AgDM newsletter article, May 2001

Profiting from the cattle cycle: alternative cow herd investment strategies

John LawrenceBy John D. Lawrence, extension livestock economist and director, Iowa Beef Center, 515-194-6290, jdlaw@iastate.edu

Can producers use knowledge of the cattle cycle to make more profitable investment decisions? Yes, if two basic principles of economics are applied. First, "buy low and sell high," and second, "find out what everyone else is doing and do the opposite." While easier said than done, this paper will evaluate alternative heifer retention strategies to put the principles into practice in order to profit from the cattle cycle.

The cattle cycle

The cattle cycle is largely driven by the economics of the beef cow enterprise. One explanation is that producers form the naïve expectation that current calf prices will continue into the future. When calves are high priced that must mean that they will stay high priced in the future so ranchers should save back heifers to produce more calves. When they are cheap, they will stay cheap and ranchers don't what to produce as many so they reduce their herd size. Another possibly more plausible explanation is that cash flow needs drive heifer retention decisions. When calves are cheap, ranchers sell more calves (steers and more of the heifers) to meet cash flow obligations. As prices increase, they do not have to sell as many to meet their needs and can thus retain more heifers.

Regardless of the reasoning, as more heifers are retained for the breeding herd there is a smaller supply of feeder cattle available for the feedlot and ultimately the supply of beef declines and prices increase encouraging more heifer retention. At some point, approximately 2 ½ years after the heifer was weaned and retained in the breeding herd, the supply of beef stops declining and begins to increase due to the additional calves coming to market as Choice steers. Prices begin to level off and then decline as supplies build causing an increase in cowherd liquidation and more heifers go into the feedlot rather than the breeding herd and thus the cycle continues.

Analysis

This analysis evaluates four alternative heifer retention strategies over a 30-year period between 1970 and 1999, using annual returns and wealth produced over the period. The starting point is January 1, 1970, with an inventory of 82 bred cows, 18 bred first calf heifers, 21 virgin heifers being developed, and 5 bulls.

Four alternative heifer retention strategies are modeled for a representative beef cow-calf producer.

Steady size (SS): The producer retains the same number of heifers each fall to maintain the same size of cowherd year after year. This strategy is fairly common among cattle producers who have a fixed land base and manage the cowherd to match the land resource. The SS strategy is used as the baseline for comparison to the other strategies.

Cash flow (CF): This producer's objective is to maintain the same cash flow each year. All steer calves, cull cows and bulls are sold. Next, enough heifers are sold to reach the cash flow objective and the remaining heifers are retained for the breeding herd. If there are not enough heifers to achieve the cash flow objective additional cows are sold to achieve the needed income. The annual cash flow is equal to the average annual cash flow of the SS strategy. When calf prices are high revenue from steer calf sales are higher and more heifers are retained for the breeding herd. When calf prices are low, more heifers are sold to generate additional income and fewer heifers are retained.

Dollar cost averaging (DCA): This strategy follows the time-tested method for stock market investments in pension plans. The producer retains the same dollar value of heifers each fall. When calf prices are low the producer retains a higher number of heifers. When calf prices are high fewer heifers are retained. Because of the cyclical nature of cattle prices, the lower priced heifers tend to sell higher priced calves and vice versa. The annual amount of investment in heifers is equal to the average SS investment in heifers. Thus, over the 30-year period the same amount is invested in heifers, but the timing of the investment is different.

Rolling average value (RAV): The producer retains the 10-year average value of heifers each fall. The annual investment is equal to the 10-year average value of 21 head of heifers; the same numbers as the SS strategy. Like the DCA strategy, RAV uses the value of heifers based on prices to determine how many heifers to retain each year for the breeding herd.

Impact on inventory

Animal inventories by type of strategy are summarized in Table 1. The SS strategy retained 21 heifers each fall as designed. The DCA and RAV strategies kept an average of one more heifer than SS, but there was much greater variation from year to year. The range was from 15 to 43 a year for DCA and 13 to 33 for RAV. The CF strategy had the greatest variation in the number of heifers retained, 0 to 55 head a year and on average it kept fewer heifers.

The number of cows calving was constant for the SS herd. RAV also calved an average of 100 cows, but had a range of 91 to 120 head. The DCA strategy averaged more cows calved, had a wider range in number calving, 86 to 138, and ended the 30 year period with 4 more cows than the SS herd. The CF herd averaged fewer cows calving and ended with the smallest herd.

The number of animal units (AU) is a measure of feed needs for the entire herd and reflects the inventory of all cattle. An AU is based on 1,000 pounds of body weight. Bred cows and heifers were assumed to have the same weight as cull cows sold, virgin heifers weights were the cull heifer weight, bulls were assumed to be 1.5 AUs and calves were 0.3 AUs. Notice that the AUs in the SS herds increased over time reflecting the move to genetically larger cattle over the 1970-1999 time frame. There is much greater variation in AUs in the DCA, RAV, and CF strategies compared to the SS because of the variable investment decisions. It is assumed that the producer rents pasture by the AU rather than by the acre, which may be an important restriction. The analysis will address this issue later in the paper.

Table 1. Heifers Retained, Cows Calving, and Animal Units by Strategy, 1970-1999
 
Average
Minimum
Maximum
Ending
 
Heifers Retained per Year
SS
21
21
21
21
CF
15
0
55
0
DCA
22
15
43
21
RAV
22
13
33
23
 
Number of Cows Calving per Year
SS
100
100
100
100
CF
85
32
144
32
DCA
106
86
138
104
RAV
100
91
120
120
 
Annual Animal Units
SS
159
152
170
170
CF
132
47
229
47
DCA
169
142
215
179
RAV
160
139
206
206


Impact on profits

Table 2 shows the gross revenue and returns over economic and cash costs by strategy. The SS strategy generated average revenues of $43,676 and had the smallest range in revenue. DCA had the largest average revenue and the largest range in revenue. Most of the variation came on the upside with revenues as high as $96,218. CF had the lowest average revenue and had revenue as low as $14,002.

All of the strategies had a long run average return over total economic costs near zero. While disappointing, this result should not be surprising given the declining demand the beef industry suffered from 1980 through the late 1990s. Also, economic cost includes a payment to all resources used in the enterprise, including depreciation and interest on owners' equity. SS had the lowest average return and a range of more that $35,000 from the lowest year to the highest year. DCA had the highest average return, but the largest range of more than $58,000. CF had the smallest range in returns, but the lowest maximum. Also, note that the CF returns came in part from selling off the cowherd as the ending inventory in Table 2 was only 47 animal units.

Return over cash costs more closely reflects the rancher's checking account and potentially his/her decision framework although this measure does not include debt service. DCA had the highest average cash return (33 percent over SS) and the widest range, near $63,000. RAV had the second highest average (15 percent over SS), a slightly higher minimum, but lower maximum. SS was next in the average and did have a higher minimum. CF had the lowest average return over cash cost (15 percent under SS) and the most stable. However, the objective of the CF strategy was to produce a targeted level of cash flow each year. While the model was not able to perfectly match the target each year, the cash flow was much more stable than the other strategies.

A stable, or at least predictable, cash flow is an admirable objective for producers and particularly for their lenders. Risk and risk management are important issues in agriculture. However, the variability or range in returns alone is not a good measure of risk. A more meaningful measure is the downside variation. How large are the losses and how long do they last? The DCA and RAV strategies' minimum was $7,000 and $4,500 less than the worse SS return, making them more risky. At least a portion of this lower cash return is due to retaining more heifers at low calf prices meaning there is less income and more expense from developing additional heifers at a time of low calf prices. Producers using one of these strategies with higher average returns must be financially prepared to weather periods of larger losses in order to be in position for higher returns in the good years.

Table 2. Annual Revenue, Return Over Economic Cost and Return Over Cash Cost, by Strategy, 1970-1999
 
Average
Minimum
Maximum
Ending
 
Total Revenue
SS
   $43,676
   $26,877
   $64,707
   $39,564
CF
   36,417
   14,002
   65,081
   14,002
DCA
   47,374
   24,710
   96,218
   41,773
RAV
   43,853
   22,504
   75,119
   49,221
 
Return Over Total Economic Cost
SS
-$1,817
-$16,332
$19,406
$545
CF
-924
-11,172
2,872
2,666
DCA
108
-21,146
37,465
1,740
RAV
-449
-17,577
27,792
3,097
 
Return Over Cash Cost
SS
$4,869
-$7,861
$27,178
$5,900
CF
4,152
2,873
6,387
4,757
DCA
6,474
-14,900
48,054
7,135
RAV
5,581
-12,399
35,934
8,356


Impacts on net worth

Another economic comparison of the strategies is to compare the change in net worth resulting from following each strategy over the 30-year period. Table 3 reports the accumulated cash over 1970-1999 period and the value of the cattle inventory at the end of 1999. The accumulated cash results from returns over cash costs compounded annually at the annual real interest rate. As expected, the strategies with the largest returns over cash cost also had the largest increase in accumulated cash and herd net worth. Compared to SS, DCA had 34 percent higher accumulated cash and 30 percent higher herd net worth. RAV produced 21 percent higher accumulated cash and ended with 23 percent higher inventory value. CF ended with the least amount of cash and inventory value.

Given that the performance variables are the same for all strategies, where does the difference in returns come from? The DCA and RAV strategies sold more total cattle and at higher average prices than the SS and CF strategies because of the timing of investment in heifers. DCA sold more cattle than the other strategies and CF sold the fewest. RAV sold about the same number of steers but fewer heifers and cows than SS. Cattle sold in the DCA strategy received a higher average price suggesting that it sold more cattle during the high price period of the cycle and fewer during the low price period than did the other strategies. This was particularly true of heifer prices. The RAV strategy was second highest on steer and heifer values.

Table 3. Accumulated Cash and Herd Net Worth, 1970-1999, by Strategy
 
Accumulated
Value of
Herd
 
Cash
Inventory
Net Worth
 
Values at the end of 1999
SS
$492,110
$70,846
$562,955
CF
383,853
15,576
399,429
DCA
659,843
74,308
734,150
RAV
596,510
86,974
683,484
 
Compared to Steady Size
CF
-22%
-78%
-29%
DCA
34%
5%
30%
RAV
21%
23%
21%


Fixed Land Base

Most cow-herds have a fixed land base rather than a flexible one as modeled above. The producer owns or rents a specific area of pasture (acres). Often this land base is difficult to increase or decrease, and if additional land is available it is often in "lumpy" proportions rather than one AU at a time. The SS strategy matches a fixed land base because it keeps the herd the same size each year. The DCA and RAV strategies have higher average returns and net worth growth, but vary the herd size and the required land base over the cattle cycle. If the land base is fixed are the returns to DCA and RAV still as high?

Because it is not likely as profitable to under utilized pasture during part of the cattle cycle, a stocker enterprise was added to compare the DCA and SS strategies. The stocker operation adds flexibility to a fixed land base because the number of stockers purchased each spring can be adjusted to match available forage. If the cow inventory declines, more stockers are purchased. If the cow inventory increases fewer stockers are purchased.

The stockers were assumed to be purchased in April and sold in September at the monthly average price, respectively. It was also assumed that they gained 200 pounds during this period. The returns for this analysis were based on the change in grow value less $25 per head.

For the analysis including stockers it was assumed that the land base was fixed at 215 animal units. The SS herd maintains the same cowherd size and buys the same number of stocker cattle each year. (Note that the number of stockers purchased actually declines over time as animal size increases on a fixed number of acres, but changes in the SS herd are gradual.) The 215 AUs were chosen because it is the maximum herd size for the DCA strategy if it buys no stockers.

On average, DCA calved more cows and purchased fewer stockers than did the SS herd (Table 4). As with the earlier analysis, the DCA enterprise produced higher average revenue and returns over total economic and cash costs (Table 5). However, the advantage was not as large with the fixed land base and stockers as it was with full land flexibility. The DCA generated returns over cash costs 22 percent higher than SS compared to 33 percent higher in the earlier analysis. An evaluation of accumulated cash and herd net worth showed similar results. DCA generated more wealth over the 30 years, but its advantage was only 22 percent higher than SS rather than 33 percent with a flexible land base.

Table 4. Number of Stockers Purchased and Cows and Heifers Calving
 
Average
Min
Max
Last
 
Stockers Purchased
DCA
30
0
47
23
SS
36
29
41
29
 
Cows and Heifers Calving
DCA
106
86
138
104
SS
100
100
100
100


Table 5. Economic Returns to the DCA and SS Strategies with a Stocker Enterprise
 
Average
Min
Max
Last
 
Total Revenue
DCA
49,393
22,860
96,461
44,005
SS
46,112
24,710
66,062
42,378
 
Return over total cost
DCA
1,585
-19,486
37,468
3,924
SS
-151
-15,455
19,669
3,334


This analysis suggests that the DCA and possibly the RAV strategies that factor cattle market prices into the heifer retention decision outperform the SS strategy even with a fixed land base if stocker cattle are purchased to utilize forage not needed by the cow herd. While this analysis focused on the cowherd investment and used stockers as a residual, operations with a larger stocker enterprise could use the same strategy to shift investment between cows and stockers over the cattle cycle.

Purchased cows or heifers

The analysis described above was developed for producers retaining heifers rather than buying bred cows or heifers. Although the timing between the investment and the birth, production and sale of offspring is a year quicker with the purchase of bred females, the price sensitivity may be greater. This analysis valued retained heifer investment at cost of production plus heifer development expenses. As was seen by the large losses during the low price years, it is possible to buy heifers at less than the cost of production. Although there is not a good data series for bred female prices, there are clearly times when these animals can be bought for less than what it costs to produce them. Likewise, there are times when the selling price has a substantial premium built into it. The DCA concept should guide a producer's investment decision for purchased females as well as it does for raised heifers.

The DCA and RAV concepts should also work for purchased open heifers. The decision of how many to retain was based on the market value, but the actual investment was based on the cost of producing the heifer. Actually buying the heifer at the market value would reduce investment cost during low calf prices and increase investment cost during high calf prices and should result in at least as large, if not a greater advantage to the DCA and RAV strategies.

Summary

Beef cowherd owners can benefit from incorporating price signals into their heifer retention decisions. While a perfect forecast of calf prices over the productive life of the heifer added to the herd would be ideal, such information is not available. However, simple decision rules that incorporate current or recent prices and the knowledge that the cattle cycle likely will repeat itself can help producers improve their investment decisions. A dollar cost averaging strategy that retains the same dollar value of heifers each year and a rolling average value strategy that retains a 10-year average value of heifers out performed strategies that sought to maintain a constant herd size or a constant cash flow.

The dollar cost averaging and rolling average strategies produced higher average annual revenue, returns over economic and cash cost and accumulated cash and herd net worth than the other strategies. These results hold for producers who have a fixed land base if a stocker enterprise can be used as a shock absorber for excess forages as the size of the cowherd fluctuates based on investment decisions. However, producers who retain and develop more heifers when calf prices are low and produce more calves and retain fewer heifers when calf prices are high, also have greater variation in returns. Producers who implement these strategies must be prepared financially to weather wider swings in cash flow.

 

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