Opportunities in Sustainable Farming Practices
PGIM IAS uses the example of alfalfa to show how farmland, can provide an answer to reducing greenhouse gas emissions.
In the recent IAS "Investing in Agriculture" webinar, we discussed many ways to invest in agriculture. In public markets, investors can invest in commodity futures – grains (e.g., corn and wheat) and softs (e.g., coffee and sugar) – and in publicly-traded agribusiness equities (market capitalization of $417 billion, as of Q2 2020).[i] In private markets, investors can invest in farmland, private equity and venture capital asset classes. Today more than $100 billion is invested in private agriculture funds.[ii]
Not surprisingly, the main driver of returns in agriculture are commodity price returns. Investors can access these returns directly by investing in commodities futures markets. Historically, investing in the grains sector has returned 2.2%/year but experienced a greater volatility than equities (20.1% vs. 14.4%).[iii] While commodity futures give investors exposure to grains and softs commodities, they do not offer the opportunity for exposure to many permanent crops (e.g., pistachios and almonds).
The second driver of agriculture returns is farmland real estate value appreciation, which has been 4.6%/year from 1980 to 2018.[iv] Investors looking for exposure to the real estate value component of return may purchase a row crop (e.g., corn and wheat) farmland and lease it to a farmer for two to three years at a fixed cash rent. While such an investment has limited exposure to commodity prices over the short term, rents will fluctuate with the broader commodity cycle over time. In addition, the investor has exposure to rental delinquency.
The third driver of returns is total factor productivity in agriculture, which historically has been 1.4%/year.[v] Total farm output has increased 1.5%/year and in contrast, inputs have increased by only 0.1%/year, mainly due to reduced labor demand (-0.5%/year) and innovations in farming production which have limited the growth in intermediate good inputs (0.6%/year). While yields have grown over time, the growth trend is too low to double crop yields by 2050 to meet future demand from population growth. Today, food security is a major concern and total factor productivity needs to increase to 1.75%/year to meet future needs.[vi]
Active farmland management – adopting sustainable farming practices such as precision and regenerative agriculture and other innovative technology – is needed to increase total factor productivity.[vii] This is especially important for owner-operated permanent crops as their yields are more variable and a greater share of their returns is from operating income.
An example for decreasing the yield gap (the difference between current and potential yield) is the use of sensor technology for:
Investing in public or private agribusiness equities (i.e., companies involved in food production, processing, distribution and technology) may provide investors with access to agriculture across the entire food supply chain and to the potential rewards from productivity improvements.
Given all the various ways to invest in agriculture, how might institutional investors approach this asset class? A correlation analysis (using 1-year returns) for grains and softs commodities, row and permanent crops, and agriculture equities suggest a significant diversification benefit (average pairwise correlation = 0.14, January 1992 – March 2020) by investing across the various asset classes and sectors within agriculture.[viii]
Previously, we have discussed how farmland can be included in real assets strategies meant for diversification, inflation protection or stagnation protection. For institutional investors with a well-diversified portfolio of stocks, bonds and alternatives, allocating to agriculture may help improve outcomes in scenarios of concern such as low economic growth or high inflation. See "The Diversity of Real Assets: Portfolio Construction for Institutional Investors."
[i] Datastream. For agribusiness stocks, we include fertilizers, food products and agriculture machinery industries. Investors can also invest in Farmland REITs, however this market is very small currently (<$1b).
[ii] Preqin, 2019
[iii] Performance from 1946 – 2015. A. Levine, Y. H. Ooi, M. Richardson, and C. Sasseville, “Commodities for the Long Run,” Financial Analysts Journal, 74:2, 55-68, 2018.
[iv] USDA Economic Research Service 2018, since 1980 nominal per annum growth rate in value of farm real estate.
[v] USDA 1948 – 2015.
[vi] “Tracking Productivity: The Gap IndexTM”, 2018 Global Agriculture Productivity Report.
[vii] Precision Agriculture includes techniques to efficiently improve crop yield while minimizing inputs. Precision techniques include use of wide array of technologies such as GPS guidance, sensors, drones etc. Regenerative Agriculture includes techniques to regenerate soil organic matter, increasing biodiversity, improving water cycle, etc.
[viii] PGIM IAS, NCREIF, Bloomberg, and Datastream. Agriculture equities are a cap-weighted index combining Datastream fertilizers, machinery – agriculture, and food products indexes.
This material represents the view of the author as of 9/8/2020 and is for informational or educational purposes only.