The U.S. cattle industry has a history of investment and divestiture. Capital has flowed in and out of ranching in competition with other investment opportunities for 125 years. It's why we have a cattle cycle for one thing — and why ranching is more than a “lifestyle” undertaking.
The cattle business in the Great Plains and West developed around opportunities in which domestic cattlemen, along with capitalists from Europe, sought high returns on their investment by selling beef animals to a growing and hungry country.
“Market participants today, like they did 125 years ago, make decisions daily on the potential returns available in the cattle business,” says John Maddux, Maddux Cattle Co., Wauneta, NE. A third-generation rancher and former Wall Street investment banker, Maddux was a featured speaker at the recent Range Beef Cow Symposium XVII in Casper, WY.
“Evaluation of return possibilities and risk assessment determine the prices set for cattle, land and other input prices in our production system,” Maddux explains.
Measuring this return is best calculated by dividing the income returned above and beyond all cost (the numerator) by the assets necessary to produce this income (the denominator).
“Calculation of return on assets (ROA) is an important factor that has driven the increase in productivity and intensification,” says Maddux. “Like it or not, I believe this phenomenon will continue for the foreseeable future.”
There are very few barriers to entry into the cow/calf business. A cow can survive eating sagebrush in the West or swamp grass in the Southeast.
“Any cow/calf profits realized are a green light for market participants to deploy more capital in order to capture these profits,” adds Maddux. “This fact is the driving force behind our 10-year cattle cycle.”
Moreover, he points out, many producers have a few cows solely for the romance of ranching and enjoyment of raising cattle.
“These cattlemen are willing to accept extremely low returns or subsidize their cattle operations with other sources of income,” he says. “This makes it doubly hard to realize high returns in cow/calf production.”
A common denominator facing all cattle producers is that the bulk of their costs are outside of their control. And, the assets involved in a grazing operation consist mainly of real estate. Ranchland assets have appreciated greatly over the past several decades — for obvious reasons.
“Increasing land values have a major depressing affect on our ROA equation,” says Maddux. “Market value is the appropriate value to use because ranch land could be sold and that capital invested elsewhere.”
A Portfolio Approach
Whether fully stocked or left ungrazed, the cost of owning land doesn't change. The cost of the capital tied up in your ranch is present regardless of your system.
“These fixed costs are so high that they make our variable costs trivial in comparison,” says Maddux. He adds that this should cause you to be skeptical next time a neighbor or professor says something about putting on cheap grass gains.
“They believe that we should use production costs rather than market prices to calculate returns. Taking a portfolio approach and being willing to move capital from your ranch to other investment opportunities dictates that we use opportunity costs.”
We've all known of a family member living away from the ranch who wants to sell the place and divvy up the money. Maddux's example illustrates the importance of an ROA/portfolio approach to the ranching business.
“The hard truth is that if the returns to ranching were equal to or better than equities, bonds or other investments, there would be little incentive for family members to call for a ranch sale,” he points out.
“I really challenge ranchers — and academics — to adopt an ROA/portfolio approach to cow/calf production,” he says.
Economist Harlan Hughes agrees with the Maddux approach. In fact, the national standardized performance analysis (SPA) program focuses on return on investment (ROI) as the bottom line, he says.
“I think John's approach is correct economics. I, too, calculate it for any beef cow herds that I analyze,” the North Dakota State University professor emeritus says.
Hughes says ROI is a little-used concept in ranching today. “I agree it should be, but not many ranchers are comfortable in calculating ROI,” he says.
While Maddux contends that the drive to increase ROI is what motivated ranchers to increase production efficiency, Hughes believes that since ranchers do not actually measure ROI, it can't be a driving force. The driving force, he says, is the desire to increase production. The problem is that industry-wide increased production drives down ROI on each ranch.
Consider An AUM's Opportunity Cost
Every weekday at the corner of Broad and Wall streets, investors using the New York Stock Exchange unleash the incredible power of the marketplace. They trade dollars for stock in publicly traded companies, forcing them to generate market rates of returns on their corporate assets.
Failure results in a low stock price, and disgruntled investors discipline management through corporate takeovers and proxy fights.
Very few agricultural operations are publicly owned, but they are not exempt from the pressure for competitive rates of returns. Even with a family-owned ranch, on a multi-generational basis, there is pressure to keep returns competitive.
For example, today in western Nebraska, rangeland is worth $200/ acre. One acre of rangeland would on average produce one-half an animal unit month (AUM). An AUM is the amount of land needed to support a cow and her calf for one month. Therefore, it would take two acres on average in western Nebraska to produce one AUM.
Now, selling those two acres would generate $400. With the long-term, 75-year historical returns to the stock market being 10%, the proceeds from this theoretical land sale (if invested in equities) would over the long run return $40 annually. This means that the opportunity cost of an AUM in this example is $40.
Moreover, this is before paying any taxes or labor or accounting for any depreciation on the depreciable assets (waterworks, fences) associated with grazing operations. This compares very unfavorably with the rental rate for an AUM of $20-$25.
This example illustrates the high opportunity costs associated with grass and ranches. It also demonstrates why ranchers are continually pressured to intensify production and marketing.
— John Maddux