I caught up with Stephen Johnson of AgCapita recently. He’s been a good source for me on the different trends happening in agriculture.

Below, you’ll find my recent interview with Stephen and his thoughts on the great opportunity we have in farmland today.

Enjoy!

Sincerely,

Chris Mayer

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Chris Mayer: So how’s business in the land of farming?

Are we past the food crisis worries?

Stephen Johnston:

Global production numbers are going to be up this year, so the feeling in some quarters is that the problem is over.

I think this view misses the point — agriculture has consistently had productivity gains. Year-on-year production is generally always increasing, barring weather events. Agriculture is one of the rare sectors of the economy in which you've had consistent productivity growth over many decades. If you look at the last 50 years of data, productivity growth has averaged around 2% per year. This disguises the fact that it was 5–6% per year in the early part of that period and is now averaging around 1% or less per year.

Mayer: Right, I was going to say those productivity gains have been slowing pretty steadily. That's part of the crunch.

Johnston: Yes. So now, although it appears that we will have a year-on-year increase in production, my expectation is that it has not come from significant yield expansion.

Ultimately, even though productivity growth is slowing, the production side isn’t where the main challenge lies. It’s the demand side of the equation that's the challenge

— this is a demand-driven market. Demand growth is increasing at a time when production growth is slowing.

Mayer: And when we look at the big picture for farmland, there is a declining arable land resource globally, particularly in some places like China. So you've got that, and you have slowing productivity gains.

Then we still have increasing demand, particularly from China and India and the other emerging markets. They're shifting their diets, so all that plays into making farmland attractive, correct?

Johnston: Unequivocally. We have a global recession, depression

— choose your term — let’s just say we've had a serious contraction in global GDP. When your look at a graph of per capita income versus meat consumption, you see quite clearly that the curve is extremely steep at the beginning of that income change.

In fact, most of the change in diet happens as people move up to the $5,000 per year income level. That is a level that approximately 80% of the people in the world have yet to reach.

The Chinese and Indians are still experiencing growths in nominal terms and improvements in their per capita incomes, even now, during this recession.

They still have 100 million people moving into the middle class every year. All of this continues to drive a very large change in meat consumption, so one of the key agriculture commodity price drivers remains unimpaired.

Mayer: Right. There is some research that shows that of every incremental dollar they earn in China, something like 40% of it goes toward food. And in India, something like 70% goes toward food.

So even though we're still in this global recession, we still have these massive populations for which of every incremental dollar they earn, a significant piece of that's going toward food.

Johnston: That's an excellent way to explain what the math of the income-to-meat consumption curve I mentioned above says

— the slope is extremely steep at the beginning.

Mayer: One other thing I'm curious to ask you about. What about the water problems China and India have had

— falling water tables and desertification of certain land?

That would make certain farmland much more valuable than other kinds. Obviously, you've got a secure water resource nearby, being in Canada, but how does that play into it also?

Johnston: I saw an interesting piece of research that shows that when a country experiences rapid industrialization, domestic food production drops for a period. That might seem counterintuitive at first. Then when you begin to think about it a bit more, it actually makes sense, because when a country rapidly industrializes, the cities and factories grow.

Cities are typically located on high-quality farmland. In an agrarian economy, people tend to aggregate where land is good. Then as you have economic and population growth, that land is consumed.

Therefore, during the transition to a middle-class industrial economy, the best-quality farmland tends to be consumed at the early stages. Developing economies are losing arable land this way. Of course, you put your finger on one of the other problems for China, which is water

— both surface water and that the country’s been mining from its aquifers.

I've heard the expression that wheat is a very cheap way to import water. You look at all the major wheat-importing countries in the world; they all have water deficits. It's typically Middle Eastern countries, and it's China, and they all have a water deficit. You can't import water cost-effectively, so you import wheat.

Mayer: I remember also how the water tables are dropping so fast in Beijing that some places are falling eight inches a year as those aquifers get depleted.

Johnston: We have an article from the BBC on our Web site just talking about that. It's amazing. They have a serious water crisis, and it's not going away.

On top of shortages in absolute terms, agriculture also can't currently compete with industry for water at the margin because of the much higher value of water for use in industrial production. The value of an incremental liter of water to a factory is many times more than the value of that same incremental liter of water to a farm. Economics in industrializing countries, therefore, tend to drive water consumption out of agriculture into industry.

That’s the issue that China is struggling to address. Population growth, desertification, loss of water and an industrializing economy are depriving domestic agriculture of water. Where you are water constrained you can't cost-effectively use water for agriculture and still grow your economy.

Mayer: It also competes directly with energy, so in some cases, you see countries doing these big land deals so they can produce palm oil. Or even in the U.S., we have ethanol competing with food crops.

Johnston: I would argue that ethanol in the United States is just an indirect way to subsidize agriculture. As you probably know well yourself, the only bioethanol that makes sense is sugar cane, and the rest are…

Mayer: The rest are all garbage.

Johnston: The rest are all garbage, yes, exactly.

Mayer: It just consumes a tremendous amount of water and energy.

Johnston: You're basically turning fertilizer into alcohol.

Mayer: Yes, and driving up food prices in the bargain, where in some places they really can't afford to do that.

So another thing I wanted to ask you about: Recently, there was that news item about how U.S. farm prices had fallen a little bit. How do you explain that, with all that we've just talked about? In some pockets, I guess, we're seeing where farmland prices have gotten way ahead of or were part of the current bubble in some way. So I'm interested to know what your take on that is.

Johnston: There's no asset class immune from the effects of cheap credit. I would say that farmland's been insulated to a large degree because it's less easy to invest in, but it's not impossible. In the United States, where, on average, you've got farmland for $3,000 an acre, and in some places as much as $5,000

–6,000 an acre, prices have increased significantly over the last five years.

Ultimately, the price of farmland has to have some correlation to the operating returns you can generate, and I would argue that in some markets, that relationship is out of equilibrium. As I just mentioned, American farmland doubled in the last five years, and that's a big run.

Mayer: And compared with what you see around the world, it hasn’t been that way?

Johnston: Well, strangely

— or perhaps not so strangely — other than sub-Saharan Africa, where I'll leave it up to your readers to decide if they want to invest, virtually every market in which you can actually buy farmland has seen large price movements in the last five years. It's not us just "talking our own book," but Canada's one of the few places where there that hasn’t happened.

Mayer: All right, so that's good. So maybe we should segue into talking a little more specifically about your backyard, then, your bailiwick. Tell us a little about the macro story in Canada, and drill down to your situation, what you're seeing.

Johnston: Sure. The key thing for people to remember is that farmland ultimately is a productive asset. At a high level, you're paying for a bushel of yield. You always have to have that in the back of your mind. Then superimposed on top of that, you are making an investment in a potentially politically controversial asset class. So you've got two things you should be focusing on: The price of your yield and the political risk.

Mayer: It's almost like an energy asset, really. It reminds me of that, hearing you talk. It's like investing in oil wells or something.

Johnston: It's exactly like that. Let’s say you can buy oil wells for $5,000 a flowing barrel in Africa or you can buy them for $30,000 a flowing barrel in the United States. There's a reason for that discount, and the primary reason is the political risk. I think that people have forgotten the political risk analysis in their decisions about where they're going to invest in farmland. I think that political risk is going to be a key determinant of agriculture returns in the next 20 years.

We're fortunate in western Canada, as we have low prices, or low prices of yield, first-world infrastructure and no significant political risk. It's one thing to say farmland in Africa is $500 an acre. The more important question is whether you're going to own it in 10 years.

Mayer: So the yields are still attractive that you're seeing?

Johnston: Absolutely.

Mayer: So, is it now off to the races or do you think you’ve got several years of great gains?

Johnston: If you predict that Saskatchewan prices will reach parity with Alberta prices, that will require Saskatchewan to go up approximately 300%. The two provinces are neighbors with similar yields, weather, infrastructure, etc.

— this is a like-on-like comparison, for the most part.

Mayer: And when you compare that to what's going to happen in other asset classes, like what you might get in Treasuries, that's going to be mighty, mighty good.

Johnston: Exactly. And of course, nothing stands still, and I know that there's a deflation/inflation debate running right now. But if we get into an inflationary period on top of just that pure arbitrage between Saskatchewan and Alberta, we know that in inflationary times, farmland significantly outperforms.

I would argue that if Saskatchewan caught Alberta, you would still have Saskatchewan land at approximately $1,200 an acre, from the $450 an acre it is currently. Looking around the world, $1,200 an acre is still competitive to most other markets.

Mayer: So you mentioned the inflation-deflation debate. That's a really, really hot topic among my readers. I have a feeling I know where you come down, but just what are your thoughts on that whole thing?

Johnston: To me, we have finally arrived at a point in financial history where there's no restraint on money printing globally and no fiat currency with sufficient market size and stability to act as a safe haven.

Prior to 1971, you could argue that there was at least some restraint on printing. Now we're in a period when virtually every government and central bank has a policy of inflation. In fact, there is a widespread belief that inflation is actually a good thing.

It's not as if inflation is incidental to what they have been doing. They're not saying, "Let's bail out all the banks and hey, that might be inflationary." I think they have an explicit, although often unspoken, policy of creating inflation, and their history of debasing their currencies, I would argue, is near perfect.

Mayer: Yeah, you don't want to bet against the government's ability to destroy its currency, which is what the deflation argument seems to be to me.

Johnston: Yes, destroying your currency is just inflation. I'm pretty confident that they'll get around to destroying their currencies.

Mayer: So load up on those hard assets?

Johnston: Yes, the currency debasement issue may not be as conspicuous to the average person, because there's that old saying that currencies don't appreciate, they just depreciate at different rates. We’re experiencing that now. I would also argue that the banking system is incentivized to create leverage and lending, so I can't see that all this money sitting on the sidelines indefinitely.

Mayer: Yeah, I agree.

Johnston: Also the governments of the world are now saying "If you're not going to lend it, we'll borrow it." Hence, we've got fiscal deficits exploding across the globe. We have the same thing happening in Canada. They have lots of nice terms for what they are doing

— quantitative easing, stimulus, etc. — but strip away all the polite jargon and it’s simply printing money, borrowing money and spending money. If history is any guide, it will be inflationary.

Mayer: Agreed. Let's talk specifically about if investors or readers are interested in actually investing in farmland, without actually going out and buying it and doing it themselves, what are some options?

Johnston: Unless you are worth a significant amount of money, it's very difficult to invest in farmland directly. Let’s say you were worth $20 million, and you wanted a good-sized 10% exposure. That would mean you were still targeting only a $2 million farmland portfolio. In a place like Saskatchewan, that amount of money would not get you a diversified holding.

Farmland is really one of the few asset classes where it really makes sense to go through a fund, because you cannot get diversification without deploying large amounts of capital, and of course, once you've deployed large amounts of capital, you have to monitor it, you have to find renters, all the things that come with that.

Mayer: No, I agree. I know, because I've looked all over the place for ways to get exposure to farmland. There really aren't any. There are a few stocks out there, but it's not really a direct thing. Like everyone knows Cresud in Argentina. There's a company called Black Earth Farming. But these are all kind of iffy things, not quite the same as investing in a fund like yours, for example, in which you're actually then just one step removed from actually owning farmland.

Johnston: Black Earth Farming and Landkom have political risk, and they do not own land. They lease it.

In Cresud, you have land ownership combined with lots of different operational businesses

— they actually grow crops, they merchandise crops. So if you don't want that exposure, the universe starts to shrink down and you have companies like ours in Canada. In the United States, you have much a much bigger and more developed market. For instance, you have Hancock, which is a pure farmland fund approximately $1 billion in size.

In Africa, you have Emergent, which is buying land in sub-Saharan Africa. The questions again is what is the political risk in that investment?

Mayer: Right. I remember we talked a while ago. Your fund was only open to Canadians. Is there a way that Americans can invest in Agcapita yet or not?

Johnston: We are looking at that, and it’s technically possible depending on the province in which the capital is deployed. But our current funds are limited to Canadians.

And also, unfortunately for U.S. investors, the capital-raising process for foreign companies coming into your market is very complex, time-consuming and costly.

Mayer: Yeah, it's terrible. That's why more and more companies aren't even bothering listing here. They list in London or they stay listed in their home markets.

Johnston: It's hard to justify the costs and the time.

Mayer: That's a bummer. Anything else you want to add in there before we wrap this up?

Johnston: No, I think we covered it all. You know the macro better than anyone.

It's interesting, because we've become schizophrenic in the West as far as our attention span.

Mayer: Yeah, before the financial crisis rolled around, this was the hot topic. And then it died.

Johnston: And now it's back on the front burner again. But all the while, China has just been relentlessly securing supply. It doesn't take its eye off the ball.

Mayer: I'm always amazed at these food and land deals that go on, whether it's China or India or Saudi Arabia leasing out acreage somewhere else. It's fascinating.

Johnston: We’ve had overtures from the Saudis, who wanted an off-take agreement for 400,000 hectares.

Mayer: Wow.

Johnston: Of course, that isn't even remotely possible. But they asked with a straight face.

Mayer: That's amazing. They don't mess around, huh? They got money.

Johnston: They basically had unlimited money for this purpose and they didn't want to own farmland. They just wanted an off-take where they could guarantee the supply.

Mayer: Thank you very much for your time here. This is a lot of good stuff.

Johnston: Oh, thanks, Chris, I appreciate it.

Farmland is one of those things that takes us back to mankind's most basic needs -- food, water, and energy. They'll never go away.