October, 2016 Print
Sherilee Mace, Institutional Business Development Director, Insight Investment.
Sherilee Mace of Insight Investment outlines some unique characteristics of global farmland and the potential advantages of investment in the asset class
Income-generating real assets have grown in importance for local authority pension funds, as they have for institutional investors more broadly, as conventional asset classes alone have struggled to generate the desired returns in the current environment of policy experimentation by global central banks. Local authority pension funds have gradually reduced equity allocations over the years by diversifying into other asset classes, such as real assets, that potentially offer similar long-term growth and income characteristics. But while most of the interest in real assets and flows have gone towards property and infrastructure investments, farmland investments have so far been underrepresented in portfolios despite boasting equally appealing characteristics.
We believe that now is the time to consider going beyond the core to seek a greater degree of diversification and to also benefit from a unique confluence of factors that should be very supportive for farmland assets going forward.
The secular return case for the asset class is premised on increased demand for agricultural production in an environment of constrained supply response. The demand for agricultural commodities will grow as world population continues to expand. The supply-side, however, remains constrained due to a combination of short-term limits to growth, and the availability of high-quality land coming under pressure as climate patterns shift and resources – water in particular – become scarcer. These dynamics will place a premium on quality land in geographies with a comparative advantage in production that have the ability to grow their outputs. Investors in those regions, holding the right assets, we believe, will be rewarded.
Now seems an opportune time to consider investments in the sector as asset prices in some geographies have declined due to sharply lower prices for their output, creating an environment which, we believe, will not persist. Strong short-term supply shocks have resulted in record grain and dairy production over the last four years putting pressure on the prices of cereals, oilseeds and dairy products. The impact has been compounded by shifts in demand coming from China, in particular. As a result, agricultural prices, as measured by the Food and Agricultural Organisation’s food price index, have fallen by almost 30% since 2011. Against this backdrop, the currencies of key commodity producers have also declined sharply and in many instances without an equivalent offsetting adjustment to the price of the underlying asset. We believe these shifts present a compelling entry point into the sector.
Global farmland boasts strong diversifying characteristics which could provide attractive levels of income in the current low-yield environment coupled with the potential for long-term capital appreciation. Farmland assets are a source of consistent income, which is generated either through leasing out the property to operators or by directly managing the assets. The level of income from farmland investments varies by commodity, region and operating model, and a well-diversified portfolio can potentially generate an attractive annual income.
Adding farmland assets to a broader portfolio should have substantial diversification benefits, compared to both mainstream and other real assets. Returns for farming are impacted by factors such as the climate, demographics, trade and government policy in ways which are unique to the asset class. Furthermore, farmland investments have substantially less correlation to economic growth than other assets. This is particularly contrasted with timber investments that have a high correlation to economic performance due to the linkage with the real estate sector.
Investing in real assets is particularly attractive as a hedge against rises in inflation. Farmland is by nature an effective hedge against inflation over the longer term. Historically, farmland has had a positive link to the level of inflation through two key mechanisms, namely through long-term adjustments in land prices and short-term sensitivity to commodity prices.
Commodity prices, being more sensitive to bouts of unexpected inflation compared to other assets, are likely to reflect changes in the environment and expectations much more quickly and possibly overshoot in certain environments, particularly on the upside, before moving back to equilibrium. This heightened responsiveness to changing inflationary conditions is what creates the link in the short term. In the longer term, the capital value of the land itself also provides a link to inflation similar to other tangible assets, of which there is a finite supply.
The inflation protection that farmland provides is compelling and “inexpensive” when compared to other alternatives. Whereas inflation-linked bonds may provide the most reliable hedge, the return give-up for investing in them can be substantial and possibly unjustified in today’s extremely low interest rate environment, making them an “expensive” hedge. Farmland investments, on the other hand, would be expected to have a high beta (or sensitivity) to inflation due to the quick response of commodity prices to unexpected inflation, albeit being less reliable than an inflation-linked bond.
When investing in global farmland, it is important to focus on responsible investment implications. We believe this should be a core consideration as agricultural production is an essential resource for society. From an investment perspective, the key advantage of doing so, we believe, is to enhance performance over the long term while at the same time mitigating downside risk.
Insight believes that the best approach is to embed responsible investment considerations throughout the investment process, from the investment selection phase, through to the day-to-day management and execution. The core of Insight’s approach is based on Integrated Farm Management, a dynamic framework developed by LEAF (Linking Environment And Farming), which aims to provide guidelines for effectively balancing farming’s key objectives of productivity and profitability with environmental and other considerations.
Institutional investors and asset managers, including Insight, have been proactively looking to formalise guidelines for investing in farmland in a global framework. The main motivation for this has been to foster greater transparency and to encourage investment in an asset class which is deemed to be of long-term interest to investors. The effort has now been incorporated within the UN Principles for Responsible Investment, of which Insight is a founding signatory.
We believe the case for real assets is well understood in terms of its potential in generating returns over the long term and for its role as a good diversifier. However, the opportunity for greater diversification within real asset categories exists given that farmland investments have so far been underrepresented in investors’ portfolios in favour of property and infrastructure investments.
Exposure to global farmland can be achieved through different vehicles and a range of strategies. Companies with close ties to the sector, either directly or indirectly, exist at all points along the value chain and may present attractive investment opportunities. We believe direct ownership of farmland assets is a unique investment proposition as it offers significant diversification benefits, inflation hedging characteristics and the potential for capital appreciation and steady income generation over the longer term. Demographic trends and pressures on natural resources have resulted in constraints on the availability of quality land, underpinning the secular case for the asset class.