Rising Agricultural Product Prices: The Agriculture Sector Offers Structural Investment Opportunities

The window during which the defensive attributes of the agricultural products sector come into play is relatively brief, while in the later period, as expectations of reduced agricultural output persist, the pressure of rising prices and the pressure to boost agricultural production will continue to be focal points for investment in the agricultural products sector. We recommend paying attention to: 1) varieties with relatively strong expectations of output reduction, such as rice and cotton; 2) after the disaster, the government may introduce some favorable agricultural policies for the purpose of boosting agricultural production.

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Report Summary

Judging from recent price trends, weekly data from the Ministry of Commerce show that since mid-April the edible agricultural product price index has risen in a pattern contrary to seasonal norms. Looking at the recent rise in agricultural product prices, the increase has mainly occurred in some vegetables and fruits; grain prices and pork prices are both rising, but the pace of increase remains relatively moderate.

The second quarter is China's most important sowing season for autumn crops, and in 2010 climatic conditions have already affected crop production in some regions on multiple occasions. Although it is still too early to assert that China's grain output will definitely decline, expectations of reduced output will be difficult to dispel for some time to come, which means that expectations of rising prices will also persist. On the other hand, given the established fact of rising grain prices, prompting grain prices to turn downward would also be detrimental to maintaining farmers' enthusiasm for production, which means that later government intervention will be aimed more at influencing the pace than the direction.

Because the production cycle of agricultural products is relatively long, any supply gap is difficult to improve in the short term, while demand for agricultural products is relatively rigid, so they often become an excellent vehicle for excess liquidity. We have observed that some agricultural product prices have risen astonishingly, such as garlic, mung beans and potatoes, all of which recently hit record highs. Against the backdrop of liquidity being difficult to drain away in the short term, agricultural products are still expected to continue serving as a liquidity vehicle; the emergence of a supply gap is the most important basis for liquidity inflows, and among major agricultural products, cotton is a variety whose supply pressure is relatively certain.

The correlation between the performance of the agricultural products sector and the broad market has declined markedly recently; while the broad market fell continuously, the agricultural products sector achieved relatively good relative returns. We use agricultural product prices, favorable policies and the sector's defensive nature to observe the performance of the agricultural products sector. The window during which the defensive attributes of the agricultural products sector come into play is relatively brief, while in the later period expectations of reduced agricultural output persist. We recommend paying attention to: 1) varieties with relatively strong expectations of output reduction, such as rice and cotton; 2) after the disaster, the government may introduce some favorable agricultural policies for the purpose of boosting agricultural production, and the agricultural input products involved are expected to benefit from the influence of favorable policies.

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Agricultural stocks got off to a strong start in May. Since May the sector index has risen 3.8%, with relative returns exceeding 10 percentage points; historically, monthly relative returns exceeding 10 percentage points represent a very good performance.

Excess returns came from resilience against declines. In 2010 the sector index's excess returns mainly came from resilience against declines in two stages: the first stage was January, and the second stage was the strong consolidation since April 15 amid the broad market's sharp plunge.

Agricultural stocks became a refuge. Hotspots in agricultural stocks have rotated very quickly this year, showing more of a safe-haven effect in a weak market, somewhat similar to investors choosing gold as a safe haven, which is also the origin of this article's title.

Two major reasons for refuge. First, the agriculture industry has never seen bearish policies; on the contrary, policies supporting agriculture are introduced from time to time. Second, agricultural stocks benefit from inflation, and coupled with the unusually frequent severe weather this year, expectations of agricultural product price increases have strengthened.

Agricultural product prices will rise moderately. The final wave of soft commodities has yet to appear; severe weather has lowered expectations of continued grain output increases; the ongoing economic recovery has revived inflation expectations; agricultural products will show moderate increases.

It is only a matter of time before pig prices bottom out and rebound. There is limited room for further declines in live pig prices; the currently low pig-to-grain price ratio leaves farmers unwilling to restock, so a rebound in pig prices is only a matter of time. Based on a long-term average price of 13-14 yuan/kg, and using the current price as a base, there is still room for live pig purchase prices to rise by more than 30-40%.

Beware of catch-up declines. Agricultural stocks are not gold, nor are they like gold. In the latter half of a market correction and even after the market stabilizes, the risk of catch-up declines in agricultural stocks is very great, especially when the industry as a whole has already achieved huge excess returns.

Haid Group is the top pick. In terms of industry space, earnings growth, management team and governance structure, Haid Group's current valuation is within an acceptable range, making it an investment target capable of delivering long-term returns.

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The price cycle remains in a state of divergence: in terms of the price cycle, although mineral product prices and coal, oil and electricity prices are already at high levels, and agricultural product prices are also in the process of rapid increases, the price of live pigs, one of the most important agricultural products, is still hovering near the relative bottom of the price upcycle. At the same time, in absolute terms, pig prices have now fallen back to the level of April 2007. Therefore, if this special factor of price cycle divergence is taken into account, a future cyclical rebound in pig prices will further push up agricultural product prices and even the overall inflation level.

A rebound in pig prices from the bottom will be a high-probability event: whether viewed from the impact of inventory——costs——profit changes on prices within the pig cycle, or from the perspective of disease or government regulation, at the current point a rebound in pig prices from the bottom will be a high-probability event. At present, live pig prices have already begun to bottom out and rebound.

A new round of high inflation “from both internal and external sources” may be arriving: various pieces of evidence indicate that a new round of inflationary pressure has already arrived imperceptibly. Against the current backdrop of price cycle divergence, as various internal and external inflationary factors emerge one after another, the circular reinforcement of future inflation by rising pig prices, together with the added momentum from drought, will very likely give rise to an inflation “from both internal and external sources” more severe than that of 2007-2008,

Agricultural stocks that hedge against high inflation risk will usher in a relatively good phased investment opportunity: looking back at 2008, against the economic backdrop of high inflation at the time, the agriculture, forestry, animal husbandry and fishery sector performed extremely prominently. At the same time, we find that in an inflation cycle, the most pronounced excess returns for agricultural stocks occur in the stage when moderate inflation shifts to high inflation; thereafter, every rebound in agricultural product prices is reflected in relatively pronounced excess returns for agricultural stocks. Looking ahead, under expectations that the forward inflation level may jump, agricultural stocks are still expected to become the investment theme of the next stage.

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Including China's pesticide industry in our research coverage for the first time

We are including China's pesticide industry in our research coverage for the first time and have assigned ratings to 5 stocks. Although the frequently fluctuating severe weather this year will have a negative impact on crop production, which is unfavorable to the fertilizer industry, under warm weather conditions and after droughts, pests usually breed in large numbers.

Therefore, we expect pesticide demand to remain strong in 2010-2011.

Over the next 5-10 years, we expect rapid industry consolidation and a reshuffling of leading enterprises to become the main investment themes, and we believe the recent decline in share prices in this sector has created a good opportunity for people to invest in long-term winners.

Investment Opportunities

We favor pesticide enterprises with well-known brands, diversified products, strong R&D capabilities, broad or unique distribution networks and solid customer bases. We scored each company according to the above principles, and the top picks that ultimately emerged are Yangnong Chemical and Lier Chemical.