How to profit from Chinese forestry

With a global credit crunch in full swing and consumers feeling the pinch from rising food and oil prices, now is the time for investors to start battening down the hatches.

So where's a safe place to hide your money? Well, there is one asset class that has an impeccable record during financial collapses, rising in three out of the four market slumps that took place in the last 100 years: timber.

The thing about timber is that it is the only low-risk, high-return asset there is, says long-time fan Jeremy Grantham of the GMO Investment firm timber has risen steadily for 200 years, returning an average of 6.5% a year over the last century.

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With the global supply of timber dwindling one tenth of the world's forests have disappeared in the last 25 years, just as international sanctions to combat unsustainable logging are being firmly enforced timber has never been so precious. Benchmark pulp prices have risen more than 30% in two years, says Alison Leung for Reuters.

One country really feeling the pinch is China. When your urban population is expected to swell from 530 million people to 875 million by 2030, you need an awful lot of timber. Chinese lumber consumption is expected to grow by 10% a year for the next five years, says Morgan Stanley analyst Charles Spencer, as 50 cities the size of London spring up around the country and a new consumer class looks to furnish their homes.

But China is seriously short of trees. Forest covers just 18% of its total land area half that of many Western countries. When the Yangtze River burst its banks in 1998, claiming the lives of over 3,000 people and costing the economy $24bn, deforestation was singled out as one of the main causes for the disaster, forcing the government to put serious restrictions on harvesting forests.

As a result, the Chinese have been relying heavily on imports, which have grown at an average rate of 26% a year in the last decade, with much of the wood coming from Russia. But that's becoming costly. Moscow sharply increased its export tax on logs earlier this year, while crucial suppliers, such as Indonesia, are scrimping as they face a crackdown on the illegal logging that makes up 50% of their forestry industry.

So the Chinese government is doing everything it can to boost its own domestic wood industry. All sorts of perks have been rolled out to private forestry firms to boost wood production. A forestry levy that accounted for 15% of total costs was removed earlier this year. And subsidised loans were made available to the sector by the ministry of finance. A cut in corporate taxes is also on the table.

A handful of listed companies have sprung up, looking to exploit China's 960 million hectares of forests, of which only 5% is in plantation use, says Leung. They are already turning a fast buck as they focus on planting fast-growing, high-yield trees, such as eucalyptus and poplar. And if the forests become eligible for carbon-credit trading under the Kyoto protocol, says Leung, they could have another very lucrative source of income.

There is, of course, a risk with a lightly regulated, fledgling industry like this that the government could introduce unexpected policy changes, says Alex Tang of Core Pacific Yamaichi. But with huge demand for timber brushing up against a serious shortage in supply, Chinese forests (see below) could be the ideal sanctuary during the impending financial turmoil.

The two best bets in the timber sector

The industry leader in China's wood sector is Canada-listed Sino-Forest (TSX:TRE). Sino is unusual in that it is a foreign firm operating in China, owning both timber plantations as well as wood-processing plants. The group has spent $366m on timberland acquisitions and tree planting this year, lifting the value of its timber holdings by 37% to $1.03bn this year alone.

And with very little debt on its books, there is plenty more scope for acquisitions. The forestry assets are expected to grow towards 1,000,000 hectares from the 352,000 it had on its books last year. "This is one of the best China material plays," according to analysts at Morgan Stanley. "And it should increase its earnings per share by more than 30% annually for the next five years." That puts it on a forward p/e of 10.3 for 2009.

Domestic forestry firm China Grand Forestry Resources (HK:0910) recently diversified into the biofuels sector with a £400m acquisition, which will more than double its profits, says HSBC's Ken Ho. It has seen its market value balloon 18 times since last year, but its earnings model is still sustainable, says Ho. The group is set to grow its forestry reserves to 800,000 hectares before 2011 and is valued on a forward p/e of 12.77.