Key Points:

* Agribusiness funds generally employ two main methods to obtain exposure to the sector – through
indices linked to commodity prices and through equity investments in related companies
* Strong population growth, increasing middle class and increasing productivity are three major drivers
for agribusiness
* Competition for arable land from fuel crops may put cost pressures on certain companies
* The agribusiness fund on Fundsupermart.com platform – DWS Global Agribusiness

Dr. D. Subbarao, Governor, Reserve Bank Of India states, “Headline and core inflation have significantly
overshot even the most pessimistic projections over the past few months. This raises concerns about
inflation expectations becoming unhinged.”

The negative outlook was issued in the monetary policy statement for the financial year 2011-12. The
price rise has left the common man as well as policy makers quite distressed. One sector that has been
touted to be able to benefit from rising inflation is agribusiness.

What Is Agribusiness?

The agribusiness sector, as its name suggests, mainly invests in commodity indices, companies that are
related in the agricultural products value chain or a mix of indices and equities.

The sector is commonly sub-divided into three sections – upstream, midstream and downstream. The
following diagram gives a good idea of the typical processes involved in each section of the value chain.
Reasons For Agribusiness

Strong Population Growth

One of the main drivers of agribusiness is the exponentially increasing global population. Based on UN
estimates, global population will hit 8.9 billion by 2050 based on medium growth projections, a 29%
increase from today’s population of 6.9 billion (See Chart 1).

The relationship between population growth and the prospects of agribusiness is relatively
straightforward. An increasing populations drives up demand for food, which some analysts argue will
lead to similar growths in companies’ earnings.

Growing Middle Class

Another global trend that may boost earnings in the agribusiness sector is the rapid growth of the middle
class. One yardstick of ‘middle class’ is the proportion of discretionary income to an individual’s total
income. An individual who has approximately a third of his income left for discretionary spending after
paying for necessities like food and shelter is deemed to belong to the middle class.

Chart 1: Estimated world population, 1950-2000, and projections: 2000-2050

In February 2009, an estimate by The Economist puts more than half of the world’s population in this
category. The article also highlighted that the middle class population in China jumped from 15% to 62%
of its total population from 1990 to 2005 and more countries are expected are expected to experience this
exponential rise in its middle class population, India being a prime example.

Since the middle class by definition has a sizeable amount of income for discretionary spending, analysts
believe that demand for a higher quality of life will lead to increasing amount of spending of higher-quality
food products. Similar to the argument for an increasing global population, proponents of agribusiness
believe these trends will contribute towards the coffers of companies.

Increasing productivity

Another factor in favour of agribusiness companies is the potential for increased productivity through the
use of technology. Compilations by the US Department of Agriculture (USDA) and AGCO Corporation, an
agricultural equipment manufacturing company, show the gap in corn yields between US and the rest of
the world.

Chart 2: Differences in corn yields between US and the rest of the world

It is theorised that with better use of technology such as harvesting techniques, fertilizers, stronger strains
of crop, and automated machinery to increase farm efficiency, crop yields in less developed countries
may reach levels of those in their developed counterparts.

Thus, the belief is that this difference in crop yields are representative of the upside potential that
companies have not harnessed. Increasing productivity levels should boost revenue margins, thereby
increasing companies’ earnings in the long term.

Ways to invest in Agribusiness

There are two main ways for agribusiness funds to obtain exposure to the sector:

- Through a basket of indices that track commodity prices, or

- Through investments in the companies that participate in the value chain of agricultural products

A fund that uses the first method will be less concerned with corporate earnings and company strategies
since its returns will follow commodity prices as opposed to equity prices. Instead, factors such as
weather, political agreements, and natural disasters will probably have more impact on commodity prices,
and hence the fund’s returns. Such funds will probably provide a partial hedge against inflation, since the
impact of inflation has already been priced into commodity prices. In addition, historically, commodity
prices are usually less correlated to the broader equity market, thereby providing diversification benefits.

However, direct investors of commodities should expect a more volatile ride since their returns are tied to
commodity prices without any buffer to ease out any large movement in prices should any event severely
affects the supply or demand of a particular commodity. Examples include the occurrence of natural
disasters or political conflicts that disrupt supply which may push up prices.

On the other hand, funds that invest directly into the equity of related companies will have to pay greater
attention to each company’s strategy instead of the price movements of the underlying commodity. Even
when faced with decreasing profit margins, companies that are able to grow their business volume will be
able to maintain their value.

We may use the Gordon Growth Model to illustrate. The model is a simple tool used to determine the
intrinsic price of a security based on its future earnings or dividends.

P0 = price at t = 0
D1 = dividend at t = 1
k = required rate of return by investors
g = growth rate of company

The numerator, D1, is used as an approximation of the firm’s future earnings at t = 0. It can be deduced
from the formula that even if the firm’s earnings may decrease, a stronger growth rate, g, will be able to
compensate for the loss.

Hence, investing in the agribusiness sector through related companies may give lower volatilities with
smoother returns as compared to investing through commodity indices.

Points To Note

Though there are many compelling factors for investing in agribusiness, there are also some arguments
against it.

Competition For Arable Land

As the world turns towards clean and renewable energy, the competition between food crops and fuel
crops for arable land has heated up. In Brazil, 8.7% of its arable land is used for sugarcane for the
production of ethanol as a biofuel in 2005 (Table 1).This number will only go up as demand for biofuels
increases.

Brazil’s Agriculture Minister Luis Carlos Guedes Pinto announced in 2007 the government’s intention to
raise US$13.4 billion worth of investments to increase its ethanol output and triple its ethanol exports by
2014. Other than Brazil, several countries have demonstrated interest in ramping up usage of biofuels in
place of conventional fossil fuels. The European Union legislated that all gasoline had to be blended with
2% ethanol, starting in 2005. This blend has since increased to 5.75% ethanol in 2010. Sweden has also
rolled out incentives for using flexible-fuel cars that are capable of running on any proportion of blend
between gasoline and ethanol. Both Japan and China have also passed laws for gasoline-ethanol blends,
and are negotiating ethanol trade with Brazil.

Table 1: Ethanol productivity in Brazil, 2000 to 2005

Area/Year 2000 2005
Total arable land for permanent crop 65.2 66.6
Ethanol area harvested 4.8 5.8
% ethanol area harvested per total arable land 7.4% 8.7%
Source: Food and Agriculture Organization of the United Nations, 2009

Increased competition for arable land for use of fuel crop instead of food crop will probably lead to higher
land prices, putting cost pressures on companies. Companies who have greater pricing power and are
able to pass on such costs to customers will not be affected much. However, firms who are unable to do
so will face lower margins and depressed earnings.

Hence, though agribusiness companies may benefit as a whole due to increasing global population, there
is an uneven playing field and companies will not share equal growth prospects.

Rounding All Up

While there are many global trends that look to support the agribusiness sector fundamentally, investors
should take note if the investment product they invest in provides them with the type of exposure and risk-
reward profile they desire.