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Trees are at fair value [ClearOnMoney]
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Commentary

Trees are at fair value

10 Nov 2010 by Jim Fickett.

Valuations of timberland fell about 15% in the last two years, and are probably near fair value now. The risk of further downward adjustment following previous excesses is balanced by a squeeze on supply due to a mountain pine beetle epidemic. Forests provide a tangible return – wood products. Thus while current prices are probably not a great bargain, and the large returns of the past should not be expected, it is reasonable to expect a decent real return.

Last month Jeremy Grantham wrote in his fall letter (registration required),

My personal advice (i.e., how I invest my sister’s pension fund, etc.) is to give the benefit of any doubts for very long-horizon (20 years) investments to resources in the ground, agricultural land, and, above all, forestry.

Commodities are near the top of my list right now, so this strong recommendation of forestry caused me to finally look into an area I've ignored for too long.

Basic attractions

The three positives one hears most often about investing in timberland are (1) trees are a tangible asset, of immediate practical use, and hence provide protection from inflation, (2) returns have been historically high, and (3) timberland provides portfolio diversification.

The first point is self-evident. I won't discuss diversification, as I've never seen any value in pursuing diversification for its own sake. If you are interested, there is some quantitative data in a 2009 presentation from The International Woodland Company.

Timberland has, indeed, given high returns historically. However this has been due, to a significant extent, to one-time events. First, after a few endowments and pension funds took the lead, forestry became a fashionable investment and, as Wall Street facilitated the transfer of most productive forests from lumber companies to investors, prices for forested land went from undervalued to overvalued. Forest investments are now somewhat beaten down, but by no means forgotten, and the mass popularization is not going to repeat. Second, a significant portion of returns has been due to speculative land flipping, where forests were bought, cut, and the land sold to developers. While land speculation and housing booms will no doubt come again, it will be quite a while before tracts of spanking new McMansions are a primary driver of timberland value.

An illuminating, concise history can be found in a very useful report entitled U.S. Timberland post-recession: Is it the same asset?, by Jim Rinehart of R&A Investment Forestry:

Timberland has progressed through a series of phases characterized by changing competitive conditions.

1983 to 1995. During its initial stage, forest products demand was high, resting heavily on Japan. Stumpage prices [the price of the uncut tree] were increasing at a real rate of 1.5% per year, competition was low, and values other than timber value were not considered. Expected real returns were 6.0% to 10.0%, depending on region and perceived risk. Forecasting assumptions were aggressive. …

1996 to 2000. … more investors wanted in, forcing timberland prices to increase in the face of falling revenues. Feeding timberland supply was the forest products industry, now in a divestiture mode encouraged by Wall Street. With C Corp double taxation and low current income, timberland simply became more valuable to investors than to the industry. The fact that per acre values continued upward in the face of increased supply attests to the magnitude of capital available from institutional investors. …

2001 to 2004. … Investment in long-term “soft” activities gave way to cost- cutting, eliminating much of the R&D, silviculture, and community relations that industry had invested in. Focus on parcelization intensified as a means of increasing per acre value. …

Returns, which had continued downward at the period’s outset, had turned upward on the basis of valuations driven by new high- priced transactions. …

2005 to 2009. By the end of 2009, industry had sold off another $15.0 billion of timberland, essentially completing the transfer. Weyerhaueser is the only integrated forest products company remaining and they will convert to a REIT by the end of 2010. … Annualized nominal return for the period was 10.9%. With the economic crisis, however, return in 2009 was negative 4.75%.

From 1983 to 2009, 43.4 million acres valued at $39.7 billion changed ownership type. The forest products industry gave up 37.7 million acres valued at $33.1 billion, while TIMOs and REITs gained 26.9 million acres valued at $30.4 billion. …

Speculation could always drive spectacular returns again, especially with the Fed in bubble-blowing mode, but there is no guarantee of that. Nevertheless, if one can buy at fair value, it is reasonable to hope for decent returns. As long as the sun shines and the rain falls, the trees grow. And the value of wood has probably grown faster than inflation over the long term. The Forest Investment Review, from the Forum for the Future, says,

An overall tightening of supply and an increase in demand has resulted in real timber price increases over the past 50 years.

And Robert Stammers, writing at Investopedia, comes back to Grantham:

According to legendary investor Jeremy Grantham, timber prices in the last century (~1905-2005) have also grown at a rate that is approximately 3% greater than inflation

Neither of these sources provide any data beyond a one-sentence summary. Jack Lutz, a Maine forest economist, using long-term data on pine stumpage prices in Louisiana, points out that the data are quite noisy, the fit of any trend line is not very good, and so statistical evidence for a long-term rise in real prices is weak.

Overall, I tend to think that the world population is reaching the point where many resources will be under pressure, and so I'm inclined to believe in a long-term gradual increase in real prices. But Lutz' point is well taken, and one should try, as always, to make volatility one's friend – buy low and wait for a chance to sell high.

One other aspect of forests frequently mentioned is that they grow even when the market is down. That is, unlike with metals, grains, or fuels, if there is a down year when you need to just wait for the right time to cut and sell logs, the forest keeps growing and its capital value rises. This is an oversimplification, as there is an optimal harvesting schedule, but the basic point remains valid.

Finally, an aspect of forests that I personally find attractive is that the assets are all visible and countable. In mining stocks, which have occupied a good bit of my time lately, this is far from true. Valuation is never as easy as you hope, for any asset, but at least with trees, unlike with mineral resources, you know that they are really there.

Current valuation

The best overall discussion of current values I've found is in the above-mentioned Rinehart study (from April 2010). A few of the key fundamentals in the current market are as follows.

  • The two main areas of demand are wood pulp for paper and lumber for construction; both of these are currently depressed (see graph below)
  • Home construction will recover but it may take several years
  • The market for paper is likely to remain in gradual, long-term decline, but this will be partially balanced by some additional demand for wood as fuel
  • As for many other commodities, China is a significant current driver of demand; this is probably good for long-term demand but could lead to short-term volatility
  • The mountain pine beetle has devastated a large fraction of all pine forest in western Canada and the northwestern/Rocky Mountain US (for maps see this 2008 NY Times article and the Natural Resources Canada website); this will lead to significantly tighter supply in the medium-to-long run
  • Although home builders are not currently buying large amounts of land, the possibility of clearing the trees and selling the bare land continues to figure in valuations

There is little public data specifically on forestry, but sub-indices of the US index of industrial production for wood and paper products give a reasonable idea of the current downturn in demand. It is no accident that the line below for the wood products index looks very much like charts for the main indicators of the new home market.

J. Brian Fiaco is a forestry investment professional who writes the Timberland Blog. He has written a useful series of posts (one, two, three, four, five) explaining how the industry thinks about valuation. This is mainly in terms of forecasting wood production volumes, and using discounted cash flow models to bring these back to a net present value.

Both Fiaco and Rinehart maintain their own databases of major transactions in timberland. I think it is a fair interpretation of comments from both of them that the market for timberland, now down about 15% from the peak, is approximately at a near-term bottom.

There are most certainly risks – in particular that discount rates may need to rise, eroding values. On the whole, however, Rinehart expects that, once the bottom is clearly in, valuations are likely to rise over the next 15 years.

On the whole, it seems likely that current valuations are near long-term fair value.

Investment choices

Endowments, and Grantham's GMO, buy large tracts of forest directly. This options is not open to most retail investors.

ETFs are attractive for many investors, in that one can invest in a sector trend without worrying too much about the specifics of particular companies. There are two ETFs in the forestry space, iShares S&P Global Timber & Forestry (WOOD) and the Guggenheim Timber ETF (CUT). However these are not really forestry-specific. For example both include International Paper, which has divested all of its forest land.

The US companies with the largest holdings of forest land were, as of 2008, Plum Creek Timber Co., Weyerhaeuser, Rayonier, Sierra Pacific, and Potlach. I will be looking into these, hoping to find one that looks like a solid buy.

It should be mentioned that the tropics have an innate advantage for forestry. With more heat and light, trees grow faster, and the same amount of land produces more wood. According to the Forum for the Future study, most opportunities in South America (Brazil is particularly popular these days) are only available via private equity. However there are public companies in Asia. See the report for possibilities.

Cautions

On the whole I think there are likely to be some good values in this sector. But it is important to keep some cautions in mind:

  • There is no guarantee that the recent price correction is fully over
  • High debt service, or unrealistic dividends, can force a forestry company to sell wood at inopportune times
  • Forestry stocks are more volatile than timberland, and the recent run-up in commodities may already have gone too far for good value
  • The big push for high returns over the last two decades has pushed forest management culture towards cost-cutting, flipping, and quick returns; long-term investors should look for evidence of a long-term mindset in target companies
  • In valuing a company, strong emphasis should be placed both on the timberland itself and on sustainable earnings