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Time to Diversify?

January 8, 2014
By: Ed Clark, Top Producer Business and Issues Editor
 
 

Spreading risk can boost farm returns

With a $4-something outlook for corn prices for the near future, now might be just the time to consider diversifying your operation and making alter­native investments. Not having all your eggs in one basket can spread risk and balance out future income streams.

"Diversification can mitigate risk," says Michael Langemeier, ag economist at Purdue University. "Doing so can increase net returns over time."

When profits from one enterprise are down, another can be up. Take one of Langemeier’s favorite suggestions for Indiana farmers: Consider adding a contract swine enterprise. While hog profits have been tough to come by in recent years, profits in the intermediate term should be strong—at a time when the outlook for growing corn hovers just above break-even.

Potential benefits. Langemeier agrees that this might seem like an about-face as agriculture is becoming increasingly specialized. However, diversification can pay dividends. First, it can create a new profit stream. Second, diversification can cut costs if the new business is farm related. Existing overhead, such as farm equipment, can be shared.

Risk reduction is another reason to diversify. That’s particularly true with the expected elimination of direct payments in the next farm bill, leaving crop insurance as the only safety net.

In 2013, the $5.68-per-bushel crop insurance revenue guarantee for corn was great risk protection, but that won’t be the case in 2014. In fact, Langemeier notes that if the February corn futures price is just $4.25 per bushel, the effective per-bushel crop insurance revenue guarantee is only $3.36 per bushel, far below breakeven for many.

"This scenario is quite possible," he says.

Diversifying makes sense regardless of the current crop price outlook, maintains Moe Russell, Farm Journal columnist and farm business consultant. He shares this example: Say you have $100,000 to invest in one enterprise and it returns 7%. At the end of 10 years, you nearly double your money to $196,968.

To illustrate how Russell’s diversification model works, let’s start with $100,000 and invest it equally in five enterprises. The first $20,000 investment earns 20% and is worth $123,834 after 10 years. The second $20,000 earns 15% or $80,914. The next investment earns 7% or $39,343. The fourth investment, meanwhile, earns nothing, so at the end of the period, you only have your original $20,000 investment. With the fifth investment, you lose it all—even the principal.


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"Add this all up and it’s $264,091, or 34% more than your original investment of $100,000 at 7% after 10 years," Russell says. "This is the power of diversification—even with two losers out of the five."

Diversification works because it offsets the high volatility of having just one enterprise.

He agrees that livestock is the first enterprise that should be considered because for many farmers that’s a good fit. "But don’t get into something you don’t know and don’t understand," Russell says, adding that advice applies to nonfarm investments, as well.

In one case he shares, a farmer invested in convenience stores, but it didn’t work because the producer did not have the right management elements in place.

Of course, every new enterprise not only requires expertise but also upfront investment money, says Scott Brown, ag economist at the University of Missouri. "Now is a great time to think about reducing risk; however, if I were a crop producer, I’d want to make sure that I was as efficient in the new enterprise as I am with my crop business," Brown advises.

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FEATURED IN: Farm Journal - January 2014

 
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