Smarter than the Market? Not Likely

Food cardMichael Swanson, Ph.D., Wells Fargo Chief Agricultural Economist

Many agricultural producers are making key decisions for 2019’s crop today since they need to line up the acres and inputs months before the planters roll next April. They make the stability of their future cash flow, and survival, hostage to their long-range forecasting abilities. Without a doubt, everyone overestimates their ability to forecast the future.

No one saw the tariff disputes coming, and early 2018 opportunities disappeared with each new piece of information that popped up. So, no one should doubt that 2019 will be a repeat of this process of new developments blowing up plans and changing opportunities. My advice to farmers and livestock operators is to become “Newtonian” in their hedges and plans. Sir Isaac Newton’s third law of physics gets paraphrased as “for every action there is an equal and opposite reaction”. A true hedge of a decision involves an equal and opposite decision that locks in a margin, whether that margin is good, bad, or indifferent.

Too many farmers and livestock operators think it can only be a hedge if it locks in some profit. So, why would anyone ever lock in a loss? The simple answer: at least they know what their loss will be, and they would have decided that they can survive that loss to move onto the next round. Or, that particular loss represents a smaller piece of the overall profit and loss equation.

The market knows the averages of the trades, but it doesn’t know or care about the individual transactions. For example, the cattle feeder futures moves relentlessly according to feed costs and the fed cattle contracts. If feed costs rise and/or fed cattle contracts decline, the feeder contracts immediately lose value. It isn’t that the feeder cattle are any different. The market simply calculates what price works to make the break-even for feeding the cattle. And, it works the other way around, as well, with a shock to the feeder cattle supply pushing fed cattle contracts up or down.

The crop side resembles the cattle and hog markets, but it has a lot more approximations and time lags between the market signals, creating opportunities for the participants. When grain and oilseed prices rose between 2005 and 2012, the input markets chased them up as the suppliers saw the farmers had higher margins. Conversely, the input markets have been forced down as the margins in crop production have been constricted. Farmers who would have hedged on the way up would have left lots of profits on the table, and farmers who hedged on the way down would have gained lots of profits.

At the end of the calculation, would the hedgers be better off than the gamblers? Based on assumptions, you can get any answer you want to that question. And more often than not, the answer we come up with flatters our original belief. I think one thing is for certain, the hedged strategy always exposes the real profitability relative to execution.

The real long-term and sustainable advantage comes from operational excellence in the field of competition. The price swings for inputs and outputs can obscure relative performance in the short-run. Sometimes a less efficient and effective operator gets “lucky” with price swings, and given human nature, they attribute their success to their choices. However, randomness catches up with everyone, and their success disappears with the “bad luck”. The same would be true of an efficient and effective operator who simply rolls the dice, but their earnings and losses are constantly better than the poorer operator by their “average of excellence”.

Without getting too technical, one should think about statistical distributions with means and variances. Both operators get whipsawed by the market prices, but over time, they have different average returns on assets and profitability.

Hedging curve chartSource: Wells Fargo

A well hedged operator using a “Newtonian” approach won’t change their average profitability, but they will change their variance of profitability. A lower variance of profitability will allow them to do two things very differently that will make a significant impact over time. First, they can use more debt in place of equity which improves their return on equity. Debt financing can be changed faster and cheaper than accumulating equity over multiple years. Secondly, it allows them to calculate their true competitiveness. Additionally, they can focus on things like yield and efficiencies in labor and management. The chart below shows 20 years’ worth of dairy returns between average and excellent operators. They all were whipsawed by the milk and feed prices. The variance of profitability from year to year for the two groups is almost identical, but the excellent operators had more than twice the return on assets.

Return on Assets: Dairy Cattle and Milk ProducersSource: Wells Fargo

The “Newtonian” approach to hedging matches input purchases and futures sales both by timing and quantity. This allows operators to prioritize the long-term factors that drive the differentials between the competitors. It is trite, but true, that we only can control the things that we focus on. So, the winners focus on the handful of things that make the biggest difference. And, hopefully, by eliminating the marketing “noise” from the game plan, farmers and livestock operators will have time to manage their success better in 2019 and beyond.