Plant your money in a forest – and wait for great long-term growth
Cris Sholto Heaton Jan 10, 2013
For most people, buying a Christmas tree at the start of December and throwing it out five weeks later is the closest they ever come to buying timber. Yet there’s a very good argument to be made that everyone should have at least some timber in their portfolio – it’s not only a well-established asset class, but one with some unusual properties and a rather good track record.
Historically, timber has delivered double-digit annual returns, with relatively low volatility – in other words, you’re unlikely to experience as many heart-stopping moments with timber as you might with equities. It has a fairly low correlation with the performance of other assets, which makes it a good way to diversify your portfolio. On top of that, in the past it has provided at least some protection against high inflation.
Together these qualities make timber a rare – perhaps unique – asset. Indeed, Jeremy Grantham of US fund group GMO, a well-known advocate of timber and a highly respected investor, once described it as the only low-risk, high-return asset in existence.
As a result, many institutions – such as pension funds – have allocated part of their assets to timber since the 1980s, especially in the US. Wealthy individuals in the UK are also keen on timber and forestry due to its tax advantages.
But involvement from most private investors remains much lower, partly because it’s not that straightforward to invest in timber if you don’t want to buy a forest outright, and partly because many investors are simply unaware of it as a specific asset class on its own.
So here, rather than focusing on the tax implications of buying a forest, I want to look at what drives the timber market, and the best ways for individual investors to get exposure to it for their portfolios.
Making money from wood
The return you make on timber comes from two sources: capital return on the land the trees are grown on – this tends to appreciate in value over time; and the ongoing yield you make from harvesting and selling wood. Taking the two together, returns in the past have been very attractive.
Using data from the US, you’d have averaged a return of 13% a year from US timberland since 1987 (measured using the NCREIF Timberland Index). During that time, the average income yield has fallen from around 10% to around 5%. In other words, if you invest directly in a US forest today, you expect to earn around 5% from timber sales after costs each year.
That’s still reasonable compared to many income investments, but the fact that it’s halved over the period tells us that land prices have risen by more than the selling price of wood. This strong historical capital appreciation, and lower starting yield, suggest it will be hard to get returns that match the historical 13% in the future.
But an average total return in the high single digits remains likely, says Gabriel Micheli, who manages Pictet-Timber, one of the few timber investment vehicles available to retail investors. GMO forecasts similar long-term returns of around 6.5% plus inflation.
We’ve focused on the US above, but it’s important to be aware that returns on timber vary greatly around the world. Changes in the value of land typically depend on local trends, and may reflect whether an area of forest land can be redeveloped for housing, agriculture or other uses that command higher values.
Country-specific factors also play a key role. For example, as noted already, the UK offers rather favourable tax treatment on direct investment in forestry, meaning that UK timberland prices have been driven up by their value to wealthy investors for tax-avoidance purposes.
On the other hand, the income return from timberland is more heavily dependent on macroeconomic factors, depending on what purpose the harvested timber will be used for. Commercial wood use falls into two main categories: sawlogs, which will be used for higher-value purposes such as construction (accounting for around 60% of global demand); and pulpwood, for paper and packaging (around 30% of demand).
Different regions and forests will have different levels of exposure to each of these markets. For example, eucalyptus plantations in South America produce wood that is solely intended for pulp. Fir and pine forests in the US, on the other hand, mainly serve the construction market, although thinnings and residues from these forests go into the pulpwood market and are important to profitability.
Obviously, the level of income you get from forestry depends on demand for sawlogs and pulp, and the prices they fetch. Right now, there are two main drivers of this demand, says Pictet’s Micheli: US housing, and China.
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The drivers of demand: US and China
The US housing market is the largest user of wood for construction purposes. Demand for sawlogs dropped sharply after the housing bubble burst. US sawlog prices are still below the levels of 2006. This meant a sharp drop in income from forests that supply a significant portion of wood to this market. So the fact that US housing now appears to be recovering should lead to a major improvement in earnings over the next few years.
Meanwhile, China’s wood consumption has been rising. It is importing more and more pulpwood to meet growing demand for paper, packaging and hygiene products. As a result, some pulpwood prices are now around or above where they were prior to the global financial crisis. Chinese import demand is set to keep rising: Wood Markets, a consultancy, estimates that imports will rise by 50% from 2010 to 2015, to 150 million cubic metres per year.
In short, China is having the same kind of impact on timber that it’s had on so many other natural resources. As long as US housing continues to rally, and Chinese growth does not completely collapse, lumber prices could improve significantly in the next few years.
But demand is only half the picture – how does the supply situation look? The supply dynamics for timber are unusual. There is always potential oversupply, since the amount of timber on the stump (that is, still in tree form) that could be harvested at any one time exceeds global demand.
But timber takes a long time to grow (30 years or more for spruce, pine and fir sawtimber to reach peak value in the US and Europe, and five to ten years for eucalyptus pulpwood in Latin America), so harvesting too much too soon would both hit current prices and reduce future supply, which would not be in the sellers’ long-term interest.
It also helps that, if prices are too low, trees can be left to grow until the market recovers. This is very different to most ‘soft’ commodities, which grow quickly and must be harvested once grown, creating regular boom/bust cycles.
In the shorter term, unpredictable events can upset the market. For example, in Canada, a beetle infestation is devastating British Columbian forests, while trees are also vulnerable to hurricane damage. This can create short-term timber gluts as owners harvest damaged wood and sell it cheaply.
Fire outbreaks or tougher environmental restrictions may have the opposite effect of suddenly reducing supply. But over time, the industry generally seems to have adjusted supply quite well, which partly explains timber’s steady long-term returns.
Hedging against inflation
So with demand rising and supplies unlikely to surge, the fundamentals for timber look good. That takes us to the final reason to be interested in timber: its use as an inflation hedge. The data are limited, so we should be cautious, but it’s worth noting that the NCREIF Timberland Index rose sharply ahead of US inflation shocks in both the mid- and late-1970s, as the chart below shows. And as a physical asset, you would expect timberland to maintain its value in real terms over the long term.
So, how do you invest? Institutions and wealthy private investors can invest directly, typically through private-equity pooled vehicles. This option isn’t available to most private investors, but there are a handful of funds and listed vehicles you can use.
The basic principles of investing in timber aren’t too different to most other companies: you’re looking for a business that will generate good cash flow and pay a steady, sustainable dividend over time. But there are a few points to watch for.
First, buying timber means buying a physical asset that is firmly fixed in one location and which will hopefully be around for decades to come. That means you should be confident that the firm has secure property rights which ensure it can maintain control of the timber far into the future. Related to this is the question of transparency: does the firm own and operate the resources in the way that it claims? Not all parts of the world are alike on this front.
Areas such as North America and Europe are well-established for timber investing, but many emerging markets are another matter. Pictet’s Micheli views Brazil and Chile as safe, but property rights in China are not secure, and transparency for Indonesian and Malaysian timber companies can be poor.
Second, timber is very much about the long-term, rather than short-term punts. An annual return of 5%-7% after inflation would be a very good outcome. Potential returns on forestry investments in many emerging markets might be greater, as figures from consultancy Pöyry show (see the table below), but these carry much higher political, business and environmental risks.
|Region||Real internal rate of return on forestry investment|
Timber is not a regulated investment, and several schemes have recently been marketing themselves to UK investors, promising great returns on forestry in emerging markets. Some may well be Ponzi schemes, while others may not be outright fraudulent, but their claims are still too good to be realistic. We recommend you ignore them.
Lastly, investing in listed timber firms is not the same as investing directly in timberland. Most listed companies are not pure plays on forestry ownership – they may have other operations, from those related to processing wood to businesses in entirely different sectors.
Shares in timber stocks may be more volatile than timberland prices, and the desire to maintain dividends to keep shareholders happy may lead to short-termist decisions such as selling land or overcutting when prices are low, whereas privately owned firms can simply leave the timber standing and wait for conditions to improve.
On the upside, a listed timber company is much easier to buy and sell than a forest. And because timber investment specialists mostly work in private equity rather than stockmarkets, listed timber stocks are often underanalysed and sometimes undervalued – that means opportunities for investors who get to know the quirks of the sector. We look at some of the best ways to invest below.
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The best investments to buy into now
There are a small number of easy ways for private investors to buy into the timber sector. I’ll list the main options here, then highlight the ones I think are the most useful.
First, the funds. Pictet-Timber is an open-end managed fund which invests in listed companies that own and manage timberland or operate in other parts of the industry, mostly in North America, Europe and South America. The total expense ratio (TER) is 1.95%.
There are also two US-listed, passive, exchange-traded funds (ETFs) built around timber: the iShares S&P Global Timber & Forestry (US: WOOD) and the Guggenheim Timber ETF (US: CUT). The TER for each is 0.65%.
While we generally prefer low-cost ETFs, on this occasion I’d favour the Pictet fund, because it’s more focused on high-quality firms with high timber exposure than the ETFs, which have greater exposure to sectors such as palm oil.
As usual with open-end funds, you should aim to buy through a discount fund broker such as Cavendish Online to bring down fees.
If you want to buy directly into stocks, the obvious starting point is the four US-listed timber real estate investment trusts (REITs). These are among the most popular listed options. Each provides a slightly different angle on the timber market.
If you are looking to bet heavily on the US housing recovery, Weyerhaeuser (US: WY) and Potlatch (US: PCH) stand out . The former has a homebuilding division, while the latter is most geared to domestic demand due to the location of its timberlands.
The third REIT, Rayonier (US: RYN), sells more of its products globally; it also has a high-value speciality fibres business. Plum Creek Timber (US: PCL) is the most all-round play in terms of geographical and product diversification.
There are several other US-listed timber plays such as Deltic Timber (US: DEL) and Fibria Celulose (US: FBR), the world’s largest pulp company, which grows and processes eucalyptus in Brazil. But if you’re looking for a listed stock that’s as close as possible to pure timberland ownership, the most interesting is a small cap, Pope Resources (US: POPE).
Unlike most listed timber stocks, it derives virtually all its revenues from growing and selling timber, rather than the manufacturing and other operations that are a major part of income for the big timber REITs. But there are caveats.
For one, the shares are not very liquid; for another, it’s structured as a master limited partnership (MLP) rather than a REIT. The tax treatment of MLPs is different to that of normal US stocks. You may need to file an annual claim with the US Internal Revenue Service to avoid losing out on excess US withholding tax (brokers are reportedly inconsistent on how they apply the rules on withholding tax on MLP dividends for foreign investors).
What about UK-listed options? For the last few years, there have been two options – but one, Cambium Global Timberland (LN: TREE), is scheduled to wind down over the next two years after a disappointing performance. The other, Phaunos Timber Fund (LN: PTF), has also performed poorly since its launch (see chart below) and currently trades on a discount to reported net asset value of 47%, but it now seems to be making some operational progress.
It has a potentially interesting portfolio of direct timber investments, with a mix of hardwood and softwood plantations in New Zealand, East Africa, Brazil, Uruguay and the US, among others. But apart from the question of whether the fund will ultimately deliver, another reservation is the relatively high fees: a 1.5% annual management charge fee and a 20% performance fee on annual returns over 8%.
Phaunos may well be a good investment if things start to improve at the company, but right now my favoured option is Pope Resources if you’re looking for a pure play on timber and are happy to deal with the MLP complexity. If you’re interested in getting some additional leverage to the US housing recovery, then go for Weyerhaeuser.
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