August 28, 2015

Tim McGavin Chief Executive Officer Laguna Bay

Agriculture is second only to land as the most ancient investment. Together, land and agriculture have outlasted most other investments as preservers of wealth and long-term generators of cash-flows. Yet to many institutional investors the rewards from agricultural investment have been marginal.

Some investors, however, have absorbed the lessons of past experience into their portfolio construction processes and recognised the advantages of Australian agriculture. Five practices stand out.

Capture Proximal and Environmental Advantages

The majority of income growth and unmet food demand is expected to occur in Asia. This provides Australia with the clear advantage of proximity re-enforced by trade and cultural connections. There is also the benefit of seasonal differentiation to food products produced in the northern hemisphere.

Other factors that should enhance risk-adjusted returns by allocating to Australia include:

• Land which is inexpensive on a yield basis but has yet to appreciate relative to fundamentals;
• A highly skilled and innovative workforce;
• A stable business, governance and regulatory environment;
• An absence of major pests and diseases that reduce production costs relative to other countries; and
• A history of strong productivity growth.

Current market conditions further support Australia. Many traditional investors are now absent after a decade of tough operating conditions brought on by droughts and floods. Further, many attractive assets are under-valued due to a poor understanding of productivity improvements achievable with modest capital improvements.

Diversify and Structure Portfolios to Enhance Risk Weighted Returns

Australia’s diverse climates and abundance of land allows for varied production systems and the ability to scale production. A portfolio spread across these climates and systems also mitigates the risk of adverse seasonal conditions.

Portfolio risk is also managed through exposures to different foods – cereals, meat (livestock), protein (chickens, pigs and aquaculture) and dairy. Because meat, for example, is an important dietary component of the affluent its demand is largely driven by income growth. On the other hand cereals are the staples for those on lower incomes so its demand is largely driven by population growth. Different drivers ensure that food prices are less than perfectly correlated so a diversified portfolio is likely to reduce volatility.

Unlike many other asset classes the benefits of diversification within this class are quite pronounced. This is achieved through exposures across diverse climates and geographies, diverse foods with low price correlations, across irrigated and dry land assets, both permanent and annual, and to water, which can be allocated either to the highest margin user or to permanent crops during times of low allocations.

Hire the Unhireable

Studies identify management capability as the key distinguishing characteristic of top 10% producers. Input costs and prices received vary little between elite and average producers, while management decisions and execution contribute to machinery and labour efficiency, timeliness of operation, production and price risk management, and the adoption of innovations.

Yet these skills have been largely inaccessible to institutional investors in Australian agriculture. The lesson is three-fold; the need for benchmarking to identify top-tier operators, the importance of the right deal structure, and incentives to be able to partner with the previously unhireable. This demands strong relationships and broad networks, a deep understanding of the needs of vendors, operators and tenants, and the ability to structure transactions so as to be mutually beneficial to them and to investors.

Adopt a Disciplined, Counter-Cyclical Approach

The confluence of the cyclicality of individual assets, variable climatic conditions and investors chasing last year’s seasons and margins creates a powerful advantage for patient, disciplined, value-oriented investors. A lengthy investment period and perpetual capital further ensures they are not to be forced to buy/sell at the worst possible time.

Portfolio construction should focus on generating a stable, growing income yield, preserving capital and building the potential for long-term capital appreciation. This favours acquiring assets that are significantly undervalued relative to their intrinsic worth. It also demands a thorough analysis of the agricultural cycle to identify timing of entry and exit. At times assets can be out of favour with the market so investors will benefit from a contrarian mind-set.

Investors should also favour undervalued assets which:

• Have greater productivity potential than currently valued by the market;
• Have the potential to capitalise productivity gains realised via strategic infrastructure and resource investments (e.g. by the addition of water infrastructure to grazing land); and
• Have the potential to capitalise productivity via a change of use (e.g. by converting grazing land to farming land).

Bridge the Gap between Farming and Finance

Extracting maximum value from the interaction between finance and farming demands particular skills in both fields. This is required, for example, to identify attractive opportunities before assets come to market. Effective deal structuring needs to be coupled with thorough risk analysis and due diligence on potential assets. As well, extracting the maximum return for investors demands financial efficiency as well as knowledge and techniques to increase yields and reduce operating costs.

Conclusion

The effect of rising populations will be further compounded by greater incomes, resulting in exponential demand growth for agricultural products. In fact, The Economist predicts that over the next 40 years humans will need to produce more food than they did in the previous 10,000 years combined¹. Australia, as a cost-effective supplier to the world’s biggest and fastest growing regional economy, is in an unchallenged position to reap the benefits.

A thoughtfully structured portfolio of Australian agricultural assets diversified across different markets, economic factors and risks is likely to generate a stable and growing income yield and long-term capital appreciation.

A mix of leaseback and manager-operated assets aligns well with this proposition. Similarly there is considerable merit in a broad mandate which has the flexibility to include investment in water entitlements, agricultural infrastructure and in up/ down stream operations.

We are confident that such a mandate will generate strong returns, with at least 50% being in the form of income. Furthermore, we believe there is an added return in doing all this at an elite level. That is, by purchasing and structuring well, exiting certain assets at opportune times, expanding productivity potential and improving operating efficiency.

Finally, agriculture is an asset class that generates a cash yield, offers an inflation hedge and provides genuine diversification benefits with respect to most other asset classes. In other words it enhances overall portfolio efficiency.

Tim McGavin is a member of the speaking faculty at Global AgInvesting 2015 (Wednesday, 29 April, 10.00am – Agribusiness Opportunities in Australia and New Zealand)

¹ Economist 2015, ‘Barbarians at the farm gate: Hardy investors are seeking a way to grow their money’, 3 January, viewed 9 January 2015,

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