Water, Wood & Earth: Are Agricultural Commodities Right For Retail Investors?
Humans have traded commodities since we were cave-dwelling Neanderthals exchanging prized assets like food, weapons and basic tools. Much has changed since then, but commodities are still attractive thanks to their tangible nature and ability to act as a hedge against inflation. This is a hot topic right now as economists worry that the Fed’s current ultra-loose monetary policies, particularly during the COVID-19 pandemic, could create high inflationary conditions over the next few years.
In this edition we’ll dig into three key commodities our ancient ancestors would also have traded - timber, water, and farmland - and look at how they measure up for retail investors.
Commodities for Retail Investors
Until recently this complex market was mostly limited to professional traders, but the growth of exchange-traded funds (ETFs) and index and mutual funds have made it much easier for retail investors to get involved.
Other options include hiring a community pool operator (CPO) who pools funds from multiple investors which is then invested in a particular commodity or commodity basket. A CPO typically works alongside a community trading advisor (CTA) to manage your investment. CPOs usually invest in futures contracts and options which can be challenging for inexperienced retail investors to access on their own.
Alternatively, the simplest option of all is just to invest in commodities stocks. The key downside here is that your investment is subject to the company’s individual performance as well as the market value of your chosen commodity. You could be stuck with low yields even when commodity prices trend up. On the other hand, commodities can provide diversification protection for portfolios weighted with economically-sensitive stocks.
Timber
Lumber prices more than tripled in May 2021 to $1,600 per 1000 board-feet from a five-year low in November 2020. To put that in perspective, a homebuilder needs around 15,000 board-feet to construct a single-family home. Yet since May prices have plunged back to November 2020 low.
Figure 1: Lumber Prices Have Both Soared and Collapsed in the Last Twelve Months
Source: Trading Economics
So what happened? Stuck at home during the pandemic and flush with cash as traditional discretionary expenses dropped dramatically, homeowners began DIY projects like building outdoor wooden decks or even building a whole new home. These tendencies played out across the country in a very condensed time frame, causing lumber prices to soar. Sawmills and loggers across the country frantically upped production, only to be hit by price collapses as falling demand collided with rising supply.
This event highlights the biggest risk factor with commodities - their volatility. Unlike other investment vehicles like stocks and bonds, commodity prices can fluctuate wildly as supply and demand are impacted by consumer trends, natural disasters, global competition, and so on.
A less risky option is to opt for securities which typically demonstrate lower volatility when compared to underlying timber prices. Commodity prices tend to be more sensitive to supply and demand since, in this case, it’s not possible to quickly produce more timber. Companies usually have more buffer between supply and demand, such as timber reserves or good financial management and alternative income streams to weather unexpected change.
Timber REITs
One of the easiest way for retail investors to get involved in timber is to buy stocks in three REITs: Rayonier Inc. (NYSE: RYN), Weyerhaeuser Company (NYSE: WY) and PotlatchDeltic Corporation (NASDAQ: PCH).
Rayonier owns or leases 2.7 million acres of timberlands in the U.S. South and Pacific Northwest and in New Zealand.
Weyerhaeuser owns 12.4 million acres of timberlands in the U.S. and manages 14.0 million acres of timberlands in Canada under long-term licenses.
PotlatchDeltic owns 1.8 million acres of timberlands across six U.S. states and operates six sawmills and an industrial-grade plywood mill.
Timber EFTs
There are also two dedicated ETFs, NASDAQ: WOOD and NYSE: CUT, which own a broad portfolio of timber stocks. These are cost-effective and lower-risk options for retail investors concerned about the highly-speculative nature of most commodities. Interestingly, the NASDAQ: WOOD is up 13.62% and CUT 16.71% YTD, while ongoing oversupply means lumber prices down -44.57% YTD as of August 31st 2021.
Water
The Veles California Water Index, which tracks the spot price for California water entitlement, has nearly doubled in the first eight months of 2021. Water is becoming an increasingly scarce resource due to population growth, pollution by fertilizers and factories, and extreme weather induced by climate change. As an example of the last point, many areas in the western U.S. are in extreme drought conditions, including 85% of California.
Figure 2: Spot Price of California Water Has Spiked in 2021
Source: WestWater Research LLC
Other areas experiencing pronounced water scarcity around the globe include regions of China, Egypt, India, Israel, Mexico, and parts of Africa. You might remember the headlines from Cape Town back in 2018 when the city nearly ran out of water. It was forced to cut down hundreds of thousands of trees to avert a humanitarian catastrophe. At the same time, demand for water continues to grow at an unrelenting pace as emerging markets emulate Western lifestyles and eating habits; according to UN Water global usage is growing by 1% annually with a sixfold increase over the past century.
Figure 3: Per Capita Bottled Water Consumption (Gallons) in the US 1999 - 2020
Source: Statista
Water EFTs
Given the variety of companies participating in the global water industry and the breadth of their involvement, investing in a water ETF like First Trust Water ETF is one of the simplest ways to gain water industry exposure. Its biggest holdings are Pentair plc, an American water treatment company, and Roper Technologies, a manufacturer of pumps and fluid handling systems. For those who want more global exposure, other options are iShares Global Water UCITS ETF and Guggenheim S&P Global Water Index ETF which aims to track the S&P Global Water Index.
Water Stocks
Also of some interest to retail investors are water utility stocks like American Water Works (AWW) or California Water Service Group (CWT). The sector is currently grappling with combined issues of consumer affordability, the need for large-scale infrastructure updates, and quality concerns which are prompting many Americans to shift to bottled water. Yet despite these challenges, AWW is up 18.75% YTD and CWT 18.9%.
Farmland
Farmland prices in the U.S. have increased at a fairly consistent 5-6% average annualized pace since the mid-1980’s. Regional prices can vary dramatically; prices in the prime Corn Belt region are about five times those in the Mountain region.
Figure 4: Average US Farm Real Estate Value, 1970-2020 ($ per Acre)
Source: U.S. Department of Agriculture
Figure 5: Average 2020 Farmland Value by Farm Production Region ($ per acre)
Source: U.S. Department of Agriculture
When you also factor in cash rent yields, farmland has produced a positive return every year since 1991 with an average annual return of 11.5% according to the USDA. Farmland returns are also typically less volatile than other asset classes like gold, the S&P 500, and the 10-Year US Treasury Bond.
Farmland stocks
For most retail investors, it’s probably not a good idea to start buying up prime farmland. Instead buying stocks in companies that own or lease farms used for agrarian or pastoral agriculture can be a great introduction to the sector. Two good examples are Adecoagro S.A. (NYSE: AGRO) which has gained 80.85% over the past year and Fresh Del Monte Produce Inc. (NYSE: FDP), up 39.37% as of August 2021.
Farmland REITs
Retail investors can also look at farmland REITs such as Gladstone Land Corporation (LAND) and Farmland Partners (FPI). Gladstone is worth over $900 million and owns 115 farms which are diversified across 45 crop types. The firm follows an equity model, renting out its land to tenant farmers. The stock has performed well over the past year with 52.18% growth, and investors can benefit from a dividend yield of 2.56%.
Farmland Partners has a market capitalization of $400 million and works closely with their farmers to improve profitability. Dividend yield is currently 1.5% and YTD stock performance is a respectable 40.80%. Unlike Gladstone’s diversified approach, FPI is more focused on corn with 60% of their land planted with row crops which could make it more sensitive to crop-specific price swings.
Final Thoughts
Timber, water and farmland all have their appeal for retail investors, but some of the easiest and safest ways for most individuals to get involved are via REITs, EFTs and stocks. These can offer greater insulation against the volatility which often characterises these types of commodities. Of all the major asset classes commodities are most correlated to inflation. If economists’ predictions prove correct, trading in these three essential commodities could be a useful hedge against inflationary tendencies.