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Stephen Johnston

Stephen Johnston

Stephen has over 15 years experience as a fund manger - working for organizations such as the European Bank for Reconstruction and Development, Societe Generale…

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Leverage is Dead, Long Live Value Investing

My purpose today is to leave you with some hopefully constructive ideas to mull over the holiday season. Most of all I want to give you what I believe will be a compelling recap of the rationale for direct, unlevered farmland investments in Canada.

Let's turn our attention first to the matter of leverage. In todays volatile and alarmingly correlated markets, we believe most investors should avoid investments with material operating or financial leverage even more so when underlying assets have demonstrated high volatility themselves - this amounts to piling risk on risk and with that the magnitude of potential losses. The markets are finally returning to the idea that capital preservation should be the average investor's first and foremost concern.

Financial leverage (at least as it has come to be used in the last 15 or so years) is the logical but abused investment tool of a great 30-year period of declining interest rates. I know this may seem counter-intuitive in a negative real interest rate environment, but I believe in the short to medium term most investments should incorporate less leverage rather than more. The reason is the lethal combination of increasing volatility and leverage or in the case of currently heavily indebted sectors (e.g. the finance, insurance & real estate or "FIRE" economy), de-leveraging. As a rudimentary example, we are now in a market where there is a pronounced difference between buying an asset using 100% equity or buying an asset with 25% equity and 75% debt. This was not often the case over the last 2 decades - leverage, both operational and financial, was virtually always your best friend.

We are moving into a period where "margin of safety" is your new best friend. Leverage is no longer a universally superior return enhancement strategy. On a purely cynical note, leverage has increasingly been employed with a view to enhancing management returns (who disproportionately share in the upside but not the downside) rather than investor returns. Remember that you are always free to create leverage yourself in the way you finance your investments rather than having management dictate the level of leverage for you. In this scenario, you also have the added benefit of being able to vary your leverage over the life of your investments. Of course, margin of safety returns are much more difficult to find and require more investment selection skills than the "leveraged beta returns" that have been passed of as "alpha returns" over the last 2 decades.

At the risk of being accused of talking part of my book I want to move to a discussion about the appeal of Canadian farmland. I believe it stems from some highly unique and increasingly sought after characteristics - low volatility, low correlations to traditional asset classes, high risk adjusted returns, strong linkage to emerging market growth with limited political risk, reliable cash-flow generation and, if structured correctly, minimal counter-party risk. Taking each of these in turn:

  • Volatility: Farmland prices exhibit low volatility in general and in particular when compared to listed equities. Canadian farmland prices have experienced approximately 1/4 the volatility of the S&P 500 over the last 20 years.

  • Absolute Returns: Farmland typically generates higher absolute returns than listed equities over most measurement periods. The combination of lower volatility with these higher absolute returns leads to one of the most important financial qualities of farmland - high risk adjusted returns or Sharpe Ratios.

  • Risk Adjusted Returns/Sharpe Ratios. Investors in public equities are being asked to accept nominal returns below 6% over long periods but with increasingly high price volatility. Meanwhile, farmland generates higher absolute returns but with lower price volatility. The result is that farmland consistently generates superior risk adjusted returns over public equities - often by a substantial margin. Investors are beginning to realize that they are not being properly compensated for the risk/volatility of public markets and we believe that farmland is becoming the beneficiary of a secular reduction in listed equity exposure amongst investors. In the face of poor public market Sharpe ratios, investor capital is wisely moving elsewhere - one of those places is farmland.

  • Correlation: Farmland has a low correlation to traditional retail investments - public equities and bonds and commercial real estate. Most of these traditional retail investments are exhibiting high positive cross correlations so it is very difficult for investors to construct diversified portfolios with the mainstream options. So for investors looking for genuine diversification, allocations to non-traditional and uncorrelated sectors like farmland continue to grow in appeal.

  • Emerging Market Linkage: As emerging markets develop, the consumption of energy and agriculture commodities increases rapidly at the early stages of GDP/capita growth. However, recent events in SinoForest should highlight the difficulty of making direct investments into emerging markets. By way of contrast, direct investments into farmland in developed nations provide linkage to emerging market growth but without political risk, opaque accounting, dubious legal systems - the list goes on.

  • Cash-flow: By cash renting (i.e. leasing the land to farmers for 100% upfront cash payment rather than operating) an investor in farmland can look forward to reliable cash-flow (on the order of 6-7% gross pa) wiithout operational risk. In addition, as cash-rents tend to track land prices with a lag, farmland rental cash-flows tend to be inflation hedging themselves.

  • Minimal Counterparty Risk: The recent bankruptcy of MF Global has shown that investors cannot afford to be complacent about counterparties. It is increasingly apparent that many financial intermediaries only appear to be well capitalized because risks, where apparent, are thought to be hedged. Via hedge transactions, intermediaries argue that net exposure, rather than gross, is the key measure for investors to consider. This is not the case and where there is a concentration of risk in critical counter-parties (e.g. AIG), in a world of high positive correlations across markets and asset classes, hedges can fail leaving catastrophic gross rather than net exposure and therefore bankrupt counter-parties behind. It is because we believe that counter-party risk remains opaque and non-trivial that direct farmland investments make sense to us - an unlevered portfolio of farmland has no counter-party to fail.

In addition to the qualities above, Saskatchewan farmland also trades at a demonstrable discount to global averages which I believe provides the critical margin of safety necessary for value investments. Saskatchewan price increases over the last 4.5 years (the period over which Saskatchewan farmland prices began to accelerate) go a long way to bearing out the existence of this "margin of safety":

  • Alberta farmland returns (2007 to present, ex rents) - 6.4% per year

  • Saskatchewan farmland returns (2007 to present, ex rents) - 11.4% per year

The margin of safety appears to be a substantial 5% per year of additional return (excluding rental cashflows) in Saskatchewan. Recent data also appears to support the idea that the Saskatchewan margin of safety returns may be growing. In the first half of 2011, when Alberta farmland increased a respectable 4%, Saskatchewan farmland increased 12%. Not surprising given that Alberta farmland trades for approximately $1,400/acre on average while Saskatchewan farmland trades for approximately $550/acre on average.

Thank you for reading these letters over the course of the last year. I hope you enjoyed reading them as much as I enjoyed writing them. Perhaps it is true that we are all thwarted writers at heart. Until the New Year...

Kind Regards

 

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