Is this as good as it gets for Australian agriculture? The Federal Government’s forecaster tips the sector to break records this financial year, peaking at $63.8 billion. Dairy excepted, the agriculture sector is benefiting from higher soft commodity prices and good rainfall.

But after three years of strong growth, the agriculture sector will plateau after this financial year, predicts the Australian Bureau of Agriculture Resource Economics and Sciences (ABARES). It will take at least five years for a new record in production value to be set.

Prospective investors in agriculture stocks might feel they are buying at the top. Arriving late at a sharemarket rally is never a good idea, especially in agriculture.  The sector is notoriously volatile because of commodity prices, weather, pests and natural disasters.

But extrapolating the agrictulure sector’s good run in the past few years to ASX-listed agricultural stocks is not as clearcut as it seems. Switzer Super Report analysis of more than 50 agriculture stocks shows a patchy performance over the past 12 months. The underlying ag boom is not broadly reflected in the market this financial year.

Granted, there have been some terrific performers in the past 12 months: Treasury Wine Estates (TWE), Costa Group (CGC), A2 Milk Company (A2M), Huon Aquaculture (HUO) and Select Harvests (SHV), for example. Treasury is a longstanding member of the Switzer Super Report Takeover Portfolio.

I nominated Costa Group Holdings as one of three top floats from 2015, for this report in October that year. Costa, Australia’s largest grower and marketer of fruit and vegetables, has rallied from $2.21 since then to $4.41 and still looks okay value given its growth prospects.

In addition, I outlined a bullish view on agrictulure-related stocks for this report in late 2015 and nominated four: Incitec Pivot (IPL), Nufarm (NUF), Rural Funds Group (RFF) and Lindsay Australia (LAU).

Incitec has a one-year total shareholder return (assuming dividend reinvestment) of 24%, Morningstar data shows. Nufarm has returned 26% over that period, Rural Funds Group is up 24% and Lindsay Australia has lost 18%.

But for every well-performed ag stock there have been several poor performers. MG Unit Trust (MGC) and Bellamy’s Australia (BAL) have been prominent disappointments. Initial Public Offerings Inghams Group (ING) and Tegel Group Holdings (TGH) have been early laggards.

Australian Agriculture Company, also in the Switzer takeover portfolio, has fallen 25% from its 52-week high in a healthy livestock market, but it is still up over 12 months. Feed producer Ridley Corporation is flat over 12 months in a booming ag sector.

This analysis reinforces the importance of bottom-up company analysis in ag stocks rather than relying on top-down commodity or industry trends. The lift in sector conditions was priced into some agriculture stocks long before mainstream media started writing about it.

For the record, I’m bullish on the Australian agriculture sector over five to 10 years. Although ABARES predicts the aggregate production value to ease in the next few years, it will remain above long-term industry averages.

My interest is on the cost side. The market might be underestimating the coming revolution in farm economics as drones, robots, software algorithms and big data transform crop production, harvesting and maintenance.

Having interviewed several leading researchers on this topic, I’m positive about the potential of agriculture technology (ag tech) to drive cost savings, lessen the sector’s cyclicality and risk profile and create new revenue streams, such as farmers selling big data.

Longer term, the burgeoning Asian middle class will boost demand for Australian agriculture products, particularly proteins. The upshot: a more efficient sector benefiting from global population growth and a larger middle class. Agriculture is surely one the great long-term growth sectors.

GrainCorp looks interesting

The owner of grain-handling infrastructure has typified the challenges of ag stock investing over the years. Bumper grain harvests have led to some terrific years for GrainCorp, but weak harvests have crunched earnings, given the company’s high fixed-cost base.

Chart 1: GrainCorp

Source: ASX

GrainCorp’s Return on Equity (ROE) has averaged 5% over the last four years, Morningstar data shows. That’s too low and symptomatic of agriculture stocks that, on average, deliver a lower return because of the capital-intensive nature of their business and commodity cyclicality. Even at its peak, GrainCorp’s ROE has been just in the double digits.

The company’s annualised 10-year total shareholder return is 3.4%. The five-year return is marginally worse. But long-suffering shareholders have cause for optimism that GrainCorp is starting to turn thanks to better strategy and execution.

GrainCorp’s one-year total return is 21%. The company in February issued FY17 guidance that beat market expectation.  It expects underlying earnings (EBITDA) of $385-$425 million in FY17, up from $256 million a year earlier. After-tax net profit of $130-$160 million could triple the FY16 result ($53 million).

The company is benefiting from record eastern Australian crop production and GrainCorp Malt’s solid performance. Strong export demand is another driver and a key to GrainCorp achieving the upper end of its profit guidance range for FY17.

Some brokers are forecasting exports of up to 6 million tonnes in FY17 for GrainCorp, which would double the previous result. The company has exported up to 10 million tonnes of Australian grains in previous bumper years, so the market could be underestimating its export potential, particularly given ABARES’ forecast for an “exceptional” season for wheat production this financial year.

ABARES tips the gross value of wheat and barley production to rise by more than 20% this financial year, although plentiful global supply should keep a lid on prices. Clearly, the tailwinds for GrainCorp this financial year are their strongest in years.

Longer term, GrainCorp’s structural achievements are as important as its cyclical gains. The company has diversified earnings, acquiring a global malt producer in 2009 and two edible oils businesses in 2012. It sold its 60% stake in flour miller Allied Mills Australia in January 2017.

The results of that strategy are starting to pay off. The malt business, which counts some of the world’s biggest brewers as customers, is performing solidly. Malt, less cyclical than the grains business, has reduced GrainCorp’s overall earnings volatility. The oils business faces intense competitive pressures in the food sector, but is delivering efficiency gains.

I like GrainCorp’s strategy to diversify the business and improve the balance sheet through sales of non-core assets, such as Allied Mills. GrainCorp has a lot of drivers underway to deliver a higher, more sustainable return on equity for shareholders.

The market has mixed views on GrainCorp. Five of 11 brokers have a buy recommendation, four have a hold and two have a sell. An average price target of $9.67 suggests the company is a touch undervalued at the current $8.86. Broker valuations range from about $8 to $10.80.

I lean more towards the high end of that range, over 12 months. The market’s valuation for GrainCorp appears to be lagging its earning upgrades and there is potential for a result at the high end of guidance when the company reports its FY17 result in May, such is the momentum in grains production and exports this financial year.

But it GrainCorp’s longer-term outlook that appeals most: a company that is diversifying earnings, improving the balance sheet and lifting return on equity.

I suspect grain-handling infrastructure will be more valuable than investors realise as more food must be moved effectively, to more parts of the planet, to feed a growing population in coming years. Like other hard-to-replace infrastructure assets, food facilities will have significant strategic value.

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at March 15, 2017.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.