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 more...>Louisiana Agriculture Magazine>Past Issues>2012>Summer>

If Market Investors Turn to Agricultural Stocks, Why Shouldn’t Farmers?

Joshua D. Detre and Hector Zapata

Louisiana farmers are constantly seeking to improve profitability and reduce business risk. To accomplish this, they often use futures markets, crop and livestock diversification, insurance, value-added agricultural enterprises, and other farm business management strategies. Of particular interest is the development of value-added enterprises that focus on healthy foods and agrofuels such as ethanol and biodiesel. The growing consumer demand for locally sourced and organically raised food along with rising oil prices has made value- added activities economically viable for Louisiana farmers.

Indeed, given the unprecedented growth in these areas, agribusiness corporations are no longer ignoring these markets. Instead, they are making significant investments in these new ventures. For example, food processors and manufactures such as General Mills and Unilever have introduced their own organic product lines. Archer Daniels Midland (ADM) and ConAgra are investing in the agro-fuels market. Wall Street has taken notice and recognized that agribusinesses are involved in industries necessary for human survival and are rewarding them accordingly. For example, Standard and Poor’s (S&P) is one of multiple investment houses that has developed thematic indices devoted to natural resources and agriculture. Investment in agribusiness and commodity indices allows farmers to have exposure to the supply chain of the agribusiness sector without having to make physical investments in facilities necessary to produce value-added agricultural products.

This begs the question: Do agribusiness stocks, similar to commodity futures markets, provide diversification potential for Louisiana farmers? The answer requires knowledge of the relationship of farm profitability measures to the returns from investing in publicly traded agribusiness firms. For example, if a farmer owned two assets, a corn operation and shares in ADM, and those two assets were perfectly negative correlated (when one asset is up, the other is down), all portfolio risk would be eliminated. However, if they happen to be perfectly positive correlated (both assets are up or down at the same time), the combination does not eliminate any risk in the farmer’s portfolio. Thus, farmers through the combination of various on-farm enterprises and publicly traded agribusiness stocks would seek to maximize the risk-adjusted return in their portfolio, which would minimize risk for a given level of return through diversification.

Farm profitability is typically measured using two ratios: return on assets (ROA) and return on equity (ROE). For this study, profitability data for Louisiana farms was obtained from the U.S. Department of Agriculture’s (USDA) ARMS database from 1991-2010.

Annual returns to publicly traded agribusiness firms are measured by the percentage by which the value of the stock has grown or declined from January 1 to December 31 for a year. This holding period return for the agribusiness stocks is calculated from data obtained from the Center for Research in Security Prices (CRSP). The CRSP database is the leading provider of the most comprehensive U.S. historical stock market databases.

The USDA’s Economic Research Service provides a listing of industries closely related to farming by SIC code, which includes those industries having generally 50 percent or more of their national work force employed in providing goods and services necessary to satisfy demand for agricultural products. For this study these SIC codes were used to cull the S&P 500 to obtain a list of publicly traded firms with SIC codes that correspond to the Economic Research Service classification of agribusiness firms. For a firm to be eligible for inclusion in this analysis, it had to be an active member of the S&P 500 from 1991 to 2010.

Results of the correlation analysis between the 29 publicly traded agribusiness firms and the two farm profitability measures reveal a changing story about the relationship between farm and agribusiness profitability. First, correlations over the entire 20-year period show that agribusiness stock returns and farm returns have a small positive average correlation across all stocks for ROA and ROE. In particular, 19 out of the 29 agribusiness stocks exhibited a positive correlation, which means that there is some evidence that farm profits move in the same direction as the returns to the agribusiness stocks, but they do not move in lockstep.

This positive relationship does not hold for the most recent 10-year and five-year periods. There is a dramatic shift in the average overall correlation value from being slightly positive for the 20-year period to large negative values of minus 0.38 and minus 0.39 for ROA and ROE, respectively, for the 10-year period, and minus 0.70 and minus 0.73 for ROA and ROE, respectively, during the fiveyear period. These results indicate that the profitability of farms and agribusiness no longer move in the same direction, but instead in opposite directions.

At first, these results seem surprising because commodity prices reached record highs during the most recent five-year period. It is important to note that high revenues are not necessarily indicative of high farm profits, which were dampened by soaring input costs, both variable and fixed. Moreover, agribusiness stocks and commodity markets in a declining stock market have traditionally outperformed other industries because food prices typically increase during market downturns. Based upon the aforementioned results, it appears that diversification benefits of investing in publicly traded agribusiness by Louisiana farmers have increased over the past 20 years as the general market conditions became more favorable for both pre and post farm-gate agribusinesses relative to farms. Consequently, the overall return to a farm household would have been subject to less risk if the farm operator had incorporated publicly traded agribusiness stocks in his/her portfolio of assets.

Benefits to investing in agribusiness stocks go beyond diversification. First, with the increased emphasis being place upon capturing more of the consumer dollar beyond the farm gate, stocks offer a less expensive and a more liquid investment opportunity than traditional value-added investments. For example, a row-crop producer could buy shares in ADM or they could invest in physical facilities such as crushing facilities, wheat mills or grain elevators. By using an online brokerage service platform, the producer can quickly buy and sell at his/her convenience, and the transaction costs of conducting such trades are relatively small. Moreover, anyone across the globe can purchase the farmer’s shares of ADM, whereas the market for buyers of a grain processing or procurement facility in Louisiana is relatively limited, and the transaction costs associated with such a sale can be extremely high.

Second, and related to the first, is that publicly traded agribusiness companies such as ADM have both proprietary knowledge about the end-users of agricultural products and established distribution channels. While it is true that a row-crop farmer might eventually develop these channels and acquire this knowledge, such an endeavor would likely be time and cost prohibitive.

The aforementioned example illustrates why the stock market may be an additional strategic management tool that Louisiana farmers can utilize to improve the profitability of their farm operation. Investing in the stock market involves the potential for substantial loss as well as significant gains, but this holds true for farming returns and returns to physical assets beyond the farm gate. Consequently, if farmers choose to use publicly traded agribusiness stocks as a source of diversification, they will need to devote time to understanding market fundamentals that can influence the share value of publicly traded agribusiness stocks. Louisiana farmers have a competitive knowledge advantage, relative to nonfarm investors, about market fundamentals influencing agribusinesses because they are both consumers (input buyers from agribusinesses) and producers (input suppliers to the value added sector). Many agribusiness stocks have been great investment opportunities over the past decade. While past performance may not be a predictor of future performance, agribusiness stock investments may be a lower risk hedging alternative for some Louisiana producers in the future.

Acknowledgment: Robert Dubman, Survey and Data Coordinator, Office of the Director, RRED USDA/Economic Research Service, Washington, D.C., for providing ARMS Data on Louisiana Farms from 1991 to 2010 and Matt Fannin, Associate Professor, Department of Agricultural Economics & Agribusiness, LSU AgCenter, Baton Rouge, LA for his helpful comments.

Joshua D. Detre, Assistant Professor, and Hector O. Zapata, William H. Alexander Professor, Department of Agricultural Economics and Agribusiness, LSU AgCenter, Baton Rouge, LA.

(This article was published in the summer 2012 issue of Louisiana Agriculture magazine.)

 
Last Updated: 9/18/2012 10:12:54 AM

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