Note: this article first appeared in Global AgInvesting on April 23, 2019 globalaginvesting.com. This is the second article of a series published by GAI News. The first installment can be found here. The eight-part series will examine how the global food system is set to be altered by eight existing trends.
Primary author: Jeremy Stroud, Bonnefield, Agricultural Investment Analyst
Contributing author: Michael DeSa, AGD Consulting
“The nation that destroys its soil destroys itself.” – F.D. Roosevelt
The oft-imagined idea of fertile, pristine farmland as far as the eye can see is drifting towards the past. Land loss is more than just a blow to those who grasp on to a pastoral ideal of the countryside; rather it marks a shift in the global supply dynamics of land resources. The literature presents a singular case: more topsoil is removed from production than is added, with some academics estimating a reduction of about 1 percent each year.
Healthy topsoil is home to billions of thriving micro-organisms which allow crops to be optimally produced. As the top soil is physically eroded or disrupted, its biological matter also declines, and therefore its capacity to produce optimal yields is compromised.
Land scarcity is not a new concept, although with the level of impact it is expected to have on society, it is a topic that deserves more discussion. In the first article of this series, we discussed the effects of urbanization on the global agricultural system. This commentary will examine another piece of the farmland usage puzzle and its impact on our collective accessibility to food: land degradation and soil erosion.
Land degradation refers to human-derived processes which lead to the decline in ecosystem functions. It manifests itself in three different forms:
physical: compaction, desertification, and soil erosion (which is the largest contributor to productivity loss)
chemical: soil acidification and salinization
biological: soil organic matter reduction and loss in biodiversity
Farmers work in different ways to combat chemical and biological forms of land degradation, although the most persistent and arguably the most difficult to mitigate of these, is physical degradation of topsoil. While usually considered as a local concern, soil erosion, compaction and other types of land degradation are globally consequential issues and evidence suggests they will have direct implications for the world’s food supply.
The Inter-Governmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) is widely considered the international authority on bio-ecological matters. The organization recently concluded a three-year study analyzing the status of global land and soil quality, which collected insights from over one hundred of the world’s leading subject experts. They found that approximately 3.2 billion people, or nearly 43 percent of the world’s population, experience negative economic impacts from land degradation in industries varying from agriculture to tourism, to mining. The effects of land degradation are expected to accelerate in magnitude as the degree of high-volatility weather systems increase.
The Causes and Status of Land Degradation Globally
Erosion takes place when soil is left uncovered and the particles are washed or blown away. Heavy downpours, surface water ponding, intensive land use and mechanical human activities are continuing to reduce top soil – particularly in the most intensively farmed regions. For example, China and India are losing topsoil at three to four times the rate of North America. Land erosion and degradation also occurs due to tillage, deforestation, and an increase in rainfall intensity. One study indicates that there has been a 53 percent increase in the number of extreme rainfall days recorded globally over the past 30 years, thereby leading to record levels of erosion and runoff.
In the past 20 years, a greater proportion of rainfall has arrived in the form of extreme single-day weather events than has ever been recorded. Figure 1 demonstrates the percentage of land area in the contiguous United States affected by extreme precipitation in each year as reported by the National Oceanic and Atmospheric Administration. The orange line represents a nine-year trailing average, highlighting a significant fact for soil erosion: the average percentage of US land affected by extreme one-day rain events has increased from 7 percent in the 1970’s to 18 percent in 2015.
Figure 1: Extreme One-Day Weather Events in the Contiguous United States, 1910-2015
Erosion naturally leads to further soil compaction, nutrient degradation and impaired water drainage, which reduces the overall productive capacity of the land. With nearly 60 percent of the world’s farmland considered degraded, our arable land base is steadily declining.
Figure 2 demonstrates where the greatest soil erosion concerns are expected to occur in the future based on a detailed joint study by the European Commission and the University of Basel. The R-factor is the rainfall-runoff erosivity factor, or an annual summation of erosion index (EI) values (erosion force of rainfall) in a normal year’s rain.
Figure 2: The Geo-Spatial Pattern of Soil Erosion, 2018
Opportunity Amidst the Loss
As soil degradation increases the scarcity of fertile land, it also creates the need to incorporate sustainable farm management practices and pursue responsible investment goals. Farmland investors and stakeholders should consider five primary categories in their path to mitigate soil erosion effects and potentially reap the upside potential that follows:
1.) Deal Sourcing & Region Identification: Investors should look to identify farming regions with topsoil abundance, low wind and flood risk, and relatively flat or rolling terrain. Investment teams have the responsibility to review an area’s historical and forecasted climatic risks in advance of deal selection. This includes past precipitation and temperature averages, available soil and yield mapping data, historical input usage, previous environmental issues and/or remediation measures. Investors may also want to consider geographic regions that successfully practice no-till land preparation, such as Argentina, Australia, and Canada.
2.) Due Diligence: Most farmland asset managers should be able to leverage geo-spatial information data and measurement tools to determine how past farm imagery compares to the current status of the field. It is also worthwhile to consider warning signs such as noticeable compaction, dispersed ponding, and natural drainage flows.
3.) Sustainable Farm Management Practices: Farm operators have the opportunity to replenish topsoil quality through the implementation of practices such as no-till and low-till farming, as well as the regular use of green manure crops to enhance soil biodiversity, structure, and to replenish nutrients. Further, integrated pest management (IPM) plans leveraging biological and mechanical processes can control pests while reducing chemical pesticide use.
4.) Investment in Loss Prevention & Restoration: Capital expenditure in ditching, tile drainage, external tree-borders, berms, and riparian-buffer maintenance can control soil erosion effects while also mitigating natural disaster risks such as flooding, wind damage, and surface ponding. For permanent and specialty crop strategies, the implementation of technology and products offered by groups like the Land Life Company – a startup that is working to restore ecosystems in degraded soil regions through reforestation efforts – should be considered CapEx well spent.
5.) Long-term Tenure Mindset: Investors who plan to own and/or operate farmland for the long-term will be naturally incentivized to adopt sustainable land management practices which can promote the health and productivity of soil. Farmland owners should be cautious of short-term (less than three year) lease structures which may create the risks of nutrient mining or high-intensity agricultural practices.
With land degradation on the rise, the tools to reduce soil loss and protect these investments are slowly becoming more available and adoptable. As soils from intensive agricultural regions continue to deplete, we hypothesize that land managed with sustainable practices shall prove to be significantly more valuable in the decades to come.
Note: this article first appeared in Global AgInvesting on March 21, 2019 globalaginvesting.com. This is the first article of a series published by GAI News. The eight-part series will examine how the global food system is set to be altered by eight existing trends.
Primary author: Jeremy Stroud, Bonnefield, Agricultural Investment Analyst
Contributing authors: Michael DeSa, AGD Consulting and Solomon Tiruneh, AGD Consulting
It is no secret that our global food system is in a state of flux. In the next century, we will be challenged to produce more food with less land, by fewer farmers, and with increasingly scarce water resources. Although evidence suggests that we as humans have the capacity to achieve this, it is imperative to explore what changes can be expected from the planet’s climatic and demographic variability. The purpose of this article series is to provide insight on these changes and place a spotlight on the regions which may weather the change most effectively. While other parts of the world are projected to experience comparatively strenuous conditions, parts of the Canadian and U.S. agricultural systems are positioned to endure and even prosper in the face of a changing climate and demographic.
A combination of industry and academic literature indicates eight existing trends that are set to alter the structure of our global food system. A growing body of data indicates that these factors may determine our collective success or failure:
1. Urban expansion
2. Land erosion and degradation
3. Fresh water scarcity and agriculture’s reliance on irrigation
4. Increasing temperatures and CO2 levels
5. Volatility of weather systems
6. Global phosphate over-use
7. Bee fatalities and pollination
8. Population growth in proportion to arable land
As with any changing market, structural movements can lead to inefficiencies which are then corrected by the activities of market participants. In this case the global agri-food sector could face extensive resource constraints and shifts in pools of capital over the next half century. This may establish the environment for public and private entities to create efficiencies by allocating capital to new infrastructure projects, accessible financing alternatives, synergistic consolidation, progressive policies, and industry-led innovation.
Let’s start with a topic that is close to many of our homes – urban expansion:
It is a modern reality that some of the world’s most fertile soil is now beneath several layers of concrete. Cities were originally established based on their proximity to agriculturally productive land and its strategic significance. As economies continue to shift from rural to urban residency, the world’s major cities naturally expand outwards. Unless geographic or regulatory restrictions exist, cities extend by developing into farmland areas that had historically been the source of their nourishment. Currently, populations in developing economies are urbanizing at a rapid pace with 40 percent of urbanization taking place in developing slums – a trend that is expected to heighten regional socio-economic disparities and sanitary-access concerns. The global urban population is set to increase by 2.5 billion people by 2050, with India, China, and Nigeria accounting for nearly 900 million additional people. Figure 1 highlights the global shift in urban vs. rural populations.
Urban expansion is projected to reduce our global cropland area by 47 million acres between 2015 – 2030, and it is taking place on cropland that is 77 percent more productive than average. This is an especially concerning issue in the developing world where population growth will expand at the highest rate throughout ‘mega-urban’ areas. Nearly 90 percent of the world’s cropland loss due to urban expansion will take place in Asia and Africa. Figure 2 exhibits the fertile areas which will be hit hardest by urban expansion.
Crop growing regions are affected by urbanization to a far lesser extent in countries with dispersed population centers, an abundance of land resources, and proactive land-use regulations, such as in Canada, the U.S., and Australia. In Canada, for example, the Golden Horseshoe Greenbelt and Agricultural Land Reserve Acts collectively protect more than 13 million acres of productive farmland. Although it may make immediate economic sense for cities to develop outwards instead of upwards, natural geographic barriers to urban expansion have contributed to some of the most prosperous and concentrated cities on the planet, such as New York and Singapore. Increased urban density (whether a consequence of necessity or planning) has also been correlated to increased productivity and wages due to the cost savings derived from urban agglomeration.
Urban Expansion and Agricultural Investing
With the emergence of concerns relating to urban expansion and its effects on agriculture, our minds naturally lean towards the merits of indoor farming as a solution to farmland loss. While urban and greenhouse farming projects have developed rapidly due to recent technological advancements and access to venture capital funding, the types of foods grown in enclosed settings are typically exclusive of the grains, oilseeds, pulses, field vegetables, and permanent crops grown on farms. The future of our food system will likely consist of a complementary combination of climate-controlled indoor and traditional outdoor farming methods rather than a slant towards just one. Investments on both sides of the agricultural production spectrum are expected to generate similar risk-adjusted returns over the long term, albeit with differing levels of volatility, asset capital appreciation, cash flows, operational risks, and sensitivity to commodity price fluctuations.
Within the context of global urbanization, farmland located on the perimeter of a growing city will typically command price premiums for development potential. This land is no longer valued for its productive agricultural capacity and would be considered a different investment class altogether. Some of the safest and most fundamentally-sound agricultural investments available are located in close enough proximity to supply growing cities with fresh food, yet far enough away not to have development premiums. These assets naturally lend themselves to the pursuit of sustainable development goals through farmland protection and their function in nourishing a demand-oriented market. Further, they retain logistical and shelf-life efficiency, particularly for direct-to-eat goods. An investment of this type also may be optimized and expanded in the long term to increase economies of scale and capacity for production of different crop types.
As productive crop growing land becomes increasingly scarce over the next century, the significance of fertile land assets have every reason to flourish.
When we founded Bonnefield ten years ago, we purposely set out to devise a business model that would create value for our investors by creating value for farmers. We believed then, and believe even more strongly now, that creating value for farmers naturally translates into value creation for our investors whose farmland portfolios we manage; a win-win for both investors and farmers. Value creation for farmers manifests itself in various ways: in financial flexibility, enhanced profitability, improved sustainability, and in contributions to local farm communities across Canada.
We codified our approach in a responsible investing policy (available here) and we actively monitor and track the environmental and social aspects of our investing activities on a property-by-property basis in our annual reports to investors. We have also tried to lead a broader discussion in the Canadian agricultural community on the benefits of responsible investing through public events such as local community town hall meetings, educational conferences, public speaking events, farm tours, documentary sponsorships and by participating in policy discussions with government officials and academics. In 2014, Bonnefield was the first Canadian farmland manager to become a signatory to the UN’s Principles for Responsible Investing.
Given this background, it has been gratifying for us to see evidence of other investors taking a sustainable approach to the agricultural sector. Over the past quarter alone, we have witnessed high-profile momentum in the sustainable agricultural investment space. There appears to be promising action being taken by investors to address some of the long-term sustainability issues facing the world’s food production systems, and we are hopeful that this emerging trend will become a broad movement. Some examples:
A group of influential investors including Bill Gates, Jeff Bezos, Ray Dalio, Richard Branson and Michael Bloomberg collaborated to form an investment fund named Breakthrough Energy Ventures (BEV). The firm offers patient capital to companies with high-impact potential and that aim to solve major, global issues. Last month BEV led an investment round in Pivot Bio, an agricultural company working on nitrogen-fixing microbes aimed at reducing fertilizer use and, thereby, environmental impacts and operating costs for farmers.
Jeremy Grantham’s Environmental Trust also led an investment round in the agricultural space. In October the trust invested in Land Life Company, a technology firm with the aim of reducing global soil degradation. They will continue to work on projects which meet their aims by offering technologies such as autonomous planting, remote sensing and blockchain verification. Grantham, co-founder of the $70 billion investment firm GMO Capital (and who I have frequently quoted in my blog posts), has adamantly expressed the importance of investing in sustainable agriculture as climate change, land scarcity and changing diets in the developing world are projected to threaten our global food system.
These stories are evidence of a growing trend: investors are giving greater consideration to environmental, social and governance (ESG) outcomes of their agriculture investments. According to the latest trends report from the Responsible Investment (RI) Association, more than half of the Canada’s investment industry considers ESG factors in their investment decisions, representing over $2 trillion in assets under management.
Impact investing takes the ESG mandate a step further by promoting investment-specific outcomes within a responsible investing framework. The Responsible Investment Association notes that impact investing in Canada has grown by over 60% (as measured by assets under management) over the past two years alone. Investors visibly aim to make a positive contribution to society while also generating attractive returns. Investors are aligning their portfolios with their values and allocating assets towards social and environmental progress as well as profit.
We are pleased to see that impact investing is being transformed from a soft, fuzzy platitude to its rightful place as a respected core principle of global financial best practices.
Canada’s farmers bring to mind the black knight in Monty Python and The Holy Grail. They keep on fighting despite being thrashed, again and again, by the seemingly endless series of challenges thrown at them over the spring and summer months: extreme weather patterns, NAFTA renegotiations, collateral damage from US-China tariffs, a diplomatic spat with Saudi Arabia and even a bizarre whodunnit relating to genetically modified wheat that mysteriously appeared in Alberta. Many of these issues remain fluid, but here is a brief mid-season summary of where things stand down on the farm:
Weather – No part of the country has had “normal” weather this growing season. The west has struggled with continued dryness all season, Central Canada had a cold wet spring followed by dry, searing heat punctuated with the occasional flooding rain storm, and the Maritimes experienced early season flooding and unseasonable heat over the summer months. Despite these challenges, our property management team reports that, for most Canadian farmers, the crops are looking quite good. Are this summer’s weather patterns an aberration or the new normal caused by climate change? The Economist recently published an excellent article on this debate here.
NAFTA – The ongoing NAFTA re-negotiations have been front-page news for more than a year now, but despite almost 24/7 coverage, no details have been publicly revealed about the potential impacts that a new deal (if any) would have on Canadian farmers. One of President Trump’s favourite objects of scorn is Canada’s supply management system for dairy products. Putting aside the fact that the US also heavily subsidizes its dairy sector, it is likely that any renewed NAFTA will mean changes for Canada’s dairy farmers. Nonetheless, we do not believe these potential changes are a significant risk for Canada’s overall ag sector. Any changes to the current system would likely include generous transition assistance that would limit the impact of any changes for Canada’s dairy farmers. In the long run, we believe that any trade deal that increases Canada’s access to booming world dairy markets, would be a net benefit to Canada’s dairy farmers. Our current supply managed dairy system effectively shuts Canadian farmers out of the strong worldwide demand for dairy products (especially from China), so greater access to world markets would, in the long run, be an opportunity not a threat to Canada’s farmers. An excellent report by Al Mussel of the Agri-Food Policy Institute separates fact from fiction in the dairy dispute and can be found here.
China-US Trade War – Canadian soy farmers have been caught in the crossfire of a tit-for-tat tariff war between China and the US. In early July, China levied a 25% tariff on soy imports from the US. In anticipation of an expected oversupply of US soy on world markets, the price of soy has recently declined to USD$310 per metric ton, from USD$442 per ton in April. The weak Canadian dollar has insulated farmers in this country to a certain extent, but prices are clearly depressed from where they would be in the absence of the trade dispute. Our view is that the market has over reacted and in the long term, if the trade dispute is not resolved, it could represent a significant opportunity for Canadian soy producers. China, the world’s largest soy importer, has an annual shortfall of 90 million tons of soybeans and the U.S. supplies 39% of that shortfall. China, on the other hand represents 62% of US soy exports. Brazil, which recently surpassed the US as the world’s largest soy producer, will be the primary beneficiary of these tariffs. Canadian soy producers, however, are also well positioned to benefit from strengthened export demand. China’s massive appetite for imported soy, leads us to believe that current soy prices are a case of “short-term pain for long-term gain” for Canadian farmers.
Diplomatic dispute with Saudi Arabia – In early August, Saudi Arabia took offence to Twitter posts by the Canadian government that urged the immediate release of human rights activists. The ensuing backlash from Saudi Arabia saw, among other trade-related measures, a ban on imports of Canadian wheat and barley. Despite the publicity Saudi Arabia’s announcements have had, Canadian farmers will not notice much of a change. In 2017, Saudi purchased about 10% of Canadian barley exports – only 134,000 metric tons – and less than 1% of Canadian wheat exports. The volumes of grain impacted by the Saudi ban are not significant and so we do not expect a material impact on Canadian farmers from the Saudi measures.
GMO wheat mystery in Alberta – The most bizarre event to befall Canadian farmers this summer, was the mysterious appearance in July 2017 of an experimental strain of genetically modified wheat in a roadside ditch in Alberta. GMO canola, corn, soy and other crops are commonly grown in Canada and exported abroad, but GMO wheat is not approved for commercial production in Canada (or anywhere else in the world). The wheat was identified after it survived an application of Round Up weed killer and, when the discovery was announced by Canadian Food Inspection Agency (“CFIA”) early this summer, Japan reacted by suspending wheat imports from Canada. Japan buys roughly 1/3rd of all Canadian wheat exports so the implications were serious for Canadian wheat producers. Canadian wheat prices fell as a result. Fortunately, Japan resumed importing Canadian wheat on July 20th after it was shown that GMO strains had not infiltrated our supply channels. But the mystery remains: how did this experimental strain of GMO wheat find its way to a roadside ditch in Alberta? University researchers and the CFIA have reportedly ruled out all plausible explanations, leaving sabotage as the leading theory. Did an anti-GM lobby group or a Russian agent scatter some genetically modified seeds along a roadside, knowing that the discovery would seriously disrupt Canadian wheat exports? According to published reports, both these groups have a history of mischievous activities in modern agriculture systems, so the theory – though it sounds outlandish – is at least plausible. It is unlikely that we will ever know for sure, but the mystery is further investigated by the Globe and Mail here.
On the whole, Canadian farmers seem to be taking all of these short-term irritants in stride. Visits with Bonnefield’s farmers over the summer months have not revealed any serious issues of concern and most remain optimistic for a reasonable harvest over the coming months.
Contrasting this backdrop of short-term challenges are the long-term trends that will continue to benefit Canadian farmers over the coming decades. These realities are pointedly summarized in the latest quarterly commentary from Jeremy Grantham, co-founder of Boston-based GMO, an investment firm with $71 billion in assets. I urge you to read it. His commentary puts into stark perspective the urgent threat climate change and soil erosion pose for the world’s food supply. It also highlights the serious role that we, as both investors and long-term stewards of Canadian farmland, owe to current and future generations. Grantham’s article, available here with a free registration, is a remarkable summary of why we do what we do here at Bonnefield, and why we are so focused on soil health and agrology.
My apologies for the cheeky “FAKE NEWS!” reference, but it does seem appropriate under the circumstances.
The Standing Senate Committee on Agriculture and Forestry just released a report entitled “How to Keep Farmland in the Hands of Canadian Farmers” and the few news outlets that noticed the report, seem to have widely mis-quoted its conclusions. The National Observer, for example quoted a Committee member as saying “…financial institutions, investment funds and foreign multinational companies [are] buying up Canadian farmland, which drives the prices up more and turns farmers into employees rather than owners of their land.” And Agri Investor carried the headline: “Canadian lawmakers warn against investment funds targeting farmland”.
For the record, the Committee’s report carries no such warnings and makes no recommendations against foreign ownership or investment funds.
While the report does acknowledge that some of the witnesses that appeared before the Committee in its 18 months of hearings expressed such concerns, the Committee’s report refrained from recommending measures that would limit either foreign ownership or institutional investment. The report also mentions other witnesses (such as Bonnefield’s Tom Eisenhauer, Farm Credit Canada, several academics and others) who found no evidence that foreign ownership or institutional investment in farmland are problematic in Canada. Indeed, the report sites examples of Bonnefield and other investors playing a positive role in providing financing alternatives to Canadian farmers and helping them reduce debt, grow their operations and transition their farms to the next generation.
While the Senate Committee’s report was not the anti-business manifesto that some news articles might lead you to believe, it was also not the call to action it could and should have been. In fact, it represents a missed opportunity to provide clear direction to lawmakers with firm recommendations for ways to ensure that Canadian farmland is protected and maintained for farmers and farming.
The report’s five recommendations range from soft (gather more data, better cooperation between levels of government, more funding for research) to downright bizarre. The report’s number one recommendation for keeping farmland in the hands of farmers? Increase the lifetime capital gains exemption for farm property. In the Committee’s view, increased capital gains exemptions will somehow help new farmers acquire farmland. Just how is unclear, as the report does not explain the connection between an increased tax exemption on the sale of a property, and easier acquisition of property by new farmers. Increased capital gains exemptions would certainly be good for retiring farmers. But new farmers? I don’t get it. New farmers need new forms of financing to build their businesses, not tax exemptions upon retirement.
Sadly, I don’t think Canadian farmland is any more protected from development or urban expansion, nor young farmers any better able to grow their farms, as a result of this Senate Committee’s report.
Note: the text of Tom Eisenhauer’s presentation to the Senate Committee, and Bonnefield’s recommendations for protecting Canadian farmland can be found here.
US farmers have had a tough time since 2013 when net farm incomes reached a record $135.6 billion after a stunning increase of 82% in just 4 years. Since those heady days, US net farm incomes have been in decline, and the USDA recently predicted further declines in 2018 – to levels not seen since 2006.
North of the boarder, the story has been very different. Canadian net farm cash receipts have enjoyed an 8-year run of continuous increases. Since 2013, net cash receipts have increased 27% in Canada, even as they have declined by 28% in the US.
DIFFERING FORTUNES – Canadian vs US Farm Profits (2000 = 100)
Sources: USDA – Net Farm Income; and Statistics Canada – Net Cash Receipts
It is a testament to the attractiveness of farmland as an investment asset, that US farmland values have not declined significantly since 2013, despite big declines in farm incomes. Farmers, after all, don’t react to short-term commodity price swings by selling land that is the cornerstone of their long-term business. According to USDA figures, average cropland values across the US are largely unchanged since 2014. In Canada, however, steadily increasing farm incomes have led to steadily increasing farmland values since 2014, in line with long-term historic averages of 6% to 8% per year.
Several years of belt tightening have deteriorated the balance sheets of many US farms, whereas most Canadian farms have maintained low debt levels and good liquidity. Farm Credit Canada (“FCC”) recently concluded that the “overall liquidity position of Canadian agriculture is strong”. The average current ratio (current assets divided by current liabilities) of all Canadian farmers was 3.0 in 2015 (the latest year for which figures are available), with the grain and oilseed sector especially strong at 3.6. By comparison, US farmers have experienced a decline in their current ratio from 2.87 in 2012 to 1.55 in 2016, according to FCC.
So, what explains the differing fortunes of US farmers and their Canadian cousins?
Exchange rates are a big factor. Declining corn and soy prices since 2013 coincided with a surging US dollar – a double whammy for US farmers. In Canadian dollar terms, corn and soy prices have not deteriorated to the same extent.
But beyond exchange rates there are important structural differences that have given Canadian farmers a significant advantage. Most investors don’t realize, for example, the extent to which the fortunes of US farmers are determined by just two crops – corn and soy. A stunning 55% of all US farmland – an area the size of France – is annually seeded to just those two crops. By contrast only 13% of Canadian farmland typically grows corn or soy each year in Canada. Far more Canadian farmland is used to produce crops which are not widely grown in the US, and which continue to enjoy strong demand (and prices) on world markets, such as canola and lentils. The result is a Canadian agriculture sector with a more evenly diversified mix of products that makes it better positioned to withstand declines in prices for any single crop.
Even within the corn sector Canadian farmers appear to have an economic advantage over many US producers. Using corn planting budgets and prevailing yield data from USDA and OMAFRA, we estimate Southwest Ontario corn producers have a 32% economic advantage over producers nearby in the US Mid-West, owing primarily to differences in land and input prices in local currency terms. Economic advantages like those can mean the difference between a profit and a loss when corn prices are low – like now.
Will the fortunes of Canadian and US farmers continue to diverge? In the short-term, corn and soy prices will determine the answer. But in the longer-term, Canuck farmers have some powerful structural advantages that should help them continue to prosper. Unlike most US farmers, Canadian farmers will see net benefits from a changing climate. While most US farmers are facing increasing heat and drought, Canadian farmers will benefit from more heat units, a longer growing season and access to plentiful stores of clean, renewable water. Most importantly, Canadian farmers are world leaders in sustainability. The Economist Intelligence Unit’s 2017 Sustainability Index, ranked Canada’s primary producers 2nd only to Germany, and 1st amongst the world’s major exporters. By comparison, the US ag sector ranked 19th behind the likes of China and Ethiopia. In an increasingly hot, polluted and dry world, sustainability will be the most important competitive advantage any farmer can have.
The current market environment is creating a dilemma for investors. On one hand, the economic picture remains bright: corporate earnings appear strong, unemployment is low and inflation, while rising, remains benign. On the other hand, warning signs abound:
We are in the midst of one of the longest bull markets in history: stock markets have enjoyed a 10-year upward run with few interruptions.
Stock prices, by almost any measure, are more expensive than they have been at any time in history other than just before the 2001 “Dot Com” crash.
Bond yields are rising, and interest rates are headed up (which is bad for stock prices).
Individual debts are at all-time highs and, more worryingly, margin debt (debt borrowed to buys stocks) is at unprecedented levels.
Bitcoin, blockchain and cannabis stocks are clearly in speculative bubbles.
Geo-political and international trade uncertainties abound, and (to put it mildly), the response of world leaders to any potential shock cannot be predicted.
In the last 34 years we have experienced five significant bull-market runs, four of which ended in large stock market declines or crashes. The first began in 1984 and ended on Black Monday in October 1987. The second started in 1994 and ended with the Asian Flu currency crisis in September 1998. The third began in late 1998 and ended in the Dot Com bust of 2001. The fourth started in March 2003 and ended with the Global Banking Crisis of 2008, and the fifth began in March 2009 and has continued until today, more or less uninterrupted for much of the past decade.
Just how exceptional has our current bull market been? Figure 1 provides some context. The previous 4 market cycles lasted an average of 29 months and saw the S&P 500 rise by an average of 97%. In comparison, our current bull market run has, so far, lasted an incredible 107 months and seen the S&P 500 rise by 354%
Figure 1: our current bull run is the longest in decades…
Figure 2: …and it takes a long time to recover after long bull runs
As Figure 2 indicates, it typically takes a long time to recover losses incurred in stock market crashes that have followed long bull runs. In the previous four cycles, the recovery period (ie. the length of time it took to fully recover the losses incurred from market declines) lasted 77% as long as the preceding bull market run – an average of 43 months. Recoveries from the Dot Com and Global Financial Crisis took significantly longer – 81 and 65 months respectively.
Simply put, it took between 5.5 and 6.7 years for investors to make up the losses they incurred in the previous two stock market declines.
What conclusions can we draw from these historic patterns?
We are surely in the latter stages of one of the longest bull markets in history, and the longer it goes on, the greater the risk of a significant decline.
At current equity valuations, future market gains will, almost certainly, be less than those of recent years and with interest rates increasing, bond returns are likely to decrease from recent levels as well.
As the prospect of further returns diminish, market risk is increasing – creating a poor risk/return outlook for both stocks and bonds.
Figure 3 illustrates how the current risk/return pattern has significantly changed from the past few decades. Using historic annual returns since 1990 for the S&P 500 and 10-year Treasury Bonds (all figures in US dollars without currency conversion into CAD), we estimated the stock-and-bond portfolio mix that would have produced a similar 10% total return as that generated by Canadian farmland over the same period.
During the 1990s, it was possible to replicate farmland’s 10% total return (through capital appreciation plus dividends and interest) by investing 39% of one’s assets in 10-Year Treasury Bonds and 61% in the S&P 500. Moreover, this strategy required no debt leverage and had a modest level of volatility at 11.6%
The Dot Com bust of the early 2000s created an entirely different story for investors during that decade. The only way an investor could have generated a 10% return from 2000 to 2010 would have been to put all of one’s portfolio into Treasury Bonds, lever it by 300% and buy the S&P with the proceeds of the debt leverage. No sane investor would have done this, and even if they had, they would have experienced a ridiculous level of volatility (69%).
The Goldilocks bull market run that we have experienced since 2010 changed the portfolio mix again. Declining interest rates and strong stock returns meant that an investor could have put 76% of their portfolio in Treasury Bonds and just 24% in the S&P 500 and still generated a 10% total return with a volatility of just 8.2%
Figure 3: portfolio mix required to match Canadian farmland’s long-term total return of 10%
This historic what-if analysis puts the changing risk/return environment in perspective. Looking forward, however, is trickier. 2018 consensus estimates for the S&P 500 and bond returns, suggest that, in the current environment, one would need to put 88% of their portfolio in the S&P and just 12% in bonds to generate an anticipated return of 10% in the coming year. But this assumes that we do not experience a significant market correction in 2018, and, as I have argued above, the likelihood of a significant correction occurring is increasing with each passing month. Clearly, the classic portfolio of 60% equities and 40% bonds no longer generates an attractive risk/return for investors.
So, what is a prudent investor to do? Moving to cash is the obvious option for capital preservation, but at the cost of low-or-no real returns. How can one protect their capital while still generating an acceptable long-term return?
Increased market and geo-political risks for future stock and bond returns, stand in stark contrast to the prospects for continued steady returns to owning Canadian farmland, all of the core investment themes for which remain intact:
a growing global population, significant portions of which face serious food insecurity;
a changing climate that is benefiting Canadian farmers and challenging most other food producing regions of the world;
plentiful access to water for food production in Canada while much of the world faces drought, water shortages and water quality challenges; and
Canadian farmland prices that have not increased significantly relative to Canadian farm earnings (in contrast to rising valuation metrics for public equities).
Is Bonnefield predicting an imminent market collapse? Certainly not. We are neither skilled enough nor smart enough to call a stock market top.
There is no doubt, however, that the lessons of history and the precarious risk/return profile of current markets are clear signals to investors seeking capital preservation and steady returns: now is the most important time in recent memory to rebalance away from public markets into alternatives like Canadian farmland – a proven steady performer, with low volatility and bright prospects for continued steady returns.
Canadian farmland has a long track record of producing steady, equity-like returns that are uncorrelated with the ups and downs of other financial assets. Bonnefield’s research has shown that long-term farmland returns are highly correlated with, and are primarily a function of, the long-term improvement in the productive capacity of farmland. Simply put, as crop yields have improved over time, and as farm operations have become more efficient through consolidation and technical improvements, the “earnings power” of the underlying farmland itself has increased, leading to an increase in both farmland values and farmland rents.
An analogy is to think of farmland like shares in a public company. If the productivity of a company improves, one would expect its profits to improve and the price of its shares to increase accordingly. But if, in management’s drive to improve the company’s productivity and profitability, they take on too much debt or weaken the company’s financial liquidity, then its profitability (and, therefore, share price) is put at risk.
The same is true of farmland. If the farm sector’s debt load were to increase to the point where farmers’ financial liquidity deteriorates substantially, farmland prices and rents would potentially be at risk. Such was the case in the early 1980’s when a debt boom coincided with declining crop prices and skyrocketing interest rates, resulting in a rare period of widespread farmland price declines.
So the obvious question is: How financially sound are Canadian farmers? Most farmers rely on debt to capitalize their operations. Are they sufficiently liquid to withstand a period of crop price stagnation and/or interest rate increases? Are we potentially at risk of a 1980’s-style farm crisis?
Statistics Canada’s most recent Farm Financial Survey suggests that the clear majority of Canadian farmers are in sound financial shape.
Recent analysis by Farm Credit Canada concluded that in 2015, 82% of Canada’s grain and oilseed producers had debt-to-equity ratios of less than 0.3. 77% of vegetable producers and 63% of potato producers had similarly low debt levels. More importantly, Canadian farmers appear well positioned to continue to service those debt levels as indicated by healthy debt-service ratios (net income divided by annual debt service payments). More than 2/3rds of all grain, oilseed, vegetable and potato producers in Canada had debt service ratios greater than 2.5, the result of several years of strong cash receipts and low interest rates.
FCC’s analysis also concluded that the “overall liquidity position of Canadian agriculture is strong”. The average current ratio (current assets divided by current liabilities) of all Canadian farmers was 3.0 in 2015, with the grain and oilseed sector especially strong at 3.6. To put this in perspective, FCC considers a farmer’s financial liquidity to be adequate if they have a current ratio of 1.5 and most Canadian farmers have current ratios well in excess of these levels.
The healthy financial liquidity of the Canadian farm sector stands in contrast to that of US farmers who, according to FCC, have experienced a decline in their current ratio from 2.87 in 2012 to 1.55 in 2016. Unlike their US counterparts, Canadian farmers have been insulated to some degree from lower corn and soy prices by a favorable USD/CAD exchange rate and a more diversified mix of crops (especially canola and pulses, the prices for which continue to be strong).
Indeed, Statistics Canada released figures in late November showing that Canadian farm revenues (“farm cash receipts”) for the first 9 months of 2017 were up 3.3% versus the same period in 2016.This increase is the 7th year in a row in which Canadian farmers have experienced year-over-year increases in revenues. Moreover, Canadian farm profits, as measured by realized net farm income, were up 4.2% in 2016, the 6th such increase in the past seven years.
The bottom line is that we are reassured by Statistics Canada’s most recent Farm Financial Survey showing that the clear majority of Canadian farmers, particularly grain, oilseed, potato and vegetable producers (the sectors that Bonnefield focuses on) are in sound financial shape.
The Liberal government’s proposed tax changes will likely cause the greatest destruction of wealth for Canadian farm families since the 1980s farm crisis. But unlike the crisis of the 1980s, from which farmers eventually recovered, the proposed changes are a permanent, structural change that will cause a drop in farmers’ income and net worth from which there will be no recovery.
Finance Minister Morneau and Prime Minister Trudeau have said that the proposed tax changes are aimed at wealthy Canadians who use “tax loopholes” to unfairly pay less tax than “middle class” workers. But the legitimate small business tax planning tools, which the Liberals plan to change, have been used for decades by small business entrepreneurs in all sectors across Canada to help manage and mitigate the financial risks associated with starting, building and selling their businesses.
The implications of these changes for all small business entrepreneurs are huge, but given the unique nature of farming, the impact on Canadian farm families will be especially severe. Farming, more so than most other businesses, rely on the entire family’s participation and support to succeed. Children, spouses and extended family members typically support the farm business, whether directly in the farm’s operations, or indirectly in unpaid, but essential ways. Canadian farm families typically incorporate as small businesses to enable them to efficiently share the income from their farm operations among family members. But the proposed tax changes will severely restrict a farmer’s ability to split income among family members, even though the reality for most farmers is that the entire extended family participates in one way or another in supporting the business.
Moreover, for most farm families, their primary (and sometimes sole) source of wealth for their retirement is their land. Because of the capital-intensive nature of farming and the volatility of most farm incomes, farmers often do not have significant other sources of retirement savings such as TFSAs, RRSPs and investment savings. By incorporating as small businesses, and having multiple family members as shareholders, farmers have been able to use legitimate tax planning tools to maximize capital gains exemptions and reduce the tax burden when it comes time to sell the farm to finance their retirement. The proposed tax changes will eliminate farmers’ ability to use multiple capital gain exemptions and will thereby dramatically reduce their retirement savings.
The extent of this pending wealth reduction for farmers is hard to estimate and is based on individual circumstances, but it is not hard to imagine that for a typical farm family like those we deal with every day at Bonnefield, the proposed tax changes could destroy a third, maybe even half, of the wealth they have accumulated over their career through land price appreciation.
Bizarrely, the proposed tax changes will make it far more advantageous from a tax perspective for a farmer to sell their business to a large conglomerate, rather than sell the farm to the next generation and keep it in the family. The 2016 census showed that the average farmer in Canada was 55 years old. So, over the next decade a substantial portion of Canadian farms are going to change hands.
At Bonnefield we often work with young farmers to help them finance the transition of their parent’s farm and expand their operations. The proposed tax changes will dramatically reduce the amount of after-tax cash available to retiring farmers and make it harder to transition the farm to the next generation.
For anyone concerned about the disappearance of family farms in Canada, the pending tax changes are a looming disaster.
Everyone agrees that tax fairness is an essential principle for a civil democratic society like Canada. But one’s tax burden should not only be proportionate to one’s income. It should also take into account the risk and sacrifice entrepreneurs incur to earn their income, as well as the benefit to society that results from their entrepreneurial spirit. Canadian farmers represent the best of that entrepreneurialism and risk taking, and all Canadians benefit from a thriving agricultural sector.
I urge you to contact Minister Morneau, Prime Minister Trudeau and your local MP and urge them to stop these ill-conceived, disastrous tax changes.
The volatile weather expeienced across Canada so far during the 2017 growing season has, once again, reiterated the need for a well-diversified farmland portfolio amidst unpredictable and challenging farming conditions. At the time of writing this blog, there are more than 150 wildfires burning throughout the interior of British Columbia due to abnormally dry weather and forcing over 6,000 people from their homes. In Saskatchewan over 60% of the province’s topsoil is considered short or very short of proper moisture levels. Meanwhile in Ontario, accumulated rainfall to date is 4 times that of 2016. The Maritimes have had relatively normal conditions so far this season.
The dry conditions in the prairies made for ideal seeding conditions but continued dryness will, with the exception of irrigated areas in southern Alberta, likely depress yields across much of the west in 2017. The rains in SW Ontario that delayed planting show little sign of abating, however, progressive farmers using good management techniques should expereince reasonably good yields.
Challenging growing seasons such as these also highlight the benefit of partnering with top-grade farmers who use progressive practices and sophisticated agrology analysis in their farm management techniques. We are seeing dramatic differences in the fortunes of farmers across the country between those who use excellent management techniques and those who do not. The former are experiencing average-to-good yields at this point in the season, while many others are seeing poor yields.
The revenue impact to Canadian farmers from a rebounding Canadian dollar has largely been offset by stronger agricultural commodity prices across the board and global demand for Canadian-based crops such as canola and lentils remains strong.
While Canadian farmers are facing challenges this growing season, most are coping reasonably well and maintain a bright outlook for years to come. Sadly, recent news from abroad is not so positive for farmers elsewhere.
FAO reported that 19.4% of China’s arable land is contaminated
A study released by MIT predicts that much of South Asia – home to a fifth of the world’s population – will be too hot for food production and human survival by the end of the current century.
Against this backdrop, investing in a widely-diversified portfolio of farmland in Canada – a politically stable country whose ag sector is expected to be a net beneficiary of climate change – looks very attractive indeed.