Easing into commodities by Genevieve Cua

FOOD prices are making headlines amid adverse weather conditions, raising the spectre of a food and inflation scare similar to 2008. This suggests that a fund investing in commodities or soft commodities in particular might be a profitable bet this year. Most strategists point to commodities as an investment theme for 2011.

But rather than put money into the futures market or a price index, which gives direct exposure to soft commodity prices, DWS director and investment specialist (Asia Pacific and MENA) Bill Barbour believes an investment in an agribusiness equities fund would enable you to profit from rising demand as well as supply shocks - and do good in the process.

'We may have 3-5 years before we can even think about turning around the global food problem, and I think it will take much longer. (Investing in agribusiness) is an opportunity to make money through helping to solve the problem rather than cause the problem - which you tend to do when speculating in soft commodity prices,' Mr Barbour says.

DWS claims to be the first to launch an agribusiness equities fund in 2006, when it woke up to what it sees as a massive predicament: how to feed a burgeoning world population on a supply base that is actually shrinking. Agricultural land, for example, is a finite resource and is expected to be a key driver of food undersupply.

The financial crisis of 2008 has also exacerbated the underinvestment in the agricultural value chain as governments, particularly in the West, struggle with large deficits. This leaves private companies to take up the slack. It is estimated that US$9 trillion in investments must be made in production to 2050 - which works out to about US$210 billion a year. But the current investment rate is only about US$120 billion.

'Capital spending by governments is a problem. The only solution in the short term is to get companies involved. Corporatisation of farms is helping to some extent . . . where companies can help increase productivity . . . The other opportunity is to invest in companies with knowledge that can monetise that knowledge.' One example, he says, is Monsanto, which is at the forefront of seed technology.

In contrast, speculating in soft commodity prices tips populations over into starvation territory, raises the risk of protectionism, and creates domestic unrest that could topple governments. The World Bank has been sounding warnings on surging food prices and the impact of inflation on the developing world. Prices of corn and soya been, for example, recently hit two-and-a-half-year highs. Livestock prices have also begun to climb.

The United Nations Food and Agriculture Organization (FAO) has warned of a food price shock as an index it uses to track food commodity prices such as meat, dairy products and grain has surpassed the previous 2008 peak.

Mr Barbour sees five key drivers for the agribusiness argument: soaring global population; rising incomes in the developing world; limited agricultural land; biofuels; and global warming. 'This is not understood by most investors or Wall Street analysts. There is a huge driving force that is relentless, unstoppable.'

Global population, for instance, is expected to grow to eight billion in a decade - equivalent to some 80 million new mouths to feed annually. But farmland isn't increasing, and is at best stagnant.

It is estimated that in 1960, 0.5 hectare of farmland supported one person; by 2020, this is expected to drop to just 0.2 hectare, compared to 0.3 hectare in 2000. This makes the need for farmland efficiency and high crop yields urgent.

Food consumption is also changing as incomes rise. Meat consumption is rising, which puts a strain on crops which are used as feed.

Biofuels, he says, are 'at best misguided, and at worst immoral' as their production diverts corn crop into a fuel that is actually inefficient to produce, and worsens food shortage.

DWS manages nearly US$4 billion in agribusiness mandates. In screening for stocks, the firm starts with a universe of roughly 1,000 stocks that run the gamut of upstream and downstream agribusiness firms. Upstream refers to those involved in resources and production including land, plantation, agriculture products, and machinery. Downstream refers to firms in the value-added chain that process products to reach the consumer.

This universe is narrowed down to about 500 companies, leaving out those with poor corporate governance, small market capitalisation below US$200 million, and those deemed to pose political risks.

Mr Barbour believes agribusiness stocks remain undervalued despite having recovered some ground since the 2008 crisis. Blue-chip agribusiness stocks, he says, shot up into overvalued territory in mid- 2008 prior to the crisis, thanks to the food and inflation scare. At that point, the fund sold names such as Monsanto, which had a price-earnings multiple of some 43 times.

'Blue chips today are still 40 per cent cheaper, and our portfolio about 20 per cheaper than the 2008 peak. The PE for our fund is lower than the MSCI World index,' Mr Barbour says.

The DWS Global Agribusiness fund (USD) has outperformed the MSCI World Index since inception in September 2006, with cumulative returns of 42 per cent to end-December 2010, compared to the World Index's minus 5.54 per cent.

The Sing dollar fund, which began investing in March 2007, isn't as impressive in absolute terms, however, even if it did beat the World Index by a wide margin. It shows a cumulative return of 3 per cent to end-December 2010, compared to the World Index's minus 27 per cent. This reflects one of the major risks that investors should take note of in this fund: as it invests in equities, it is likely to move broadly in line with the general equities market, rather than commodity prices.

The fund suffered aggressive hedge fund redemptions in 2008. In 2008 alone, the fund plunged 52 per cent, compared to the World Index's slide of 42 per cent. Still, it recovered sharply by 68 per cent in 2009, compared to a 24 per cent rise in the World Index. It has a 0.7 correlation with the World Index, and correlation with other agricultural and commodities indexes is generally below 0.5.

TRADING on leverage may seem attractive because of the potential for outsized gains, but it isn't appropriate for everyone.

Traditionally, stock investors here trade with leverage using a margin account which can be opened with any stock brokerage. In the last few years, more instruments have emerged that allow you leverage, and not necessarily incurring a financing charge.

Just as in a plain vanilla margin account, instruments such as contracts for difference and extended settlement contracts add leverage to your trade as they require a fairly modest upfront capital. For stocks, this initial margin or deposit is typically 10 per cent. This means you have to put up $100 for trade whose total value is $1,000. Your leverage factor is 10 times.

This makes for efficient use of capital. If you were to buy the stock outright, you would have had to commit $1,000.

Whether you trade CFDs or ES contracts, one obvious risk is that of adverse price movement. You will be required to maintain a minimum margin and your positions will be revalued daily. If the value drops below the minimum required margin, you will face a margin call.

What type of investor may find leveraged trading suitable? If you are an experienced investor with a fairly high risk appetite, you spend time monitoring your positions, and you have the assets to back up your trade, you may not think twice about taking on leverage. Such instruments may also be used to hedge the stocks or assets in your portfolio.

You could, however, be burnt quite badly if your view of the market turns out to be wrong. Most investors' undoing is rooted in a propensity to overtrade, and their reluctance to cut losses. The downside of a leveraged trade is potentially unlimited, particularly for those who do not know when to call it quits.

It is prudent to take a leaf from the approach of some trading coaches. That is, since leveraged trading is a form of speculation, set a limit on the amount that you are willing to lose. That should normally be a small fraction of your investible assets, perhaps just 5 per cent. And be disciplined enough to stick to that loss limit.

With CFDs, the trading platform that you use typically allows you to set limits to your position. Be aware, though, that the loss limits may not be guaranteed. Some CFD providers do offer a guaranteed stop- loss facility, but they may charge a fee for it. That fee is a relatively small proportion of your transaction value, and may be well worth the expense should the market gap down suddenly.

Otherwise, if you have a non-guaranteed stop loss, there is no assurance that the order will be transacted at the price you have selected. In a market that is gapping sharply downwards, the order could be executed at a much worse price than you have specified.

Glossary

Extended settlement contract: A contract between two parties to buy or sell a specific quantity of a security, at a specific price at a specified future date.

Contract for difference: A leveraged trading instrument that allows you to speculate on the future market movement of an underlying asset, without owning or taking physical delivery of the asset.

Initial margin: The minimum margin you are required to deposit to open a position in CFDs or ES contracts.

Maintenance margin: The margin that must be maintained in your account for outstanding positions in ES contracts.

Variation margin: Refers to the mark-to-market gains or losses in relation to the price at which the ES contract was bought or sold. A net loss increases the required margin, and a net profit decreases the required margin.

Margin call: A demand from your broker or CFD provider to top up your account to meet margin requirements. Failure to top up could cause a forced liquidation of your position.

This article was first published in The Business Times.

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