Despite the hype about food prices and the unrelenting pressures on future supply, rarely before have institutional investors built allocations to agriculture in their portfolios. SIMON MUMME examines both the direct and listed paths into the sector, and speaks to the few institutions that have put mandates ‘out to pasture’.

Agriculture presents a potentially lucrative but challenging investment case. There has been much talk of capturing attractive returns by backing the industry that will profit as the world demands more food, fuel and fibre from diminishing tracts of arable land. But despite the compelling story, few investors have bought in.

This is because the marketplace for ‘agri’ investing is immature: scarce research has been made into it, and it has attracted few investment managers. But there is data to back up the agriculture story.

The Agri Index, which measures the performance of listed Australian agricultural stocks against common index benchmarks such as the All Ordinaries, notched a whopping 79.5 per cent return against the minus 15.5 per cent return of the All Ordinaries in the year to June 30. This performance was fuelled by manufacturers in the agricultural sector, such as fertiliser companies, whose products are linked to the price of oil, says Tim Lee, director of research at Australian Agribusiness Group, which publishes the index. In total, agricultural stocks comprise 3 per cent of the All Ordinaries Index and 5 per cent of the MSCI World.

The alternative approach to the sector – investing directly in farmland or in managers operating agricultural businesses – can yield comparable returns to direct property investments and at lower risk levels than listed investments. And, since rural lots are subject to different economic forces than urban properties, they can provide some diversification within a direct property portfolio, but not the guarantee of a pure exposure to agriculture.

In a report on the sector released to its institutional clients earlier in the year, Frontier Investment Consulting looks at both approaches. Citing data from a sample survey run by the Australian Bureau of Agricultural and Resource Economics (ABARE) on the financial performance of domestic broadacre and dairy farms, the consultant finds that, among the top-quartile rankings, large farms returned 11.4 per cent, medium-sized farms returned 12.4 per cent and small farms 13.1 per cent in the 29 years to the 2005/06 financial year. In the 30 years to 2005/06, the average return from all top-quartile farms was 11.5 per cent, at risk levels similar to direct property. This compares with an 11.8 per cent return from the All Ordinaries Accumulation Index in the same time window. The survey presents, probably, the “most comprehensive analysis of farm income available in Australia,” says the consultant.

Since most of these farms were commercial entities with big operating budgets, they provide a decent indication of the opportunities available to investors, Frontier writes. While this top quartile is a moving sub-set of the farms surveyed, “it is understood, however, that there is a fairly high degree of stability within this top quartile”.

But roughly half of the returns from the top-quartile farms were generated by capital growth or increases in land values, the primary drivers of direct property returns. These similarities “diminish the diversification impact” of the investment case for agriculture, Frontier’s report stated.

The macroeconomic forces driving agriculture, however, may warrant further development of the investment market for it. “Notwithstanding the uncertainty around the data and investment capabilities of managers in the sector, the strong fundamentals of the forecast supply-demand balance suggest that a sufficient look-forward investment case is present”.

The search for new cash cows

Telstra Super and Vision Super are two major investors in the $100 million Warakirri Dairy Industry Trust, a specialist fund that buys and operates Australian dairy properties. The two funds regard the allocations to agriculture as diversifiers within their portfolios. Lachlan Beaton, head of agribusiness at Warakirri, says the product is an investment in both property and farm operations, differentiating it from other direct property holdings.

At the core of the decision to build the fund is the belief that “dairy stacked up as a solid investment over the long-term,” Beaton says, adding that Warakirri was not specifically searching for an agricultural theme, but happened across the opportunity. The same goes for its two major investors.

Telstra Super’s $30 million investment in the trust was made to provide diversification and a reliable income flow within its direct property portfolio, Kent Robbins, property manager at the $11 billion fund, says. Since rural properties are not affected by the same economic forces as office, manufacturing or retail properties in cities, their return cycles usually tend to be different, Robbins says.

Nor are agricultural properties caught in the buy-sell cycles of urban real estate investment trusts (REITs). “Diversified REITs buy all three – office, manufacturing and retail assets – and they often bid for these assets when other buyers bid, when there is liquidity, and get out when there is none, whereas rural properties attract different buyers and sellers.”

That the trust could be implemented as “a reasonable diversifier, with private equity and property characteristics,” was one motivation for Vision Super’s $50 million mandate to the Warakirri trust, Graeme Smith, investment manager with the super fund, says. Another was the potential for returns. “We look at opportunities as they come along – what they could add on a risk-return basis to the portfolio, whether they are rural or not.”

Robbins says that certain macroeconomic drivers also supported Telstra Super’s investment in the trust. Milk is one of the cheapest forms of protein, and more of it is expected to be consumed by people in developing nations as they move away from carbohydrate-based diets. The Warakirri properties, run by separate farm operators and located in south-east Gippsland, NSW and Tasmania, sell to big milk product manufacturers such as Dairy Farmers, Fonterra and National Foods. More than half of the produce is exported, and approximately 60 per cent of this is shipped to Asia, sometimes as products such as cheese and milk powder, Beaton says.

According to Robbins, Telstra Super’s mandate to the trust “had a lot to do with market timing” as the fund anticipated a steady rise in the price of milk. But both of the funds and Warrakirri’s Beaton agree that it is too early to derive meaningful performance data from the trust. The investments have incurred start-up costs, Robbins says, such as hiring farm managers and backing their operations. Also, “you need to get the herd condition up”. Furthermore, there is a sour side to the escalation in the milk price: upswings in the costs of fertiliser and of importing grains for stock feed have eroded these gains. The diversification rationale for investing in the trust is strengthened by the range of farms that Warakirri owns within an agricultural sub-sector. In its report, Frontier writes that an effective agri investment vehicle would be a fund-of-funds comprised of agricultural sub-sector specialists. But there are few, if any, of these managers available in Australia.

Given the immaturity of the sector and limited research into it from asset consultants, neither Telstra nor Vision Super is actively looking for further agriculture investments, Robbins and Smith say. While Telstra Super spent a year on due diligence of the Warakirri trust itself, Vision Super sourced research from Freshlogic, a consulting firm working in the food and agribusiness sectors, as it had already conducted an assessment of the fund.

Going direct, going long

While the potential upside is attractive, investing directly in agricultural land requires buyers to take on operational risk, high due diligence costs, and deploy farming expertise – something not so easily done from city skyscrapers. The $6.3 billion VicSuper has chosen this direct route, buying up properties in regional Victoria for its ‘Future Farming Landscapes’ theme. The fund aims to invest up to $240 million in the sustainable agriculture and environmental management program in the next 10 to 15 years.

In 2006, the fund began buying tracks of farmland in the corridor between Swan Hill and Kerang. The management of these properties has been outsourced to Kilter Pty Ltd, an investment manager based in Bendigo. Interestingly, the fund offered management or consulting roles within the program to the previous owners of the properties, from which they could draw an income. Bob Welsh, the chief executive of VicSuper, says the program is a long-term property investment aiming to manage land, water and environmental assets for traditional and new income streams, such as agriculture, forestry, alternative energy, water and environmental management projects called ‘ecosystem services’.

The fund aims to implement sustainable primary production practices on the ‘landscapes’, or collected properties, that it manages. In the initial stages, the existing farming operations will be maintained before new agricultural and environmental restoration practices are phased in. If all goes to plan, the properties will eventually be redesigned so that sustainable agricultural production and environmental protection practices are functioning. Frontier observes that conservation of land, water and native plant species, in conjunction with advances in farming efficiency and technology, will be required to mitigate future environmental challenges, such as climate change.

“We’re about sustainable agriculture. Our interest is to protect productive agricultural land,” VicSuper’s Welsh says.

Safety in numbers

In its report, Frontier describes the global trends expected to determine the forces driving prices of agricultural goods and services in the future. The global population is expected to grow to 8 billion, or roughly 50 per cent, by 2025, causing greater demand for soft commodities, livestock and water. “While current world food prices are at historical highs, the supply-demand equation appears to indicate that the pricing pressures are likely to continue,” the consultancy writes. Compounding this pressure on suppliers, urbanisation will occupy more arable land around cities.

Driven by the competing pressures of urban expansion and agricultural enterprise, the rate of reduction in arable land is between 30 and 35 times the historical rate. Water supplies will become more valuable, since agriculture accounts for 70 per cent of freshwater used in the world.

The use of farmlands to grow matter for biofuels will also make food more expensive. The Organisation of Petroleum Exporting Countries (OPEC) expects a four-fold increase in non-OPEC biofuel production by 2030, based on what these countries produced in 2005.

The possible vehicles through which institutions can access this story include:

• Specialist agriculture managers who invest directly into a sub-sector (such as Warakirri);

• Single managers that invest directly in a range of farms across agricultural sub-sectors;

• Land trust managers who pool investment funds into a farming property or properties, but lease the farm operations out to specialist providers;

• Private equity-style managers who buy equity stakes in businesses exposed to agriculture, such as food-processing facilities or irrigation infrastructure projects; and

• Funds managers who specialise in managing agricultural stock portfolios.

From these options, Frontier prefers the direct methods, but given the immaturity of the investment marketplace for agriculture, it advises that accessing the sector through equities is the more reasonable approach. This allows investors to access various sub-sectors and geographies, provides regular market valuations of investments and, because the holdings are more liquid, to better adapt to changes in markets. However, listed agricultural securities generally have a higher correlation to equities markets, are subject to more pricing volatility than unlisted assets and have less access to real farm properties, Frontier notes.

Australian Agribusiness Group’s Tim Lee says that in the short-to-medium term, agricultural producers, which returned minus 11.9 per cent in the year to June, will make a comeback in the Agri Index. “They’ve been hit hard by the drought, and as the drought eases, as it has started to, crops will improve, particularly the grains and oil seeds.”

The manufacturing sector, which produces fertilisers, herbicides and other products, boomed in the same period, racking up a growth of 92 per cent. The price of fertiliser has been carried upward in value by the rising oil price. Of these stocks, Incitec Pivot stole the limelight by jumping 132 per cent in value.

Other companies that have done well out of the surge in soft commodities prices include Australian Wine Holdings, Clover Corporation and Nufarm.

Most agricultural companies listed on the ASX seem to focus on services and industries that are at least one step up the supply chain from farm production, Frontier comments, and many of them are small or microcaps. The recent outstanding performance of fertiliser and agricultural chemical companies, and the underperformance of producers, indicates that different parts of the agricultural supply chain will deliver different returns in various market conditions.

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