Almond Orchards & Other Investments
The past few installments used water to explain the financial system – the world’s irrigation system for money. If you understand how the irrigation network is designed, then you’ll know where the money will go. Now let’s talk about water, water. California is in need of it. This year’s drought has been punitive, but it is just the worst of five dry years. California is unique among desert climates in that it lacks a functional system for allocating water. In other words, water does not go to its highest and best use, instead it flows to whomever happens to have a claim on it or to whomever gets it first.
While Los Angelinos are told there is not enough water for their lawns and toilets, Californian dairy farmers maintain large haymaking operations (i.e. lawns) in the desert. And nearby, high-value fruit trees that don’t have water allocations wither and die. Without a functioning rationing mechanism, the 2014 drought is taking a broader and harsher toll than necessary, particularly on high-value crops such as almonds.
Almonds are the trees most affected by poor rationing of water, so let’s spend a minute on them. Almond trees are happiest in desert climates. They require a dry, warm winter for pollination and a dry summer for the fruit to set. Outside of California, people living in desert climates regulate their water supply carefully. As a result, farmers in other countries can’t plant almonds – which require four times more water than row crops – willy-nilly. But since there is no rationing mechanism for water in California, the state has grown to have 85% share of the almond market globally. Almond demand has more than doubled over the past ten years as it has become the preferred low-carb snack. In turn, Californian farmers have been more than happy to plant more trees — since they don’t bear the cost of water.
But now the party is over. Without water, the Californian almond crop cannot set properly. The southwestern Central Valley lacks groundwater to pump water from wells. And to make matters worse, stressed trees produce lower-yielding and lower-quality crops for several years after a drought. As a result, production and yields will be down for several years, while global demand keeps growing at 8% a year. So it is not hard to imagine that buying an almond orchard operator in, say, Australia for replacement cost would be a good deal. This price is particularly attractive relative to other food producers/processors. Fast-growing low-carb food producers trade at 25–35x earnings and slow-growing, lower quality food packagers like Hillshire Brands are caught up in bidding wars for 34x earnings.
Shifting gears, China’s current woes are similar to those of the California almond farmer’s. After years of spraying “water” everywhere, the supply of money is now constrained in China. And there is a lack of infrastructure to allocate money to its highest and best use. China has traditionally regulated the flow of money by limiting the amount of loans that each bank can make. These levels have been tamped down since 2011, so banks started creating trusts, which make loans to state-owned companies or enterprising real estate developers. These trusts are off-balance sheet (e.g. think CDO), so they are within the rules. This new pipe of money sprayed money everywhere- in three short years, these off balance sheet structures grew to be 75% of GDP. At this moment, that pipe is being shut off as well. So that leaves one last pocket of money for lending: companies that have money are lending to companies that don’t.
This inter-company lending is pernicious because it rapidly percolates through the financial system without a standard for underwriting risk or collections. Let me give you an example — in order to stay in business, a steel mill sells steel to a bridge-maker that can’t pay, but has government backing. So the steel mill will accept an IOU from the bridge-maker and then turn around to use that IOU as payment to its iron ore supplier. Now the iron ore supplier needs to go after the bridge-maker for cash, but instead the iron supplier can pass on that IOU to a power supplier or other service provider. In this daisy-chain of money, there is no one bank, trust or company that is rationally allocating and collecting money for its highest and best use. Everyone is passing paper around trying to live another day.
The idea that China is in trouble is neither novel nor interesting. The thing to figure out is – given this design of the Chinese irrigation system – where do you want to be as an investor so you can win in any circumstance? Think about it. There is an excess supply of lending and borrowing. On the other hand, there is a shortage of risk allocators and collectors. A professional debt collection capability is the commodity that is in shortest supply and most in demand in China today.