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ETF Specialist

An ETF for Growing Appetites

Long-term growth in global food consumption should benefit this fund's holdings, but investors should be prepared for a bumpy ride.

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 VanEck Vectors Agribusiness ETF (MOO) invests in U.S. and international agricultural stocks and weights its holdings by market capitalization. This includes firms that sell agricultural equipment, chemicals, and seeds, such as  Monsanto (MON),  Potash Corp of Saskatchewan (POT), and  Deere (DE). Just less than half the portfolio is invested in foreign stocks, and the fund does not hedge its foreign-currency exposure. Despite its global reach, this is a highly concentrated portfolio. Its top 10 holdings account for more than half of its assets and have a significant impact on performance. This could serve as a suitable satellite holding for investors who want to profit from growth in global food consumption and are willing to accept considerable volatility.

Agriculture commodity prices have a significant impact on the performance of most agriculture businesses because their customers' income and demand for inputs, such as tractors and fertilizer, is tied to grain prices. But the fund's performance has been only moderately correlated with commodity prices during the past five years. That’s because there are other factors, like expenses and product life cycles, that can influence these firms’ profitability. And demand for yield-enhancing products isn’t entirely driven by grain prices. Harvest size can also have an impact.

Although weather can have an unpredictable impact on the supply and prices of agriculture commodities in the short run, long-run demographic shifts are favorable for the agricultural industry. Global population growth and increasing meat consumption in emerging markets are sustainable trends that should increase the demand for food during the next few decades. Market prices may fully reflect this long-term growth potential, though the fund’s holdings will likely trade at a discount when their near-term prospects are dim. Many of the fund’s holdings do not enjoy durable competitive advantages, so competition could erode their profits.

Fundamental View
Fertilizer and agricultural chemicals are among the most important yield-enhancing products available to farmers. Companies operating in this subindustry account for about 39% of the portfolio. These include seed and crop chemical companies Monsanto and  Syngenta (SYT). Innovation and a successful patent strategy are critical for many of these businesses to stay ahead of competitors.

Fertilizer makers, such as  Mosaic (MOS) and Potash Corporation, sell commoditized products. There are three major types of fertilizer: nitrogen, potash, and phosphate. The potash industry is oligopolistic and has historically benefited from restricted production, which has kept prices high. But Uralkali URKA upset that pricing power with its decision to pursue a volume-over-price strategy. Nitrogen fertilizer producers, such as  CF Industries (CF), have to contend with volatile natural gas prices, which is one of their biggest cost drivers. Demand for nitrogen fertilizer is closely linked to corn production, where it is a key input.

Crop prices have a strong influence on farmers' income and their demand for yield-enhancing chemicals, seeds, and machinery in the short term. But long-term growth in global food consumption is a tailwind that should benefit the fund's holdings.

By 2050, the world's population is expected to grow to 9.7 billion from 7.4 billion today. Most of this growth will come from emerging markets, where incomes are rising. As emerging-markets populations become wealthier, they are projected to increase their consumption of meat, which will have a disproportionate impact on the demand for grain because corn and soy are common ingredients in livestock feed. It requires an estimated 5-7 pounds of grain to raise a pound of beef, according to the U.S. Department of Agriculture. Beef is more efficient than these figures imply because a little less than half of slaughtering weight is raised on grain. Even so, small changes in livestock consumption can have significant impact on demand for grains.

Increase in global food consumption will require agricultural output to increase significantly during the next few decades, according to projections from the Food and Agriculture Organization. Because the amount of arable land is relatively fixed, these long-term trends likely will increase demand for yield-enhancing products. The fund's holdings' ability to help their customers meet the growing demand for food and keep competitors at bay will drive their long-term growth.

Only a handful of the fund's holdings, representing about 41% of its assets, carry a wide or narrow Morningstar Economic Moat Rating. Consequently, competition may erode the profits of many of the fund's holdings over the long term.

The past few years have been tough for agribusiness stocks, partially because of falling agricultural commodity prices. During the trailing five-year period through June 2016, the fund lagged the broad S&P Global 1200 Index by about 7.1 percentage points annualized. But its holdings were still trading at a higher average multiple of earnings and book value than those of the broad index at the end of June.

Portfolio Construction
The fund employs full replication to track the MVIS Global Agribusiness Index. This free-float-adjusted index includes liquidity-screened companies that generate at least half of their revenues from the following lines of business: agrichemicals, fertilizers, seeds, farm machinery and irrigation equipment, agricultural products, livestock, or fishing. In order to improve diversification, the index follows a modified cap-weighting approach that limits each of the top two constituents to 8% of the portfolio. This limit tapers off to 4.5% for constituents smaller than the seventh-largest holding. However, because a few large market leaders dominate this industry, the fund's assets are highly concentrated in its top 10 holdings. This concentration introduces a meaningful degree of company-specific risk. The index is updated quarterly.

Fees
The fund charges a 0.55% expense ratio, which is in the same range as other natural-resources exchange-traded funds and less than its closest peer. However, this fee could be lower. During the trailing three years through June 2016, the fund actually outpaced its benchmark by 12 basis points. This was because of securities lending revenue, where the managers earn ancillary income for the fund by lending out the underlying holdings in exchange for a fee.

Alternatives
PowerShares Global Agriculture (PAGG) is the closest alternative to MOO. PAGG targets stocks in the fertilizers & agriculture chemicals and agricultural products subsectors. But its higher expense ratio (0.76%) and smaller asset base make it a less attractive alternative.

Investors looking for more direct exposure to grain prices might consider  PowerShares DB Agriculture ETF (DBA) (0.85% expense ratio). It buys futures contracts on several commodities including soybeans, corn, wheat, and sugar. Commodity futures offer three sources of return: 1) changes in the commodity spot price, 2) returns on the cash collateral securing the contract (which is typically invested in T-bills), and 3) the roll yield. Historically, the return on the cash collateral has been a large component of the total return on commodity futures, but, because interest rates are very low, this is unlikely to be a significant source of return in the near term.

In order to maintain exposure to the underlying commodities, DBA must sell each contract prior to expiration and replace it with one maturing further out. The new contract may have a higher price than the one it is replacing on the date of the switch. This is called a negative roll yield, and it may cause the future's performance to lag the spot commodity's. It may occur if the costs of storing the commodity are high or if the market expects spot prices to increase over the life of the new contract. This is a risk that investors in stock funds, such as MOO, don't face. Additionally, equity funds like MOO tend to be more tax-efficient and lower-cost.

 

 

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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.