Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, James Govan, Investment Manager of the Baring Global Agriculture Fund, gives his latest investment update.
We are currently living in an exciting time for the agricultural equity market that has yet to be widely recognised by investors. In particular, we do not believe the market has adequately discounted the potential impact of El Niño – a band of warm air that comes off the ocean, which can cause tropical storms – on agricultural commodity prices and what it could mean for upstream producers.
While there are a number of influencing factors to supply and prices, we believe El Niño should be supportive. Together with an upturn in M&A activity in the industry, this could provide additional benefits at a time when we are already seeing compelling valuations in the sector with an earnings outlook that we believe is superior to the wider market.
The El Niño Opportunity
During the last significant El Niño cycle in 2010, Chicago corn futures rallied 78%. Then, as now, grain and edible oil prices started at depressed levels. Chicago corn futures traded at around $3.50, similar to levels in June this year. In 2010, US crop production estimates were progressively lowered in part due to El Niño related weather patterns.
El Niño is already affecting this year’s harvest in the same way, with wet weather across the US Midwest driving down market estimates for corn and soybean production. In contrast, we are seeing dry weather across Western Canada with large parts of the prairie provinces Saskatchewan and Alberta experiencing their driest weather since 1932. South East Asia’s palm oil growing regions are also seeing dry weather patterns.
Chicago corn futures rallied from the lows on June 15 as the market factored in lower US production forecasts due in large part to the wet weather. In addition, corn and soybean inventories were below market expectations in the US Department of Agriculture report on 30 June 2015, indicating strong corn and soybean demand. Accordingly, we believe we have seen the bottom in the corn price for this year.
Going forward, we think the effects of El Niño will be strongly felt in 2015. The Australian Bureau of Meteorology’s climate models indicate El Niño will likely strengthen this year and persist into early 2016. Unlike commodities, agricultural equity prices have yet to react to the potential of the El Niño effect, so we think the upside potential is not yet being factored in by the market.
In fact, the fund trades at a discount to the MSCI AC World Index on a 12 month forward price to earnings basis and offers double the earnings growth over the next 12 months on IBES consensus estimates.
Mergers and Acquisitions Rising
Today’s other parallel with 2010 is the surge in M&A activity. We often see this at the bottom of the cycle for companies that are linked to commodities and it can be viewed as an indication that corporate buyers see good value opportunities in the market. In 2010, the deal of the day was resource major BHP Billiton’s (BLT) bid for fertiliser giant Potash Corporation. While ultimately unsuccessful, the bid helped to invigorate the agriculture equity market.
We think deal activity today could provide a similar catalyst. This year, we saw a bid by the world’s number one seed producer Monsanto for Syngenta, the leading global crop protection company. We are invested in both Monsanto and Syngenta and would view a deal as transformational to these businesses and positive for shareholders in both companies.
In fertiliser, Potash Corp has emerged as a bidder for German potash rival K+S. We are also invested in Potash and K+S and believe the attainment of a deal would ultimately be beneficial for investors in both businesses.
Prepare for Changing Market Conditions
In our view, the market does not seem to have adequately discounted in the potential material impact of El Niño and the positive benefits that could accrue to upstream producers. We recognise that it is not the lone factor that will influence crop pricing and harvests, but it is important. In September, the US Department of Agriculture release their global supply and demand estimates, following the key months of July and August for the US crop, which should provide greater clarity on the factors shaping prices.
We are positioning our strategy to benefit from the changing market conditions. We have more exposure to companies upstream that stand to benefit from a rally in soft commodities than we have in recent years. With 60% of the portfolio invested in upstream companies at the end of June 2015, it stands at the highest level since December 2012. Furthermore, we consider valuations for the sector to be compelling, particularly as they trade at a discount to world equities while offering a superior growth outlook.
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