In the current economic climate, investors are reducing their exposure to volatile equity markets and other financial assets in favour of asset classes that offer better capital preservation and income generation. Natural resources and commodities are used often for this cause. One of the overlooked, but overly important and unique natural resources is timber.
What is timber?
To put it simply, timber is processed wood. The harvested timber can be used for a variety of things, such as building houses and manufacturing pulp for the paper industry. Timber investments are long term investments which earn returns through biological growth of trees, timber price appreciation and increasing land values. Timber was first introduced as a distinct asset class in the 1980s and since then the National Council of Real Estate Investment Fiduciaries (NCREIF) Timberland Index has been the standard benchmark for this asset class. The NCREIF Timberland Index has returned 14% on average annually with a standard deviation of 9.5%. Over the same time period US equities earned 9% annually with a standard deviation of 18%. Before discussing the optimal ways to invest in timber, I will first explain why timber is such a good investment for the coming years.
What makes timber a good investment for the coming years
1. The demand for timber is increasing
Since 2008, the demand for timber has been increasing as forest-related product development grows. The most important driver of the rising demand for timber is the recovering housing and construction market, which is increasing in the US after the tough years in the aftermath of the credit crunch. One of the most important indicators of the US housing market is the data on housing starts. This economic indicator reflects the number of privately owned new houses on which construction has been started in a given period. As shown in the graph below, housing starts are picking up but are still nowhere near the levels of the early 2000s. This implies that there is still more growth to come in the next couple of years, which is positive for the demand on timber.
Figure 1: US housing starts for the period 1968 – now.
2. Timber supply is reducing
About one-third of the timber needed by the US is supplied by Canada, with the majority of timber coming from the western part of Canada. In recent years, there has been a severe epidemic outbreak of the mountain pine beetle. The mountain pine beetle inhabits trees and lays its eggs under the tree. After hatching, the larva eats its way through the tree to feed itself, thereby heavily reducing the quality of the timber. Because of the recent epidemic, the amount of pine beetles increased massively, which causes more trees to be eaten by these bugs and thus more trees dying and reducing the quality and amount of timber. Since trees need to grow for a couple of years before they can be harvested, the damage done by the mountain pine beetle will affect the timber supply for quite some time. The scale in which this epidemic affects the supply of timber can be evaluated in terms of housing starts. The figure below shows that the reduced Canadian harvest is equivalent to about 10% of the market. Next to this, the expanding Chinese market demands more timber each year. This causes the supply to the US housing market to drop with another 5%.
Figure 2: Impact on the supply of timber of the decreased Canadian harvest and increasing export to Chinese markets.
3. Timber is an inflation hedge
Timber increases in value "on the stump" at a greater rate than inflation. According to legendary investor Jeremy Grantham, in the last century (~1905-2005) timber prices have grown at a rate that is approximately 3% greater than inflation. This claim is emphasized by figure 3 below, where compounded annualized returns for each 10 year investment period are compared with the corresponding annualized inflation over the same period. It is clear to see that timber investments consistently outperform the inflation rate, which makes it a perfect low risk inflation hedge. With the FED targeting a higher inflation rate in the long term after a relatively long period of low inflation, timber is becoming more attractive. Other natural resources are also touted as good inflation hedges, but what distinguishes timber is that in times when harvesting conditions are bad, it is possible to just let the trees grow and wait for more profitable time to sell the wood. This is in contrast with commodities like corn and wheat, which have to be harvested each year. Therefore, these commodities are more prone to seasonality and have more volatile returns, while timber investments offer more stability.
Figure 3: Compound annual returns of US timberland investments compared to the CPI for 10 year investment periods
4. Timber has low correlation to other asset classes
Timber prices are impacted by different economic factors than other asset classes such as stocks and bonds. Because of its stable returns and low correlation with other asset classes, timber is a perfect diversifier in any investment portfolio. Furthermore, timber prices historically rise during bear markets, which makes it a perfect investment in times of decreasing equity returns.
5. Investment in land as an appreciating asset
Although it is possible to lease the land necessary to grow timber stock, the majority of timber investors decide to purchase the land. The land supply is limited and demand continues to grow as the population and commercial development expands. Depending on location, some property can be targeted as "higher and better use" land that can be sold to developers at a premium, providing additional appreciation benefits for timber owners apart from the growing and harvesting of timber.
Due to all the factors given above, the global forest products research firm Forest Economic Advisors (FEA) forecasts a strong growth in timber prices for the coming years. Their forecast is given in the figure below for timber harvested in the south of the US (Southern Pine Sawtimber) and timber harvested in Canada and the western part of the US (West Coast Douglas Fir).
Figure 4: FEA timber price forecasts
How to invest in timber
There are a few ways to invest in timber. Firstly, there are two ETFs which offer exposure to timber focusing on the North American (iShares Global Timber & Forestry (WOOD)) and the more international (Guggenheim Timber ETF (CUT)) timber market. Both ETFs originated around the end of 2008, after the credit crunch. Figure 5 below gives the performance of both ETFs compared to the S&P 500 in the last 5 years.
Figure 5: Performance of WOOD and CUT ETFs compared to S&P 500 in the last 5 years
Both ETFs underperformed the S&P 500 over this time period, especially in the last two years, even though both ETFs provided stable returns. However, these years were characterised by a huge bull market, while timber performs better in a stagnating or bear market. With the FED stopping the QE program, the time of a new bear market is near. The underlying geographical exposure is given in the following table for both of the ETFs. In my opinion, the iShares Global Timber & Forestry (WOOD) is a more favourable investment, mainly due to its higher exposure to North American market. The downside on both of these ETFs is that they are not pure timber plays, since they also have exposure to paper producing and industrial packaging companies.
Figure 6: Geographical allocation of holdings CUT and WOOD ETFs.
The second way to invest in timber is directly through timber investment management companies. I will analyse the timber investment which I believe is the most attractive.
Plum Creek Timber Company Inc. (NYSE: PCL)
The biggest and most renowned timber company is Plum Creek Timber. Plum Creek Timber is a Real Estate Investment Trust (REIT) that manages and owns timberland. It is the largest owner of timberland in the US and currently has a market value of more than 7.1 billion US dollars. It owns and manages timberland in both the South and North Western part of North America. Over the years Plum Creek Timber has maintained solid profits, operating margins and increasing revenues, and in the last 5 years investments in Plum Creek Timber earned a stable 4,3% yearly average dividend yield.
In the meanwhile, the stock has dropped from well above $54 a share to around the $40,50 it notes now. This was mainly caused by the negative prospects of the housing market and a share issuance in 2013.
Figure 7: Plum Creek Timber share price development last 2 years.
I will present a few of arguments in favour of Plum Creek Timber. Last year, Plum Creek acquired 501,000 acres of timberland in the southern part of the US for a price of $869 million. Overall, Plum Creek now owns and manages approximately 6.7 million acres of timberland. Using the price of the acquired timberland to value the total amount of timberland Plum Creek owns, their total timberland value amounts to $11.6 billion. This number is slightly above the combined value of $10.9 billion of market capitalization ($7.1 billion) and total debt ($3.8 billion) of Plum Creek. When doing the math, this would imply that the value of operations and all other land holdings of Plum Creek Timber would be $700 million in total.
Next to its regular operations, Plum Creek Timber has an off-balance sheet commitment of $152 million in a real estate development joint venture with MeadWestvaco Corporation in which both companies contributed real estate and commercial properties currently under development. Subtracting this number, the $250 million in cash and current assets Plum Creek has left, would value its remaining holdings and future prospects at $300 million. This number is approximately equal to the mineral reserves Plum Creek Timber accumulated in its timberland acquisition last year. In the connection with the timberland acquisition, Plum Creek acquired certain proven coal reserves and mineral right of 4 quarries in Georgia of approximately $57 and $156 million respectively. Adding these numbers to Plum Creek’s existing mineral rights of $85 million, the total minerals position is $298 million in total. After crunching the numbers, the value of operating facilities is theoretically zero. In reality, this is not the case and therefore the Plum Creek Timber stock can be considered undervalued.
As noted by figure 8 below, Plum Creek will increase its harvest the coming years with about 4 million tons to a stable harvest of 20 million tons per year. This 25% increase in revenue leads to a $50 million increase of the yearly gross profits as of 2014, if the timber price remains stable. However, I expect the timber price to rise in the coming years. This will lead to higher revenues and profits and thus a higher value of Plum Creek Timber, especially if Plum Creek Timber manages to maintain its current production costs.
Figure 8: Plum Creek Timber’s harvesting forecast in millions of tons
Another argument in favour of investing in Plum Creek Timber is the recent share repurchase program. In its quarterly report of Q3 2014, Plum Creek Timber disclosed that during the third quarter of 2014 the company had share repurchases amounting to $50 million at a price of $40,21 per share. The current share price of Plum Creek Timber is not far above this value, which implies that management still thinks the stock is undervalued. At the current stock levels Plum Creek Timber will continue their stock repurchases, as their CEO noted in Plum Creek’s Q3 quarterly report.
Given the developments in the timber market, I expect timber to be one of the better performing natural resources in the coming years. With its relatively low risk characteristics timber is an ideal holding for the long term investor. While ETFs give a well-diversified exposure to timber, Plum Creek Timber (NYSE: PCL) potentially offers higher gains with its stable dividend yield and cheap valuation.
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Jauke de Jong
Jauke is always looking for the hidden gems of the financial markets.