Investment in Downstream Publicly Traded Firms as a Vertical Integration
Strategy to Increase Returns and Reduce Annual Volatility for Pork Producers
Josh Detre, Dr. Christine Wilson, and Dr. Allan Gray
In recent years, there has been a growing interest among pork producers to
substantially reduce the annual volatility of the returns associated
with their pork enterprises and capture some of the profit associated
with valueadded activities. The pork market has undergone tremendous
change. Consumers are no longer content with a homogenous bulk
product; instead, they want a product that has substantial value
added beyond the farm gate. These changes have challenged pork
producers to find ways to capitalize on the demand for valueadded
products. Many of the traditional methods for producers to capture
additional downstream value, however, have either been financially
infeasible and/or simply have not accomplished the producers'
goals. This article reports on research conducted at Purdue
University to evaluate
whether or not investment in a portfolio of publicly held companies
that are first handlers of pork products would provide pork producers
with a means of enhancing returns and reducing annual volatility
The primary objective of the research was to investigate the potential of a valueadded portfolio consisting of investments in pork
production and publicly traded valueadding processing
companies that will reduce the annual volatility of returns and improve annual
returns relative to investing strictly in pork production alone. Thus, the
hypothesis was that by investing in publicly held valueadded
processing companies in addition to the pork operation, pork producers will
benefit through an increase in reward (returns) for the amount of risk they
bear in their overall portfolios. The goal was to provide producers with
information on using investments in publicly traded companies as an alternative
to direct investment in physical assets for capturing the benefits of valueadded activities on an annual basis. The methods used
in this article are one way of achieving this goal. Although longterm and multiperiod
investment horizons are important in overall financial planning, these horizons
were beyond the scope of the research project reported here.
The Portfolio Model
Data for this research consist of monthly returns from January 1974 to
December 2001 for farrowing and finishing hogs as
well as for finishing feeder pigs. Each set of monthly returns contains the
relevant cost information, initial investment, the selling price, and the
profit (loss) per head for the pork production enterprises. The model in the
study requires monthly return on investment for each of the livestock
enterprises as well as monthly stock prices and dividends for the valueadded agribusiness firms and the monthly return data
for the S&P 500. Annual returns for the securities and the S&P 500 are
determined through compounding of the monthly investment returns.
The agribusiness firms used in this study are first handlers of livestock
products beyond the farm gate; they are the next step in the valueadded chain. Note that many of these companies have
operations beyond the first handler processing level of the livestock products.
This research developed an optimal portfolio of pork and valueadded
investments using a spreadsheet simulation model. The simulation model was used
to generate estimates of returns and risks based on the historical return data.
Results depend on a replication of historical distributions of important
parameters and/or variables about which there is substantial uncertainty. The
set of correlated simulated returns were used to develop a weighted portfolio
that sought to maximize the Sharpe Ratio, a portfolio performance measure, i.e.
they have the best return per unit of risk for a given risk free interest rate.
The resulting portfolio represents the optimal portfolio on the efficient
frontier curve of portfolio choices when the economic decisions are separated
from the financing decision. The optimal portfolio consisting of pork
production and valueadded stock investment was thus
determined by maximizing the Sharpe ratio portfolio performance measure. The
combination of investments (pork production and specific stocks) that provided
the greatest annual return per unit of risk (i.e., the largest Sharpe ratio)
comprised the optimal portfolio.
One assumption that had to be addressed in the simulation model for this
study was the amount the pork producer would be willing to invest in the
securities and the amount that would be invested in the pork enterprise on a
percentage basis. It would be unrealistic to assume that a pork producer would
make a 100% investment in publicly traded valueadding
firms and no investment in the pork enterprise. Therefore, the model
incorporates scenarios to examine varying levels of investment in the
securities and in the pork enterprise. Multiple scenarios were used to examine
the impacts on the optimal valueadded portfolio of
varying the levels of minimum investment in the pork enterprise. Two of these
scenarios are discussed in this article. The base scenario assumed that all
investment was held solely in the pork operation. The alternate scenario
assumed that a maximum of 30 % could be invested outside of the pork operation
in the valueadded stocks. Each scenario provided a
different investment strategy for the pork producer based on the given level of
investment in the pork enterprise and the agribusiness stocks available for
selection. Thus, the total investment in each scenario was 100%, but the
maximum allowable amount that could be invested in the valueadded
stocks changed from 0% in the base scenario to 30% in the alternative scenario.
Only the public valueadding companies that had a
minimum of 60 months of historical data, given the study period, were used in
the development of a portfolio.
The model used five different study periods, 1981, 1986, 1991, 1996, and
2001. The use of various study periods provided for the examination of how a
producer's optimal valueadded investment strategy has
changed over time, both in the number of stocks available for investment in and
in the amount of investment made. Some of these companies were either not
established or were not publicly traded during all or a portion of one or more
of the data study periods. Therefore, during each of these study periods, the
producer's portfolio was chosen only from all of the valueadded
companies trading during the time period that had at least the prior 60 months
of historical data available for defining the probability distributions. For
example, the portfolio as of January 1,
2001, for a hog finishing operation had 24 valueadded
companies with 75 months of historical data from which to develop a portfolio.
The data for developing this specific portfolio consisted of returns from
October 1994 through December 2000. As a second example, the portfolio derived
using only companies that had data existing in all years between 1974 and 2001
had only 14 valueadded companies available for the
producer to choose from (versus the 24 companies that existed as of January
2002). However, this longer time series allows more data per company to define
the distributions of the individual investments. These distributions are
important in the model simulations.
Results indicate that over the entire data period of January 1974 to
December 2001 for both types of hog producers (farrowtofinish
producers and feeder pig finishers), annual investment in publicly held valueadded agribusinesses and agrifood
companies provided benefits over maintaining a portfolio that was solely
invested in the hog enterprise. Benefits are extracted from these investments
in the form of a greater reward per unit of risk taken, through diversified
investments, and by capturing further profits in the food channel as well. Figure 1.
Figure 1 provides a graphical example of the benefits that a hog
finishing operation would have obtained from a portfolio that invested in valueadded agribusiness stocks. The annual return to the
finishing hog operation using historical data from 19742001 was 6.27 %, and the
standard deviation was 9.44 %. When a constraint was set that at least 70 % of
the portfolio must be invested in the hog enterprise, the producer's optimal
portfolio, based on maximizing the reward per unit of risk (the Sharpe ratio),
contained a 30 % investment in a single valueadded
stock. This increased the expected return of the portfolio to 11.28 % and the
standard deviation of the portfolio to 15.11 %. These portfolio results are
superior to those of investing solely in the hog operation because the producer
is receiving more reward per unit for the risk taken. The investment portfolio
of a hog producer when it is not limited to sole investment in the hog
operation always included the valueadded companies
because these portfolios provided a higher Sharpe Ratio, i.e., the best return
per unit of risk for a given risk free interest rate. The results for the
portfolio generated for the farrowtofinish enterprise
are similar to the results for the hog finishing operation: the portfolio
contained a 30 % investment in one valueadded
agribusiness stock, and the producer received more reward per unit of risk
Further analysis of the agribusiness companies revealed that the preferred
portfolio consisted of companies that had significant activities beyond the
initial processing sector and into the wholesale and retail sectors. This
result supports results found by Duval and Featherstone indicating that pork
producers may want to invest in companies that have operations that extend into
the retailing sector. The model provides evidence that diversification into valueadded stocks increases the amount of reward (return)
for the level of risk faced by a hog producer relative to that of another
producer who only invests in the hog enterprise. Thus, the portfolios that
included the valueadded agribusiness stocks provided
the highest riskadjusted return for each dollar
invested, i.e., these portfolios provided the largest reward to risk tradeoff
given the riskfree interest rate available for
borrowing and lending.
Analysis of the optimal portfolio using data from various historical data
study periods indicates that the advantages of valueadded
investments have increased over time, i.e., earlier historical periods (1981,
1986) did not obtain the same rewardtorisk benefit
from investment in the valueadded stocks as the most
current study period (2001). In the earlier study periods, producers, given the
semiconstrained portfolio, still maintained a
majority of investment in the hog operation, but in the most current period,
producers moved the maximum allowable investment amount out of the hog
operation and invested this amount in the valueadded
stocks. Investments in agribusiness firms that span the vertical channel from
processing to retailing tend to be the preferred stocks in the portfolio. These
results may be attributable to the changing structure of the agrifood industry, specifically the continuing trend of
more valueadded activities occurring beyond the
production level. These results suggest that markets are increasingly rewarding
valueadded activities over commodity production (for
example, hog production) activities.
Additional results indicate that the portfolio as of January 1, 2001 that had sole investment in the
hog finishing enterprise had a mean return of 12.40 % and a standard deviation
of this annual return of 5.96 % (Figure 2). The constrained portfolio
optimization model for this study period contained a 30 % investment in one valueadded security. Nevertheless, the addition of this one
valueadded security still did not generate a positive
return for this study period. However, this stock investment increased the
expected mean of the portfolio by 4 %, and the portfolio could produce a
positive expected return inside of one standard deviation from the mean,
something that could not be done within two standard deviations of the mean by
investing only in the hog finishing operation.
The research reported here is a first attempt at developing a portfolio of valueadded investments for pork producers. The results of
this study indicate real potential for producers to gain from investing in publicly
traded valueadded companies; however, there are some
limitations to the study. These limitations include: limited future analyses of
the constructed portfolio performances (Did these portfolios continue to
provide a greater return for the amount of risk for the hog producer?), the
exclusion of brokerage costs in trading (both economic and financial
components), lending constraints for producers, and the limited number of
companies with adequate historical returns data.
It should be recognized that past returns are not always indicative of
future returns; two specific examples of this are the hog prices observed in
1998 and the drastic growth period of the overall market in the late 1990s
followed by its rapid decline in the later part of 2001 and 2002. Such events
may not reoccur in the near future. However, it should be noted that even with
such events, the constrained portfolio contained investment in valueadded stocks.
The results of the two analyses in the study indicate that a hog producer in
either a farrowtofinish or a strictly hog finishing
operation can benefit from investment in valueadded
stocks. The benefits are an increase in the amount of return per unit of risk
for the producer when he/she does not restrict investment solely to the hog
enterprise and benefit through diversification and profit capturing in the food
channel. Analysis of the optimal portfolio at various historical periods
indicates that the advantages of valueadded
investments have increased over time. This result is consistent with a
continuing trend of more of the valueadded activities
in the agrifood industry occurring at the
postproduction level. The results also show, consistently, that agribusiness
firms that span the vertical channel from processing to retailing tend to be
the preferred stocks in the portfolio.
Center for Research in Security Prices Database (CRSP), University of Chicago, Chicago, Illinois.
Source of 19742001 stock returns.
Detre, Joshua, D., "Investment in Downstream Publicly Traded Firms
as a Vertical Integration Strategy to Increase Returns and Reduce Annual
Volatility for Pork Producers," Unpublished M.S. Thesis, Purdue
University, Department of
Agriculture Economics, (Dec., 2002).
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Josh Detre is a Graduate Research Assistant; Christine Wilson
is an Assistant Professor; and Allan Gray is an Associate Professor
in the Department of Agricultural Economics at Purdue