By Michael Blakeney, Blue Sky

The agriculture sector provides investors a wide range of investment opportunities underpinned by favourable macro trends. The challenge for investors is how to identify what may be acceptable risk adjusted returns from the sector for their requirements. This article examines the generic operational strategies (specialisation and diversification) of agriculture sector participants and touches on the implication for investors.

At various stages of agri-food sector development, and the economic cycle, investment has swung between specialisation and diversification, diversity gained primarily through integration. While traditional agriculture is not as amenable to Adam Smith’s theories on the division of labour as manufacturing, the overriding specialisation in economies since the industrial revolution has also been reflected across the agri-food supply chain. In fact it could be argued that the American food system, as an example, has followed a similar industrialization path of specialization, standardization of production, consolidation of farms, enhanced productivity and today is in the final stages of global consolidation of corporate control[1].  There are however exceptions to this.

Stuckey and White (1993)^[2] highlight four reasons to vertically integrate in any sector;

1. The market is too risky and unreliable – it fails;
2. The market is young and the company must forward integrate to develop a market or supply;
3. Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments; or
4. Companies in adjacent stages of the industry chain gave more market power than companies in your stage.

Applying these four factors to the agri-food sector one can start to see where integration may be more prevalent and contribute to reducing risks. Commodities or supply chains that are emerging can involve young and riskier supply chains therefore businesses integrate to mitigate against failure or to secure supply.

Vertical integration has been one approach organic agri-food processors and marketers have used to bridge the emerging status of the sector and mitigate against market ‘failures’ associated with the current higher risk and less reliable organic supply chain. Likewise with niche and more specialised agri-food products such as fruit and vegetables.

Similarly, mature multinational supply chains such as those participating in the global grain, oilseed, sugar or cotton sectors look to leverage market power by integrating along the supply chain. With less risk of market failure or supply challenges large multinational agri-food businesses have integrated across the agri-food supply chain, typically not to producer level but rather most links upstream to the farm gate. These operational strategies capitalise on the competitive advantage of utilising local assets (including local partners who have established relationships) along the chain, while leveraging the larger network effect and supply chain of being a multinational business.

Large scale specialized farmland investment portfolios undoubtedly represent attractive investment strategies, after all the lowest cost producers, particularly in commodity industries, have a significant competitive advantage. It should, however, be remembered that opportunities in the agri-sector exist across the length of the supply chain and not always in industrialized platforms.

Blue Sky’s favoured approach is to invest in the ownership of key supply chain inputs such as water; key agricultural infrastructure that supports the agri-food supply; or to provide expansion capital to proven farmland managers seeking to develop sufficient scale, change their farmland utilisation or integrate along the supply chain. We see both specialisation and diversification via integration as valid investment strategies for investors seeking exposure to uncorrelated, real asset backed returns from the agri-food sector.

The emergence of these innovative and non-traditional forms of agri-investment is a reflection of a maturing asset class and the diversity of opportunities available to investors in the Australian and other agricultural sectors. We look forward to discussing these thoughts and others at GAI New York later this month.

Blue Sky is contributing to the discussion on Australian Agricultural Opportunities at Global Agnvesting in New York on Wednesday, April 27, 2016 from 10:00-11:00.

The opinions expressed in this editorial are the authors’ own and do not reflect the views of GAI News.