends are expected to generate increased competition for land use and pressure on resources required for crop production, as urbanisation encroaches on arable land, and surface and ground water shrink. 

Moreover, extreme weather caused by climate change has a negative impact on production, while deceleration of agricultural land yield increases and environmental regulation of production remain key constraints in continuing to feed the growing world population.  

The underlying rationale is robust, but how can investors gain exposure to this secular trend? Which companies stand to benefit and which investment vehicles are most suitable?

With commodity prices at their peak a few years ago, commodity index funds, including for example ETFs on corn or soybean, drew significant assets, but many investors pulled out of these liquid vehicles in the recent down-cycle for prices.

 “We see a retreat of private investors from the whole soft commodity space,” says Markus Stierli, head of Fundamental Macro Themes at Credit Suisse in Zurich. With the fall in food commodity prices – since the beginning of last year prices have dropped by around 30 per cent – and the ethical debate about high food prices, investors prefer to gain access to the agriculture theme through equities, he says. 

“In the equity space, the attractive companies are those offering solutions to the declining growth rate of agricultural productivity, one of the world’s biggest problems,” states Mr Stierli.

That plays into better use of seeds, fertilisers and technology such as global positioning and geographic information systems which support so-called ‘precision agriculture’. This makes the more precise application of
pesticides, herbicides, and fertilisers possible and better control of the dispersion of those chemicals reduces the expense, producing a higher yield. 

In the capital goods industry, the appealing firms are those involved in the manufacturing of autonomous agricultural vehicles or driverless tractors, for example. 

Other interesting stocks can be found in the agro-chemical business. With extreme weather, the concept of drought-resistant crops is attractive, but as it involves genetically modified seeds, firms such as Monsanto, pioneers in this area, tend to be shunned by investors for ethical reasons, says Mr Stierli. 

The most favoured stocks are technology firms which reduce food waste at production level, particularly relevant in emerging markets, where about 50 to 60 per cent of total food is wasted, while very little waste is at consumption level. This is exactly the reverse of what happens in the developed world, where
production has become very efficient but food is vastly wasted at consumption level. “Sadly, what matters from the corporate perspective is how to produce food more efficiently, as that impacts revenues,” states Mr Stierli.

Analysts and fund managers are keen to stress the importance of identifying opportunities across the whole food value chain, starting from agricultural commodities through transport, storage, processing, packaging, retailing and ending with consequences on people’s diets, including health issues. 

Investors’ perception that this theme is about food commodities prices is wrong, says Henry Boucher, manager of the Food and Agriculture Opportunities Fund, partner and deputy CIO at Sarasin & Partners. “It is the growing value of the food economy that investors should be looking at, as people spend more and more money on food, as wealth increases, particularly in emerging markets,” he says.

Interesting plays are those which benefit from a structural imbalance between supply and demand, for example in the case of salmon. This is a typical developed market food with limited supply but demand is rapidly growing, in particular from Asian consumers seeking a healthier option. This gap offers a remarkable investment opportunity in aquaculture companies, mainly listed Norwegian firms that supply salmon. Despite their share price having been on a steady upward trend, they are still very cheap, says Mr Boucher. 

Similarly, businesses catering to the increasing demand for confectionary in emerging markets, such as the Philippines or Indonesia, are experiencing high single digit sales growth. Dutch firm Amsterdam Commodities and US company International Flavors & Fragrances are well positioned to benefit from the increasing need to enhance flavourings in food, as people aspire to healthier diets with less salt. 

Companies such as no-frills low-price US retailer Costco are beneficiaries of consumers’ increasing tendency to improve their standard of living by ‘trading down’. 

Sarasin’s fund invests in stocks that benefit from a “steady growth of the overall food economy”. Despite quantitative easing programmes, there has been a downturn in the long-term expected rate of inflation, both in Europe and North America. “But in the food sector, prices at consumption level tend on the whole to go up over time, although not every year,” explains Mr Boucher, and this is an easy story to explain to private investors.

However, in a big cyclical recovery, food stocks can lag cyclical stocks, as they are not as geared to the state of the economy. 

When investing in the agricultural theme, it is important to shift from one part of the value chain to another, depending on the price environment, says Bryan Agbabian, manager of the Allianz Global Agricultural Trends fund in the US. “The biggest misunderstanding in agricultural investing is that investors focus just on the input side, and do not think about it from the entire value chain perspective.”

In a rising commodity price environment, in a tight supply/demand market for agricultural commodities such as the years between 2006 up to a couple of years ago, investment opportunities should lean more toward firms that provide input into agricultural commodity or the production side of the value chain. These include fertiliser companies and farm equipment manufacturers, which benefit from the rise of efforts and investments to obtain better yield.

In case of crop recovery, such as witnessed over the past couple of years, prices fall, and the stocks to hold are those profiting from an increase in crop production and lower prices of agricultural commodities. These comprise those in chicken, beef or pork production, which also benefit from the increased protein consumption trend. 

Water scarcity

A theme closely interlinked with agriculture is that of water scarcity. One of the critical drivers of food productivity has historically been irrigation, with agriculture accounting for approximately 70 per cent of global water withdrawals.

Water use, globally, has grown at double the rate of population growth over the last century, according to Swiss Bank Julius Baer. Because of demographic growth, urbanisation and pollution, sustainable demand for water has reached a tipping point, particularly in emerging economies, such as South East Asia.

The solution in part lies in developing infrastructure where water is abundant and increasing trade in ‘virtual water’.

As water is a very bulky and expensive commodity to ship, shipping indirectly through low value-added goods that consume large quantities of irrigated water, such as bulk grains, becomes a lot more efficient, explains Mr Kreyzig, commodity research analyst at Julius Baer. One kilogramme of wheat requires on average 1,500 litres of water. The feed and processing for 1 kilogramme of beef requires 15,000 litres.

“Virtual water trade is likely to increase exponentially over time,” he says, believing this is a high conviction play. The expected key beneficiaries of increasing water stress are global grain traders, as they enjoy high barriers to entry through key logistics’ infrastructure and complicated sales networks involving farmers, governments and commercial customers. Grain logistics companies and developers of technologies that promote water, waste and energy efficiency and productivity are also very well positioned, states Mr Kreyzig.

Illiquid structures

Investors can also gain exposure to the agriculture theme through illiquid fund/private equity structures, where money is locked-up for several years, by investing in farmland and taking operating risk, with agricultural infrastructure being an attractive space. 

To meet investors’ demand for real assets which generate yield in this very low interest rate environment, an increasing number of investment firms are launching this type of illiquid funds, often establishing partnerships with professionals from an operational role.

Agricultural Asset Management (Agri-AM), for example, was the result of a recent joint venture between Dexion Capital, a UK-based alternatives investment bank, and Brown & Co, international advisers on farm land and agriculture transactions. The firm seeks to invest in farmland mainly in the US and Central and Eastern Europe, where the best risk-adjusted opportunities are believed to be.

Working directly with local farmers, the firm aims to purchase attractive farmland, share business risk and income through a combination of land leases, crop share, and custom/contract farming. It also expects to make capital investment, to improve under-invested farms, and increase farm output through the adoption of innovative technology and latest farming practices, particularly in regions such as Romania.

Given the backdrop of a long-term demand-supply imbalance in production and with the challenge of extreme climate events, “agriculture represents a long-term investment opportunity, in terms of returns and diversification,” says Ana Haurie, group managing director of Dexion Capital and CEO of Agri-AM. “As a real asset, farmland has very low correlation, if any at all, to equities and fixed income, it provides very good diversification against real estate holdings, and is also a hedge against inflation.” 

The US, in particular, is a major global agricultural commodity producer and has one of the most efficient farming industries in the world, explains Charles Whitaker, managing Partner of Brown & Co and CIO of Agri-AM. As such, it is well placed to benefit from the macro factors affecting agriculture. 

On the contrary, in emerging markets such as Africa, South America or Ukraine, investors would have to also take exposure to exogenous factors, including political and legislative risk, such as land expropriation, or lack of infrastructure. 

Agri-AM is currently looking to launch a fund which will invest in a diversified portfolio of farmland in the USA. The fund will aim to generate yearly net returns of 8-10 per cent with target distributions of 2.5 per cent and a 10 year lock-up. The firm is also able to offer opportunities for those seeking to invest in its other core areas of Eastern Europe, such as Poland and Romania.

With the right structures, incentive schemes and governance mechanisms, marrying the world of investment professionals, often from a private equity universe, with that of agriculture advisers, it is possible to create strong synergies, says Kasper Knudsen, senior portfolio manager at Danske Capital. 

But historically this has proved difficult. Incentive schemes, typically performance fees, have significantly favoured investment professionals, at the expenses of agriculture advisers. As already seen in the infrastructure space, this may lead on-the-ground operators to leave the partnership half way through the life of the structure and set up their own vehicles. This would be highly detrimental to existing fund investors.

Although a few private equity managers in this space have gained track record recently, the majority are still inexperienced in terms of governance, states Mr Knudsen.

Also, fund fees are generally too high. These include a performance fee and management fee, often based on net asset value which is expected to rise over time. The standard private equity fee structure may not be appropriate for agriculture, when return from operations, ie excluding capital gain on land appreciation, may only be in the mid to high single digits. 

“Considering the time spent and dollars put to work, this is the most expensive asset class we are looking at. We have a very hard time finding investable products,” states Mr Knudsen. He also expresses concerns about operators’ lack of experience in meeting clients’ reporting requirements.

According to Credit Suisse, gaining exposure to the agriculture theme through private equity is attractive especially in regions with high potential agricultural output, such as sub-Saharan Africa, although very small farm sizes and uncertainty on property rights make these investments quite risky. 

But private banks, including the Swiss bank, are not channelling a lot of money into private equity agricultural projects, apart from the impact investing space, where the emphasis is more on social returns, says Credit Suisse’s Mr Stierli. “With chronic underinvestment in infrastructure in Africa, impact investing is increasingly appealing,” he states.