No new way to go broke…

  • It’s always the debt
  • Who’s the buyer?
  • Conference update

Our esteemed colleague, Vern Gowdie, likes to remind us that ‘There’s no new way to go broke. It’s always debt.

We can’t argue with that.

And if you want a perfect example of it, we recommend that you read The Land Boomers, a book we finished reading several weeks ago.

It recounts the mania of the Melbourne land boom of the 1880s and 1890s.

It recounts how many Melburnians built enormous wealth, and grand houses and buildings — many of those properties still stand today.

But it also recounts how many (perhaps most) of those Melburnians saw the wealth disappear, almost overnight. Why? Because they had used debt to speculate during an asset price bubble.

And when the asset price falls, and the value of the debt doesn’t…well…that’s trouble.

But that’s not unique to Melbourne in the 1880s. The misuse of debt has ravaged investors, speculators and economies alike, both before and after the 1880s.

And it’s happening right now. No more so than in the seemingly dull and functional milk industry. That’s right, the tales of woe about ripped off farmers that you’ve heard about in the press all come down to one thing: too much debt.

We’ll explain more in a moment. First…

Markets

Overnight, the Dow Jones Industrial Average fell 23.22 points, or 0.13%.

The S&P 500 fell 0.44 points, or 0.02%.

In Europe, the Euro Stoxx 50 index closed up by 9.61 points, or 0.31%.

Meanwhile, the FTSE 100 index added 0.04%, while Germany’s DAX gained 0.66%.

In Asian markets, the Nikkei 225 index is up 62.38 points, or 0.37%. China’s CSI 300 index is down 0.05%.

In Australia, the S&P/ASX 200 index closed up 17.81 points, or 0.33.

On the commodities markets, West Texas Intermediate crude oil is trading for US$49.13 per barrel. Gold is trading for US$1,221 per ounce.

The Aussie dollar is worth 72.23 US cents.

It’s always the debt

Here’s an example of a story you may have read over the past few weeks. This one is from News.com.au:

Processor National Dairy Products has called for the reinstatement of a milk market levy.

The Victorian company, which processes about 80 million litres of milk a year, said today this levy should be collected on every litre of milk sold until the Federal Government “puts in place a national agricultural policy and a national water policy”.

Then there’s this from Yahoo!7 News:

Earlier on Thursday Agriculture minister Barnaby Joyce announced that he had put supermarkets on notice over dollar-a-litre milk and said the competition watchdog is investigating the matter.

Mr Joyce has dropped the idea of a one-off milk levy, saying it would require a change in law and an assistance package is a better way of dealing with the crisis.

Mr Joyce believes Australians are awake to the human cost of cheap milk, telling the 7 News, “they’re going to say to you, dollar-a-litre milk…gives us a bad taste in your mouth about your supermarket because we know the way that you get the dollar-a-litre milk is to exploit the person behind the farmgate.”

Bahahaha.

We’ve heard and read a lot of junk in our time — some would say that’s because we write a good proportion of it! Cruel.

The desire for higher prices is an odd fetish. In certain industries (farming being one of them), they seem to believe the only way they can make money is when prices are high.

Now, we won’t pretend to be experts on the agriculture industry. It’s a long time (over 25 years) since your editor last got his boots wet, driving Friesian cattle from the fields in for milking.

But we’re still happy to suggest that, rather than pray for high prices, farmers should look towards other industries, such as technology, where falling prices are common, and profits are just as common.

After all, we can’t remember the last time anyone complained about falling TV prices…or computer prices.

Yet, for some reason, the minute the price of milk falls, farmers start to get their tweed coats in a twist.

Why is that? We can only guess. Farming, like other ‘resource’ industries, is capital intensive. There’s a whole bunch of machinery to buy and maintain, not to mention the rearing and cultivation of livestock and crops.

But unlike other ‘resource’ industries, farming is seasonal (milk is one exception). And seasonality creates lumpy revenue streams. Costs may be spread mostly throughout the year, but revenues may be condensed into just one or two months of the year.

That can make it hard to manage cash flow. Especially if you have to spend on costs today, not knowing what your revenue will be three, six, or nine months from now.

But, excuses aside, the lumpiness of revenue isn’t the major reason farming folk get themselves in a pickle. And it’s not because Woolworths or Coles slash their prices.

The reason behind it is one that causes trouble for all businesses: debt.

As Bloomberg reports:

National Australia Bank Ltd., the nation’s largest lender to farmers, is expecting its dairy clients to seek short-term credit to assist them as slumping milk prices have thrown the industry into a crisis.

Drought in the country’s east and a 20 percent fall in milk futures globally have farmers thinking of ways to tie them over during the crisis, by refinancing existing loans and taking on short-term debt, said Khan Horne, the Melbourne-based lender’s general manager for agribusiness. Such demand is expected to help maintain agriculture and dairy loan growth at 3 percent to 4 percent this year, he said by phone on Thursday.

Let me make sure you’re crystal clear on this. There’s a drought. Milk prices have fallen 20%. This is a ‘crisis’ for dairy farmers…and yet…loans to the dairy and agriculture industry are likely to grow 3–4% this year.

As we say, our bet is that debt is the problem in the first place, and that taking on further debt will only make things worse for both the dairy farmer and the taxpayer who will have to bail him out.

But let’s see if we can find any evidence for our claim. First, check out this chart. It’s a chart for the Class III Milk futures contract, traded on the Chicago Mercantile Exchange.



chart image

Source: Bloomberg
Click to enlarge



You can see the circle in the chart. That was the highest price for milk futures going back to at least 1996 — the earliest date for which Bloomberg has data.

You know what that means, don’t you? That’s right. While the high price may not have been a price bubble, it was certainly price ‘exuberant’.

That’s reflected in what was happening in the dairy industry at the time. Take this press release from the Australian Trade and Investment Commission in July 2014:

Potential investors in Australia’s A$13 billion dairy industry can register for Dairy Australia’s first ever investment conference to be held later this year.

The Australian Dairy Farm Investment Forum is a response to growing interest in the nation’s dairy industry, which has gained an international reputation as a supplier of quality milk, cheese, butter and other products.

Australia’s dairy operations have attracted robust attention from offshore investors, who view Australian producers as offering ready access to Asia, where incomes — and dairy consumption — are growing rapidly.

You can see where this is going, can’t you? Look at the price chart. Milk futures prices had gone a little bit bonkers through early 2014.

No wonder the industry was attracting investors. And once Wall Street, Collins Street, and Martin Place get their claws into any industry, suddenly things change. No longer is the goal of the farmer to provide an income for himself; now he has investors to think about too.

And that means the drive for growth…debt-fuelled growth. In March 2014, The Australian reported:

Fonterra will fast-track up to $NZ500 million ($467m) worth of projects aimed at boosting production of higher-margin dairy products, after conceding that demand from emerging markets was growing faster than expected.

The New Zealand-based dairy giant has announced that it would bring forward the planned capital investments after a lack of existing factory capacity contributed to a slump in first-half earnings.

Normalised earnings of $NZ403m were down 41 per cent on the prior corresponding period, with the co-operative blaming its current asset footprint for the forced channelling of 25 per cent of its milk supplies into loss-making categories such as cheese, casein and other non-reference commodity products.

The mixed result is likely to serve as a wake-up call for Australia’s own dairy industry, which is being urged to invest in boosting its production and efficiency to capitalise on the booming demand from emerging markets, particularly Asia.

Just this month, Australia’s largest dairy processor, the Murray Goulburn co-operative, admitted that it would need to find up to $500m for capital projects over the next few years to boost its own global competitiveness.

It doesn’t matter whether it’s milk, gold, stocks, house prices, China, oil, or anything else — the pattern is the same.

A frenzy builds. Prices rise. Investors and businesses assume the growth will continue. Debts increase to fund the growth. Production increases to supply the demand…

And then…the growing stops or slows, and supply now far exceeds demand. But there’s all that machinery, all the capital equipment, bought new…and with debt. How in the heck will they pay for it?

That’s right, by quickly producing as much as possible, which…you guessed it…drives down prices and creates an even bigger supply glut.

You’ll forgive us if we don’t shed a tear for Australia’s dairy farmers, or the dairy industry. What’s happening in the market right now is the natural follow-on from a price bubble — a price slump.

What most mainstream economists, and most people in general, don’t realise is that prices aren’t arbitrary. The market sets prices based on supply and demand.

It’s a wonderful function of a free market that prices are a signal to consumers, suppliers, retailers, industries, and entrepreneurs.

When prices are high, it encourages new entrants into a market. This creates increased supply and, typically, lower prices.

When prices are low, it forces existing participants out of the market. This creates decreased supply and, typically, higher prices.

It’s a cycle. The problem is that debt and government intervention distorts the cycle.

When prices are rising, the addition of debt helps to push prices even higher, and draws in more capital investment than is truly necessary.

And when prices are falling, government subsidies only serve to lengthen the price depression as it keeps participants in the market, when they should have been removed from the market instead.

Why are Woolworths and Coles slashing prices for milk? Is it because of a huge protest movement against cheap milk? Don’t be daft. It’s because the supplier has more milk than anyone could possibly drink.

It’s prepared to shift it at any price. If the supplier is cutting prices, the retailer will happily cut prices too. Good news for the consumer.

And if the supplier has cut the price, that can only mean one thing: dairy farmers are supplying more milk than the market can handle. That’s why the big dairy co-operatives this year cut prices.

Not because they’re evil businessmen, but because of overcapacity and excessive production.

An unfortunate reality for the farmers — but good for consumers — is that government intervention, with a support package, will drag this out even longer. And if loan growth to the industry is forecast to grow this year, that’s another sign of looming trouble for dairy farmers.

As always, don’t blame the market. And don’t blame cheap goods. Blame the debt. It’s always the cause of every boom and bust.

Who’s the buyer?

It’s a rough time for agriculture and agriculture-related industries.

One case in point is Deere & Co [NYSE:DE], the US manufacturer of heavy farming equipment.

Revenue has fallen from US$36.2 billion in 2012, to US$28.9 billion in 2015. Sales of heavy equipment have fallen in line with those overall numbers.

However, one interesting point is that financing revenue has increased, albeit marginally, over that time. From US$1.9 billion in 2012, to US$2.4 billion in 2015.

What could it mean? It could mean that farmers aren’t in any hurry to replace older machinery with new machinery. But the increase in financing revenue presents an interesting point.

As Jim Grant points out in a recent issue of Grant’s Interest Rate Observer, Deere has its own financing unit. As the market slows, and sales slow too, a sign of desperation is when a company shifts to rely more on ‘vendor financing’.

That means, rather than taking cash from the buyer, the seller lends the buyer money in order for the buyer to purchase machinery from the seller.

Or put another way, Deere is paying itself to let someone else ‘borrow’ its equipment. That might just work…until it doesn’t.

We shall watch Deere & Co, and its income statement and balance sheet, with interest.

Conference update

At last count, fewer than 81 ‘early bird’ tickets remain out of the 400 we put up for sale for the 2016 Port Phillip Publishing investment conference.

If you’re not an Alliance member, or you’re not on the priority invitation list, you’ll get your chance to secure a spot tomorrow. But be quick, only a few tickets remain.

Check your email inbox at 3:00pm AEST tomorrow afternoon. We’re not sure how much longer these ‘early bird’ tickets will last.

Cheers,

Kris