0528GregWolfsr.cfm Malatya Haber Capital utilization
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Capital utilization

By Greg Wolf

In agricultural economics, it has typically been taught that ag producers have four primary resources to work with: land, labor, capital, and management. That is a helpful list, but in reality we can consolidate those to just two—capital and management. Both land and labor are acquired with capital. There are other dimensions of the land resource that could be named as well, including organic matter and sunlight energy. But those are more inherent to the land resource, and again—land can be acquired with capital.

In a capitalistic society, the owners of capital are capitalists, and seek to invest that capital according to some balance of risk and return. The two generally have a consistent inverse relationship—more risk is required to obtain higher rates of return. There is no single right balance, but the surprise is how little thought many capitalists put into what balance is right for them. The right balance takes into account other capital resources, investment timeframe, and the behavior style of the capitalist. Some people are inclined to worry about risks more than others, and return of capital rates higher for them than return on capital. That’s OK, and it’s one of the reasons you’ve read a lot over the last few years about “capital sitting on the sidelines”—the managers of that capital have placed it for now in very low-risk investments. As confidence in our economy grows, we’ll hear about it being reallocated in more risky investments such as companies, seeking higher returns.

Returns on capital can come in three different forms. I’ll call the first Operating returns, but I’m including here what could also be called Investment returns. This is the rate of return that the business generates, or the investment pays. A CD has a specified rate of interest paid, and business returns can be quantified and expressed as a percentage. The point is that these returns are inherent to the underlying investment itself.

The second type of return I’m going to call Valuation returns. This is all about “buying low and selling high”—it involves returns on capital that come from transactions—buying and selling, rather than the inherent returns of the underlying investment. Years ago I learned about the concept of “day trading”—buying and selling stocks in the same day, and perhaps several times in the day, attempt to generate some returns via these transactions. A day trader does not necessarily, and perhaps even ideally does not, either know or care about the underlying transactions and how profitable they are. Investment decisions are more about momentum, timing, inside information, and guessing.

The third type of return I’ll call Extractive. This is all about seeking returns by extracting something from an existing investment. Some capitalists buy large complex companies and then “divest” a portion of the company that doesn’t fit well, either to make the company better, reallocate capital to some other investment, or possibly to shift the risk/return balance. In doing that they are extracting value from an investment as a return on capital. Buying a piece of real estate and selling off a homestead is another example. Another example, but not a good one, is buying a company and then “cannibalizing” its resources—not taking care to maintain equipment, facilities or even a labor force. This can increase returns in the short term but of course is not sustainable.

An investment in ag land is somewhat unique because it can easily involve all three types of returns. Buying land simply to operate a farm or ranch is one thing, but there is a reason why I’ve always been told you have to buy land that will never cash flow as an operating investment. That is because there are expected valuation changes with a land purchase, and the two combined make a land investment work even if it doesn’t generate enough operating profit to pay for itself. But with land there is also the opportunity for extractive returns, and there has probably never been a more powerful example than what is going on today in the oil and gas industry. Land is being leased simply for the opportunity to search for oil or gas, with leases that pay more than the original purchase price of the land. That has seldom been the case—any extractive returns typically have been supplemental to operations and valuation. I have a friend that has told me over the years that he only farmed to have something to do while he developed ag land—that is a strategy that sees operational returns as incidental to valuation.

I had intended in this column to get right to measuring capital utilization—how well it does what it is supposed to do. But I felt like I had to lay out these different investment objectives because they are relevant to what and how we measure. And now I’m about out of room, but the main point I was intending to make is that in the realm of operations we measure the utilization of capital by how much revenue we generate—whether land, or leases, or equipment, or some combination of the above, how effectively does management create revenue from a given capital investment. It is also the objective of management to make a profit, and a landowner capitalist has three different sources of returns to consider for a total combined return on capital.

Editor’s note: Greg Wolf is a consultant with Kennedy and Coe, LLC (www.kcoe.com) and works to help clients of the firm navigate toward better returns in all areas of their businesses. He is based in the firm’s Pratt, Kan., office and can be reached at 620-672-7476.

Date: 6/3/2013

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