Investing in the agriculture sector can provide numerous benefits. For example, a partial shield against inflation risk, the prospect of cash flow and fixed asset value appreciation and several types of optionality. These types include the ability to change a property’s crop mix and even its fundamental use. Despite these advantages, companies in the agriculture sector often face unique issues. These make investment analysis challenging, such as high degrees of production and price volatility.
The following is a brief list of key points to keep in mind when facing issues in the agriculture sector:
1. Secure Water Access is Vital
Water is vital for agriculture. However, investors may not be aware that water needs can vary significantly depending on the type of crop. Water consumption for cotton, for example, is nearly double the typical water consumption for a hectare of grapes.
In addition to wide differences in water needs, the access and rights to water of farms can be very different. Some farms have access to water from deep wells on their own properties. Others draw a large amount of water from sources that can be severely limited in times of drought. When analyzing an investment opportunity, investors should therefore carefully study a property’s current and likely future water needs, how a property obtains its water, the state of its irrigation infrastructure and how secure its water supply will be, both under conditions of normal rainfall as well as drought.
2. Current Production Levels May Be a Weak Indicator of Future Production Performance
When considering investment opportunities in many sectors, investors often infer future production from current or recent production levels. In the agriculture sector, however, this approach may significantly skew potential investment opportunity and risk because:
– planting densities on a property may not be optimal
– crop management practices, including with respect to soil treatment, irrigation, pruning, harvesting and post-harvesting processing and storage, may not be ideal
– plants or trees may be in early phases of their production cycle and may be producing significantly less than they will produce at full maturity. Conversely, production from plants and trees in very late production cycle phases may soon begin to rapidly decline
– production may have been affected by external forces, such as extreme weather events, which are either not likely to recur or that can be defended against with different types of protective farming infrastructure
Because of these factors, when analyzing an agriculture sector investment, an investor should look beyond current production levels and instead consider what type of production could be expected from the property if it were well managed and if its maturity cycled normally evolved.
3. Agriculture Property Cost Structures Can Vary Widely
Cost structures in the agriculture sector can vary widely. There can be significant differences in key agriculture cost inputs, including land, labor, and essential farm operating expenses. Additionally, depending on their size and operating environment, agriculture businesses may face labor shortages and economic pressures from other parts of the value chain. These pressures are often transferred to or absorbed at the production level.
Accordingly, rather than simply looking at an agriculture firm’s cost structure, it is important to benchmark a business’s costs against industry competitors. They must also consider how volatile the company’s cost structure is likely to be going forward and the degree to which a company is able to shield itself from or at least counterbalance externally-driven cost increases.
4. Food Prices Can Be Highly Volatile
Compared with prices in other sectors, the prices of agriculture products can be highly volatile. This volatility is due to several factors, including:
– there can be a very large lag between the start of the food production cycle and when that product is finally delivered to the market. This creates the risk of supply and demand mismatches. These mismatches can result in overproduction even in the face of increasing demand as well as production shortfalls in markets where demand is sharply falling
– agriculture product supply can be severely affected by weather conditions and disease which can have a great impact on price
– because the price of land for real estate is usually higher than the price for agricultural land, agricultural land that is converted into use for real estate purposes can cause projected supply to sharply fall
Due to price volatility risks, investors should adopt a flexible approach when forecasting financial performance in agriculture investments. Instead of relying on exact price predictions, it is wiser to analyze potential returns under multiple price scenarios. Investors should also consider how a company may be partially shielded from price swings through fixed-price offtake agreements, a diversified product portfolio, or a cost structure that can be adjusted downward.
5. Product Distribution Strength Can Vary Widely
There are large differences between agricultural companies in terms of how their products are distributed. Some companies are highly vertically integrated with strong sales arms. Others effectively have to find buyers for their products each season. A lack of sales channel strength can negatively affect a company in many ways. It can cause the company management to waste scarce time and resources on product marketing and placement. It can also create high revenue volatility. This makes companies go into cost cutting mode even when expenditures could lead to significant company value creation.
Article written by Darin Bifani.
