Cultivate big returns from farmers' friends

Whatever side of the gatepost you're on, this debate is part of the much wider and critical issue of food security, and what is undeniable is that production must become more efficient if we are to meet rising demand for food from a rapidly multiplying global population. This is where investors stand to make appetising profits.

Demand for cereal is set to rise by almost 50 per cent by 2050 to feed the extra three billion people on the planet. And as people in emerging markets become richer they are demanding more protein, usually in the form of meat, too. At the same time, food supply is becoming increasingly constrained because of limited land availability, lower water supplies, adverse climate conditions and an increasing use of arable fields for bio fuel and animal feed rather than crops for food.

In fact, raising animals for food already uses a third of the earth's arable land mass, according to the United Nations, and producing meat is both inefficient and expensive. It takes three kilogrammes of grain to produce just one kilogramme of meat. So, with the proportion of cereal used as feed estimated to reach 45 to 50 per cent by 2050, not only must crop yields rise and costs fall, but alternatives to traditional feeds must be found.

Fortunately, there's certainly scope for innovation here after three decades of chronic under-investment in agricultural research and development. Yields have stagnated for cereals, partly as a result of declining investment, while a lack of spending on food technology has wiped out productivity growth in the UK, too. Take dairy farming, where the top one-third of UK farmers are twice as efficient as the rest. Similarly, the cost of growing wheat for the top 20 per cent of wheat farmers is £100 a tonne, while for the bottom 20 per cent, it is £160 a tonne. Wheat yields, too, have the potential to increase by 30 per cent by some estimates. The companies that facilitate this, from the processors to the seed, feed and fertiliser manufacturers, will be well positioned to benefit.

Phil Carroll, analyst at Shore Capital, calls this sweet spot the "value gap". While prices in the main commodities have retreated from their highs to a new price plateau, Mr Carroll says he's not interested in the commodities themselves, but the companies that add value to help meet demand, which is where the real opportunity lies.

In the small UK-listed agri-food sector, Aim-listed Wynnstay Group (WYN) stands out. It has a 14 per cent share of the UK seed market and is steadily increasing revenue and profit, while expanding geographically and making acquisitions. It develops feed products and healthcare supplements for livestock, but is also involved in all the areas of crop production, supplying seed, fertilisers and crop protection products. Boss Ken Greetham predicts a massive market for agricultural products over the next 30 years. "We have limited land and water and can't do much about that, but we can do a lot with technology and that has been lacking in our industry," he says. Companies in the sector are finally redirecting investment towards research and development, he adds, while the outlook for UK agriculture and exports is at its strongest since the 1940s.

NWF (NWF) is another domestic player. It now feeds one in seven dairy cows in Britain, investing in animal nutrition research projects to improve farmers' profitability. Meanwhile, Carr's Milling Industries (CRM) operates a diverse business model, manufacturing speciality feed and fertilisers as well as specialist machinery and fuel. For extra diversification, it processes and sells cereals to bakers, food manufacturers and retailers.

Then there are a suite of global giants which dominate the business of feed ingredients and crop nutrients and protection such as Mosaic Company (NYSE: MOS), Nutreco (AM: NUO) and Agrium (TSX: AGU). US-based Archer Daniels (NYSE: ADM) is developing alternatives to traditional cereal-based feeds that can transform crop residue into a nutritious feed source, squeezing more value out of every acre. This is particularly important in bad crop years and expands capacity without requiring additional land.

Indeed, crop protection, fertiliser, seed engineering and nutrition is now big business, but sustainability is becoming an equally important factor as farmers are increasingly demanding less environmentally harmful crop treatments. Chemical giant BASF (GER: BAS) recently paid $1bn (£651m) for Becker Underwood, which develops yield-improving biological products that stimulate plant growth with fewer chemicals. Bayer's (GER: BAYN) CropScience business shelled out nearly $500m to acquire AgraQuest, which also offers the so-called 'green products'.

Smaller companies such as UK-listed Plant Health Care (PHC) are also active in this space. In addition to organic fertiliser, it makes proteins that stimulate a plant's immune response, thereby increasing yields. The business strategy is to license this technology to bigger players. In 2008, it signed a deal with Monsanto (NYSE:MON) and a recent tie-up with Arysta LifeScience will see Plant Health's main product, Harpin, sold with branded fungicides in the US in 2014.

Elsewhere, pork specialist Cranswick (CRW) is experiencing high demand for meat, both at home and abroad, helped by the lower cost of pork relative to other meats. Recent European Union rules forcing continental pig farmers to up their welfare standards has also levelled the playing field and given Cranswick a boost. In addition, it has just bought East Anglian Pigs, an outdoor pig farm, suggesting Cranswick sees significant scope for growth here. Indeed, the UK is only 50 per cent self-sufficient in pig meat, while UK and European herds are in decline.

IC VIEW:

In Britain, food self-sufficiency has declined over the past decade to 59 per cent and the weather has caused havoc for farmers - last year's washout means Britain is likely to be a net importer of wheat for the first time in a decade. Yet cash-strapped Brits still demand cheap food and prefer to buy British. And, with global consumption rising, high food prices and finite resources, innovative technology to drive efficiency and boost yields will be vital to prevent demand from outstripping supply, playing into the hands of companies that help farmers maximise productivity and process their goods. This is something bigger players are picking up on and vying to gain exposure to - Glencore's recent acquisition of Canadian grain handler Viterra is a case in point. True, many of these companies will suffer short-term bumps along the way, inevitable given the nature of agriculture, but the evidence suggests that, for those of you willing to take a long-term view, investment in this sector will pay off.

FAVOURITES:

Carr's Milling is one of our long-standing buy tips (875p, 3 May 2012). It has recently seen extra demand for specialist animal feed due to poor grazing conditions and, trading on 10 times forward earnings, is below the peer average of 13. We also like Swiss giant Syngenta (VTX: SYNN), a leader in crop protection and seed supplying. Its shares have risen 11 per cent on our buy tip (335CHF, 16 Aug 2012). Rising grain prices have helped and a forward PE ratio of 16 means it's cheaper than peers Monsanto and Bayer, too. Produce Investments (PIL) recently reported a half-year loss of £1.2m, but this was largely down to last year's unseasonably wet weather. The underlying business model is sound and the shares could be worth snapping up at an all-time low of 135p, rated on a cheap five times forward earnings. It's worth keeping an eye on Canada's Agrium, too. The vertically integrated company mines its own nutrients and offers growers across the Americas crop production services through its retail unit. Buying the bulk of Viterra's agri-products business from Glencore beefs up its retail presence in Canada and Australia.