Agriculture, natural hedges and BRICs

abnormalreturns
February 21st, 2008

The impact of rising food costs are now becoming too large to ignore. Barry Ritholtz at the Big Picture notes how soaring commodity costs have impacted the bottom line of the nation’s largest food companies. This will likely lead to even higher prices at the grocery store.

There has surely got to be an investment opportunity in all of this? James B. Stewart at WSJ.com thinks so:

There isn’t much consumers can do about it [food price inflation], short of going on a crash diet. But you can ease the pain by sharing in some of the profits that are flowing into the agricultural sector.

Dedicated readers of Abnormal Returns will note that this is argument is similar to one we have made for quite some time. The concept of ‘natural hedges‘ tries to bring into highlight the purpose of our investment portfolios. Investments are not ends, in and of themselves, rather their purpose is to generate funds for future expenditures. So from an asset-liability perspective our consumption of various commodities plays a meaningful role in future expenditures and overall portfolio construction.

The ETF boom has created a number of vehicles to invest in the agriculture sector. The biggest decision investors need to make is whether they wish to play the sector through commodity funds dedicated to agriculture futures or via the equities of companies exposed to the agricultural sector.

To us, the interest in the agriculture sector reminds us of the BRIC phenomenon. Some investors have focused on four major emerging markets (Brazil, Russia, India & China) to the exclusion of the broader emerging market sector. That has indeed been a good strategy to-date. The question is whether focusing on the agricultural sector to the exclusion of the broader commodities world (energy, metals & livestock) is a worthwhile distinction as well.

In the past we have written about how one could use portfolio simplicity as an investment guideline. Trying to sort through the various agriculture investment options from futures to stocks to ETFs is anything but simple. Done properly it requires some knowledge of the futures market dynamics and the workings of the agriculture sector. Only dedicated investors looking to generate alpha need apply.

The boom in the agriculture sector is currently front page news. It could very well be the case that the agriculture sector is in the midst of a long-running bull market. The fact of the matter is that well-diversified investors already have some exposure to the agriculture sector through their equity and commodity investments.

In that light, investors need to ask themselves two questions: how much exposure do I already have to the agriculture sector? And is that too little, too much or just enough? The answer to the first question in knowable (and measurable), the answer to the second question is (as always) entirely up to you.