Brent Sheather: If it's good enough for the Super Fund

It's not quite gold but still a healthy outlook at the end of the farming rainbow. Photo / Sarah Ivey

Commodities have been one of the better investments of the past 10 years with the Goldman Sachs Commodity Index returning about 6 per cent a year in New Zealand dollar terms, versus -3 per cent a year for the world stock market.

Although the Goldman Sachs index is dominated by oil, so-called soft commodities like wheat, cotton and corn have joined the fun in recent times.

The Financial Times reports that food prices are soaring with wheat, corn and soya beans up 110 per cent, 87 per cent and 59 per cent respectively in the past year.

All this positive price action bodes well for the farming sector, although gains in milk and meat prices have been tempered by the strong dollar.

The historic price performance of dairy farms compares quite favourably with that of the stock market. The graph suggests dairy farms have dramatically outperformed the New Zealand stock market since 2008.

However, the National Bank Rural Economics team comment that they would treat the 2010 average dairy farm price with caution as it has been pushed up by the sale of a few large "golden mile" farms.

The graph also shows, extraordinarily, that the capital value indices of New Zealand stock market prices and dairy farm prices per hectare have, with the exception of the 1987 bull market, tracked each other closely, so index values between 1978 and September 2009 start and end at virtually the same point.

It is important to note that these are capital indices and thus exclude income. Anecdotal evidence would suggest this handicaps the performance of the stock market, with a 6 per cent yield, more than it does dairy farms, which in recent years, anyway, haven't produced much in the way of income.

There was more good news for local farmers this month when the NZ Super Fund (NZS), with $18.2 billion in assets, announced it had made its first farm purchase as part of its new Rural Land Strategy. This strategy will see the NZS investing, on our behalf, up to $500 million of the fund's assets in "all activities up to the farm gate in major food producing regions in the developed world".

Anyway, the first farm has been bought: it's a dairy unit of 250ha about 100km west of Dunedin. NZS has appointed FarmRight, an independent dairy farming company managing 42 dairy farms, as its manager, which is probably fortuitous, as 100km west of Dunedin wouldn't be the first place I would want to live.

So thanks to the Super Fund we can all be farmers now. But how do the economics of farming compare with shares, property or bank deposits? Has New Zealand's biggest investment fund found a bargain at its back door?

That's today's topic. We last quantified the economics of dairy farming back in early 2009 when we looked at the excellent research of the National Bank Rural Economics team. Back then the bank's Kevin Wilson noted that over the long term farm profits had not kept pace with farm prices, meaning farms had become more expensive.

Data from Quotable Value shows that since 1978 the average price of dairy farms sold per kilogram of milk solids produced has risen from $5 to a peak of around $50 in 2008, and is now around $41 per kg. This big increase in price without similar profit growth has meant that the earnings of the average dairy farm as a percentage of the price of the farm is today quite low.

National Bank rural economist Con Williams estimates that the price of the average going concern (land, stock, plant and dairy company shares) is around $40,000/ha. He further estimates income/ha, assuming management costs of $85,000 a year, at around $2350/ha.

Those are the numbers: a dairy farm is going to cost you around $40,000/ha and produce income before tax of $2350/ha, which works out to be a return of 5.9 per cent a year ($2350/$40,000).

Is this good or bad and how does it compare with alternatives? First up, Williams notes that floating mortgage rates for rural lending are at 7.25 per cent, quite a bit higher than the yield on a dairy farm, so borrowing heaps is not a viable option - unless, of course, milk prices go up. The table above makes some rough comparisons with other investments.

So why, assuming the NZ Super Fund's farm has similar economics to those estimated by the National Bank, did it opt for a farm, when both the Australian and NZ sharemarkets look better value? We better check the National Bank's numbers.

If we look at the website of the Super Fund's adviser, FarmRight, we can see its projections for a 264ha Southland dairy farm milking 800 cows. In this example, it forecasts income before interest and tax of $780,000 on $13.2 million of assets. This is a return of 5.9 per cent, spot on the National Bank estimate.

As the Super Fund is probably FarmRight's biggest customer, it probably gets shown the best deals and might even be able to increase the yield by buying several farms in the same area.

The NZS had this to say about the rationale for its foray into the dairy farming industry: "One of the ways to maximise return without undue risk is through diversification, so we don't have all our eggs in one basket.

"Rural land is a relatively under-developed asset class (not many institutional investors are in it) that delivers a range of investment exposures. These include long-term commodity price trends; macro themes such as emerging Asia and clean food; scope for adding value through active management; and a long-term hedge against inflation."

In short, NZS bought into farms despite a higher initial valuation than the NZ or Australian stockmarkets because:

* Today's returns aren't everything as the outlook is good.

* Farms help balance the portfolio and reduce risk.

What are the implications for retail investors? A reasonable view might be that if it's good enough for the Super Fund, it's good enough for Mum and Dad.

But to be properly diversified in the farming sense one needs to buy farming companies, not just one dairy farm. It's a great pity there is not an NZX-listed vehicle on the stock market, internally managed and with high liquidity, so people could get in and out at low cost.

Let's hope New Zealand stockbrokers and/or investment bankers can put something together as I'm sure there will be good support for a suitable internally managed vehicle from many retail investors.

* Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.