AFR: Making money out of food

AFR: Smart Money, January 2012

The dynamics around food are pretty straightforward: there are more and more people to feed, with less and less land available to grow food on. It’s a classic supply and demand imbalance. It is also an investment opportunity – but how to do it?

Until recently, it has been difficult for Australians to play the food industry, whether through soft commodities such as wheat and sugar, or through meat or fish. Oddly for a country that is a major producer of agricultural products and livestock, there are very few major listed companies that are exposed to those themes: the big exception used to be AWB, but in 2010 it was taken over by the Canadian group Agrium. There are still some out there – Goodman Fielder is a big example – but the dominance of the Australian market by banks and resource-linked companies is reflected in a relative paucity of food and agriculture stocks.

Yet the case for food investment is strong from both the long and short term perspective. To start with the bigger picture, the world population is today around seven billion; it only passed the three billion mark in 1960. Moreover, all those people are living longer. The proportion of the world aged over 65 – negligible as recently as the 1950s – is increasing fast. Just under eight people in every 100 on earth are over 65 today, and by 2050, it will be more than 16 in every 100. “The increased size and age of the population means we see additional demands for food, water, resources and everything else,” says Douglas Hansen-Luke, CEO for the Middle East at European fund manager Robeco, known for its work on the so-called megatrends that will shape our world over the coming decades. “It leads to scarcity.”

At a number of points over the last decade, food scarcity has become deeply problematic: there was an incident before the global financial crisis when Bangladesh, for example, was unable to secure rice at international auction because other countries were hoarding their own stocks. Had Bangladesh not had an excellent rice harvest that year, we could have seen severe shortages in a desperately poor country, and associated social unrest. Governments around the world are making food security a priority. “The absence of food security will make it much harder to pursue a broad range of other policy goals,” notes the UK-based Government Office for Science 2011 report on the future of food and farming. “It may also contribute to civil unrest or to failed states; it may stimulate economic migration or fuel international tensions.”

More pragmatically, that shortage suggests an investment case; UBS and Goldman Sachs are among the banks that have argued for a greater allocation towards soft commodities this year. Closer to home, a 2009 report from the Australian Agribusiness Group pointed out that less than 0.01 per cent of superannuation funds went into Australian agriculture, and that a greater proportion – as is common in international pension funds – would have insulated super funds from the global financial crisis. Soft commodities are a long term investment prospect and a diversifier too; and since food is usually a core part of inflation, they work as a hedge.

Shorter term, it’s trickier to be sure about the direction of any commodity in these uncertain times. “It’s not apples and apples,” says Ric Deverell, head of global commodities research at Credit Suisse, and a former Reserve Bank of Australia economist. “There are quite different balances in different markets: corn is fundamentally very tight, while wheat is nowhere near as tight.” But he says “the central tendency in most of these markets will be for markets to move sideways for the next year.”

That said, he says corn is “the tightest market we have seen since the 1970s; when it’s that tight, it only takes small changes in supply and demand to have very large movements in prices.” In that environment, weather patterns, a good or bad crop or some other macro consideration can have a major impact on prices. “If next year is an average season, some of the tension we saw because of crop failures fades away – but gee, it’s vulnerable.” And on top of that, he says the incremental global rate of corn consumption has doubled since 2003, partly because of its use in creating ethanol fuel – 40% of the US corn crop will be used in this way in 2012.

Also relevant are changing patterns in food consumption in emerging markets, and changing attitudes in different countries to self sufficiency. As always, China is a huge driver here: growing use of fish, meat and dairy products in the Chinese diet have had ripple effects all the way to Australian or South American pastoral businesses, while China’s decision to be self-sufficient in wheat and corn has had knock-on effects too – such as in soy, which it is now the biggest importer of, having reduced the amount of soy it grows domestically in order to achieve those wheat and corn ambitions. Clearly, seeing a way through all of these patterns and shift is enormously difficult, but the general long-term trend is up.

So how to play it? Late last year, it became much easier to invest in soft commodities when a series of new exchange-traded funds was launched by BetaShares. Exchange-traded funds behave like a share, in that you buy and sell them on a stock exchange, but they give you exposure to an index or an asset class, and so are a straightforward and low-cost diversifier.

BetaShares launched two new ETFs relevant to food: an agriculture product, and a commodities basket. The agriculture one tracks the performance of the S&P GSCI Agriculture Enhanced Select Index, which is made up of the big four commodities in agriculture: corn, wheat, soybeans and sugar. The commodities basket is broader, covering 24 separate commodities including energy and metals, but it also includes a wider range of food-related commodities: eight agricultural (the big four plus cotton, coffee, Kansas wheat and cocoa) and three livestock (live cattle, feeder cattle, and lean hogs). All of these commodities are established markets with a particularly long trading history in the United States.

Drew Corbett at BetaShares feels the new products fill a gap. “We’re trying to allow people access to different asset classes,” he says. “People have been able to invest in soft commodities overseas for 10 years now through access products [like ETFs], and now people here can access some assets they previously didn’t have a low cost solution to invest in.” He notes that in private portfolios, asset classes such as these can account for up to 10 to 15% of an overall portfolio, and argues retail investors in Australia should be allowed the same opportunity for diversity. And he also agrees with the macro point. “If you look at emerging market population growth, there is going to be substantial demand and pressure on food and agricultural commodities to keep up.”

One point to note about ETFs like this is that unlike a share index ETF, these can’t be backed by the underlying investments. Think about it: you’d have to have a vast warehouse full of corn and wheat that couldn’t be used (or, in the case of the oil ETF, a tanker) to back the fund. Instead, BetaShares backs its ETFs with cash, in order to reduce counterparty risk, a worry in some other ETFs.

CFD providers have watched the emergence of these ETFs with some interest, since they have provided the opportunity for investors to trade soft commodities for years without receiving a huge amount of takeup. At IG Markets, for example, you can trade cocoa (London or US), coffee (robusta or Arabica), orange juice, two kinds of sugar contract, cotton, lumber, oats, corn, soyabeans (including meal and oil), wheat (London, Chicago or milling), rough rice, live and feeder cattle, lean hogs or rapeseed. But, by and large, people don’t. “It’s not one of our most traded products, but more specialised investors will use it – we get a lot of farmers who trade these products, for example,” says Chris Weston at IG Markets.

He argues that anyone who is looking at ETFs should take a look at CFDs first. “CFDs are a much more cost effective way of trading commodities than ETFs,” he says. “They are cheaper, they track the spot or futures price more effectively than an ETF does, and we offer you a price identical to the futures price.” CFDs allow significant leverage, which magnifies both gains and losses.

Anyone who does invest in commodities needs to think about the currency. Commodities are generally quoted in US dollars, and as anyone who’s invested in gold in recent years will know, that can make all the difference if you have made your investment in Aussie dollars. The BetaShares products hedge for the currency. People using CFDs can add a currency hedge in a separate contract if they want to.

In this article we haven’t discussed the tax effective investment schemes that have sprung up around areas like wine, truffles and almonds; schemes like these tend to be used by investors for different reasons, chiefly tax. But in the big picture themes of agriculture and livestock (see box), expect more investment vehicles to emerge.

BOX: Beefing up

Alongside the grains and other soft commodities, a less-invested arm of the commodity world is livestock.

Alongside some of the ETF and CFD investments covered in the main story, a few other ways have been devised for Australians to gain exposure to this asset class.

There is a Beef Stock Market in Roma, Queensland, popular among people in the livestock industry but actually open to anyone with an Australian business number and an internet connection. The market sets a price, per kilo, to buy cattle, and also indicative prices for selling the cattle – one price for when a professional livestock manager suggests it be sold, and one for outside that period. Investors can buy a cow or a herd in this way.

During ownership, investors pay grazing fees – currently $1.15 per kilo gained, paid by direct debit every time your cattle are weighed – and at sale time, there’s an agent’s commission of 4% of the full sale amount, a compulsory industry levy of $5 a head and perhaps additional sales costs including transport to market and weighing. Whatever else is left – the difference between the buy and sell price, based largely on the weight gained in the meantime – goes to the investor.

The market provides this costed example of how it might work. You want to spend about $10,000 on cattle. The purchase price is $2.24 per kilo, and the average weight purchased 254.36 kilos, meaning you buy 16 head of cattle, weighing 4,069.76 kilos, for $9848.82. An invoice goes through for payment within 48 hours. While you own the cattle, every few months they are weighed and the portfolio updated with current weights, while your weight based grazing fee is charged to your account. Let’s say the average weight gain is 195.37 kilos and fees $1.14 a kilo; your grazing fees will be $3,594.81.

Then the livestock manager tells you the animals are in sale condition at an average of 449.73 kilos apiece. If you agree to go at this – the ‘finished sale price’ – the livestock manager goes ahead. Let’s say they sell at $2.22 per kilo, with no additional marketing or transport costs (a farm-gate sale); the portfolio of animals would have been sold for $15,974.41. Once levies, commissions and so forth are taken out, the bottom line is a return of $1,811.80 on your just under $10,000 initial investment, or a return of around 18%, which would have taken about a year to achieve. Clearly, though, there are a lot of unpredictable variables involved; this is just a costed example.

One of the leading producers of sheep and cattle in Australia is Macquarie, which is understood to have about 220,000 cattle and 240,000 sheep across more than three million hectares of land, all of it held as a method of giving investors exposure to Australian livestock. This tends to be the preserve of private or institutional investors; an example of a completed fund backed by Macquarie is Paraway Pastoral, formed in 2007, which runs 18 large-scale sheep and cattle stations across New South Wales, Queensland and the Northern Territory.

While Macquarie declined to comment on any specific funds, citing regulator issues, executive director Tim Hornibrook explains the broader investment case. In some cases, it’s similar to that for other foodstuffs around the world: too many people. “The investment case is a fairly simple one: we’ve got more people in the world eating more food but less land to produce that food on,” he says. “That is causing a structural imbalance between demand and supply, causing a shift in agriculture prices above their long term average. Over the last 40 years arable land available for agricultural production has basically halved. So whereas once upon a time we used to each have a football field we could go and farm on, today we have two fifths of a football field.”

On top of that are changes in what people eat and can afford. “There are not only more people, but those people are getting wealthier, and there is a strong correlation between wealth and diet,” he says. “As you get wealthier, you tend to consume more proteins, and that once again puts pressure on demand and supply.” To meet demand, animals are tending to be produced more intensively – pigs in piggeries, cattle in feed locks – which in turn puts further pressure on the grain and oilseeds used to feed the animals.

But some elements of livestock in Australia are very distinct to this country. “Australia is in a fortunate position,” says Hornibrook. While it ranks second as an exporter of beef globally, behind Brazil, it ranks first by value, “because we get a higher price in recognition of being a consistent provider of high-quality, disease-free meat.” Most cattle in Australia are grass-fed, which is cheaper than the feedlock system common in the US and also considered more humane, and also reduces linkages to rising grain prices. Australia has a lot of land to allow a pasture-based system; it is closer to the key Asian markets than Brazil, with cost and time benefits; and more than anything else, it is disease-free, without ever having suffered an outbreak of an export-restricting disease, a function of being an isolated island with strict quarantine and a national livestock identification system. “Once a cow leaves a farm in Australia it has to wear an electronic ear tag,” he says. “You could be anywhere in the world and order an Australian steak and I could trace it back to the paddock where it was born.”

All of these things make Australian beef (and lamb) a very compelling investment case, but for retail it’s still very hard to play. Macquarie does, though, have a track record of starting out with somewhat esoteric investment classes with institutions and private wealth, then gradually offering retail exposure to them, so that may change in future. In the meantime, the most obvious exposure is through listed companies, the principle example being Australian Agricultural Company, Australia’s biggest exporter of live cattle to Indonesia.