At the end of the 18th century, English academic Thomas Malthus suggested our crowded planet would one day have too many people on it to feed with available food stores. Economists largely dismissed him over the years, yet food still surreptitiously moves people and governments. Malthus might have felt vindicated if he'd seen the food riots erupt over the past decade. Several observers noted that the Arab Spring revolutions in 2011 might not have taken place had the price of bread not risen in Northern Africa and the Middle East. Those insurrections followed on the heels of global food riots in 2008.
Americans have felt the pain, too, when going to the grocery store. Just in the last year, food prices have spiked. The CPI index for food eaten at home rose 4.8% in 2011. Between March of last year and this year, meat prices rose 5.4%, eggs 5.1% and dairy products 6.3% (though these were tempered somewhat by comparable declines in fruits and vegetables).
The upward pressure on commodity agriculture prices has been exacerbated by a growing middle class in emerging market countries, especially in places like China, India, South America and Africa, where the bigger appetites and deeper pockets for protein have drastically altered the food landscape. Protein requires more grains to feed animals, requiring greater yield from smaller amounts of arable land.
"In the long term, we are seeing a dynamic, particularly in emerging Asia, the likes of which the world has never seen before," says Kim Ip, who leads portfolio construction and asset manager selection as a partner at Los Angeles firm Luminous Capital. "When you transition from grains to proteins, you need three to 10 pounds of grain to create a pound of protein. And that's why we're focused on agricultural products as an investment theme."
Those trends might seem to make agriculture investing a slam dunk. Not only are ag commodities bound to keep rising in price over the long term, but they are also seen, like gold, to be an inflation hedge at a time when the Fed's loose monetary policy augurs imminent inflation. Theoretically, agriculture is also a perfect diversifier, since the cost of commodity inputs should have nothing to do with equity returns.
Ip says people are under-allocated to real assets in general, whether it's agriculture or timber or real estate, and during periods of rising inflation and higher tax rates, people should be owning more hard assets, especially if they're trying to convert ordinary income into capital gains.
"I think farmland in particular has a certain level of appeal because of the systematic forces," she says. "I think it's also under-owned institutionally."
The question is how to play. An advisor could trade in futures, but that's a full-time job which requires watching harvest and weather data. An advisor could also make direct investments on behalf of clients in farmland, though that comes with its own risks and rewards.
Peter Sorrentino, the lead manager of the Huntington Real Strategies Trust fund, which trades in hard assets from grains to precious metals, says those who want to get into this area must approach it with a broad mandate, given the volatility of the individual commodities. "There are a lot of vehicles out there you can utilize, and there are new ones coming out every day."
In response to demand, a cornucopia of funds have hit the market, everything from dedicated livestock exchange-traded products to water ETFs to quantitative futures indexes.
Some, like the Market Vectors Agribusiness ETF (whose ticker symbol is MOO), track indexes of companies selling agriculture equipment, technology and seeds. But other funds try to find direct commodity exposure, investing in the futures of sugar, corn, wheat, soybeans, live cattle, etc.
One such ETF is Deutsche Bank's PowerShares DB Agriculture Fund (DBA), which invests in the futures of 11 commodities. (It had $1.8 billion in assets under management in early May.) The fund uses a quant strategy that tries to expose investors to the spot price by investing in more near-term expiring futures. But at the same time it tries to mute destructive contango situations-when contracts increase in price from month to month, and investors must cycle out their cheaper near-term contracts for more expensive next-period ones, says Morningstar commodity ETF analyst Abraham Bailin.
"DBA has a quant model which is a very solid proxy for the ag commodity futures space, and we like it," says Bailin. "It's just an algorithm. It wants to keep the sensitivity to these commodities, which means we want to buy the future closest to the spot price, but we don't want to get caught in commodity futures contracts that are heavily contangoed, and a market in contango tends to be the most heavily contangoed at the front end of the curve.
"If corn explodes, where can I get the most bang for my buck? Maybe the most bang is in the front month, but if the front month is heavily contangoed, then [investors could buy] between the first month and the second month. If those are substantially contangoed, maybe our participation is in the fourth or fifth month."
In April, the United States Commodity Funds LLC rolled out its own innovative new agriculture exchange-traded product, the United States Agriculture Index Fund (USAG), which tills a field of 14 commodities including soybeans, corn, sugar, cocoa, live cattle and hard red winter wheat. This fund tracks the SummerHaven Dynamic Agriculture Index Total Return, and its strategy is to adjust the base weights of each commodity monthly, overweighting those whose near-term expiring contracts are trading at higher levels than the ones that follow. In other words, it takes advantage of backwardation, the opposite of contango.
"At the core of SummerHaven's index methodologies is academic research that showed using levels of backwardation are adequate or the most readily available real-world proxies for low-inventory commodities," Bailin says.
Yet another fund rolled out in late March: the Teucrium Agricultural Fund (TAGS), which holds 25% equal weightings in Teucrium's underlying corn, wheat, soybean and sugar funds.
Most investors skittish about futures likely prefer to invest in this space through agriculture company stocks-seed companies like Monsanto, equipment companies like John Deere, or fertilizer companies like PotashCorp. The problem with these plays, however, is that they are correlated with the broader equity market. They act like blue chips-because they are blue chips.
"The natural resources companies as a group, whether it's energy or agriculture, there's a very high correlation to the broad equity market," says Ip. "So even if you had an investment in some type of specific energy company you're usually finding yourself 85% or so correlated to the broad equity markets."
But in the longer term, these companies still might be attractive value plays. Sorrentino and his partner are currently working up a white paper on agriculture investing. One of its focuses is the availability of arable land and its proximity to available water around the globe. Companies taking advantage of those inefficiencies are good plays, he says.
"Will it be in irrigation products, because the arable land is not located where the water is and so you essentially have to canal or pipe it in-or, as the Chinese are doing, just divert whole rivers to it? Or is it in some of the grains, the seed companies? There are some revolutionary developments taking place there in terms of drought resistance, pest resistance."
Russell Croft, the co-portfolio manager of the $330 million Croft Value Fund in Baltimore, allocates about 5% of his multi-cap value portfolio to agriculture stocks. He is also playing on the paucity of arable land and looking for companies that will boost yields.
To that end, he likes companies such as Valmont Industries (VMI). Even though it's a conglomerate, its irrigation business is 39% of the company's earnings, he says. That includes high-end pivot irrigation, which helps farmers conserve water and improve crop yield. That could be an important theme if cheap water one day turns dear.
"Water doesn't cost a lot right now," Croft says. "But what if the incremental cost of water starts kicking in?" He also owns John Deere, one of the largest makers of farm equipment in the world.
"High crops prices get the farm income up, so Deere has been in a good spot." The company plans to expand its overseas footprint to 50% from 35%, he says, and it boasts 7% free cash flow.
He also mentions Monsanto, the biotech company. "This is just straight to the heart of the matter of increasing yields-with their R&D and their technology developing drought-resistant seeds and seeds that guard against pests and insects. This is a very global company; 60% of their sales are outside the U.S."
Sorrentino also likes Monsanto for its strong R&D, but says he has reservations about the way it treats its customers. Farmers "feel that Monsanto has treated them poorly: that they charge a lot for their product, that they're constantly raising prices on it, that they put them on quota, that there is a rationing out of the product during periods of peak demand."
A lot of those people who don't like the uncertainty of futures (or the margins that must be put up) nor the correlations of blue chip stocks may instead want to instead buy the farm-the farmland that is.
After all, the average prices for it in the U.S. have been skyrocketing. The average acre of farmland increased in inflation-adjusted value from $1,230 in 2000 to $2,091 in 2011, according to the Department of Agriculture. Some states in the Corn Belt and the Great Plains saw double-digit growth in acreage value between 2010 and 2011.
But direct farmland investing has its drawbacks as well. With low interest rates and huge loans being paid out for farmland, whose values are currently being supported by high commodity prices, some worry that the sector is being set up for a disaster akin to that of the 1980s, when farmers eventually got wiped out by higher interest rates.
However, Ip says the debt-to-income levels are at historic lows. "So they don't have a lot of debt. But farmland valuations are going to be affected by cap rates, which is what could happen to commercial real estate as well. So if interest rates rise, you would see cap rates on all property, including farmland, rise. And that's a risk where you could find values compressing."
So where does farmland fit into the asset allocation?
"It really depends on what the investor's objectives are," Ip says. "For a high-net-worth individual, I would say anywhere from 5% to 10%, but it depends on what their income needs are and what their orientation is. If they are looking for something that just provides them access to the financial markets generally, stocks or bonds, then farmland might not fit in their overall picture."
The bad news is that agriculture commodities prices, which should be free of broad market sways, have been moving with the markets anyway, simply because in the new world order all risk assets are moving together. People are chasing returns and piling into ag one minute, then spooking easily at risk and getting out the next. That has led to a huge disconnect in agriculture prices and the way they ought to move.
"We've actually seen correlations increase between commodities and equities," says Bailin. "We have this very risk on/risk off sensibility."
Sorrentino agrees. He says normally prices for commodities go up in the spring until the planting data comes out and investors then read the weather reports over the summer in wait for the harvest. But the Fed statements on possible new quantitative easing have thrown all the cards in the air.
"For people to be selling off this time of year, especially on the grain side, is unusual," Sorrentino says, "because normally the expectations are, especially given the low levels of inventory that are being carried around the globe, that normally grain prices go up, fertilizer prices go up, everything kind of moves up on the ag side in anticipation of the planting data. [Now] it's really more a factor of the Federal Reserve coming out and saying we really don't see ourselves doing a QE3. You can almost, to the day, track the sudden weakness in the ag space to those comments."