Timber: grow profits in a crisis

published 19 December 2008

A lot of big reputations on Wall Street have gone up in smoke this year. Some were exposed for their hypocrisy, such as Eliot Spitzer. An entire industry, investment banking, was crushed by derivatives and the subprime mortgage crisis. But when you hear about the $50bn scam that Bernard Madoff a man who surely had no need of the money had running, you wonder if everyone on Wall Street wasn't just part of an elaborate con to siphon money out of the rest of the economy.

So it's comforting to be reminded that there are some areas of investing where sophisticated financial chicanery doesn't really work. Take forestry. Deep in the woods of the Pacific north-west, for more than 100 years, rugged characters, many of whom are members of logging families that go back to the time when the West was being settled, have spent their days recovering timber far from the comforts of civilisation. It might not be as glamorous as Wall Street, but at least trees keep growing when all else is going to ground. In fact, timber is about the only asset that has managed to thrive during market collapses rising in three out of the four major periods of market anxiety in the last century, according to GMO fund manager Jeremy Grantham. So you might well worry about how long it will take banks to digest their toxic debts. Or whether biotech groups will be able to raise the cash to develop their drugs. But with seasoned timber groups inAmerica paying out dividends in excess of 6%, there is a lot of comfort to be taken from investing in timber as the economy slides.

But what makes timber so good in this crisis? Who wants to buy timber right now? Nobody's queuing up at Ikea to buy furniture for their new home. And the dust has long since settled on America's collapsed construction boom. Housing inventory at the end of June was 4.9 million homes, or about 12 months of supply a glut not seen since 1981. So we're not likely to see a sudden rise in housing starts anytime soon.

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But investing in timber isn't really about how much you can get for a two-by-four right now. Yes, timber prices have taken a heavy hit in America, with lumber consumption in the US expected to fall 15% or more this year. But according to forestry analyst George Nichols, the price of timber itself only accounts for a third of the return an investor makes on it. The most important aspect of timber investing is the growth of the trees themselves. Nichols points out that steady long-term biological growth accounts for 61% of the returns an investor makes on timber. Meanwhile, the quality of the land a forest covers accounts for just 6% of the return it only really matters to the extent that it allows the trees to thrive.

In other words, if forest owners are not happy with the timber prices prevailing in the market, they can choose to leave their assets to grow on the stump. And the longer they grow, the more valuable they become. Take the life span of a pine tree in the forest-heavy southwestern states, says Dick Molpus, head of timber investment group Molpus Management. For the first 11 to 15 years, a tree is good for pulp selling between $6 and $11 per ton. From 15 to 20 years, you have chip and saw material. By the time the pines are between 20 and 27 years old, they'll typically fetch between $40 and $50 as the timber is sold off to make plywood or telephone poles. And unlike wood processors and paper mills, who are struggling under heavy debt and high labour costs, timber can grow without constant involvement from the owner. Soil, sunlight, air and water all the key ingredients for tree growth are provided by Mother Nature.

Timber also has a great long-term track record. According to Grantham, between 1910 and 2000, timber prices rose at an annual rate of 3.3% above the rate of inflation. So if you're prepared to wait, timber will be a very rewarding investment. Those tall pine trees that are being left to stand in North America, Canada and Europe will be worth a great deal when they are finally harvested. The United Nations Food and Agriculture Organisation estimates that world consumption of wood products will rise by 60% over the next 25 years. China alone has increased its appetite for wood 16-fold in the last 12 years, says Chris Mayer in his Capital and Crisis letter. China's frenzied building boom may be tapering off for now. But building homes, and panelling public offices for an urban population that is forecast to swell from 530 million to 875 million by 2030, will still put pressure on the world's supply of timber. China's violent lunge for prosperity has already contributed to deforestation that has seen one tenth of global forests disappear in the last 25 years.

Burning wood for biofuel will also tax timber resources. Burning wood pellets or chips has proved a useful source of renewable energy, creating little in the way of polluting waste. Britain has high hopes for biomass as a back-up fuel source, with the government hoping to raise the amount of electricity generated from biomass to 6% by 2020, up from the 3.5% used now. So while the tall trees in America and Europe silently accrue value, the drive for renewable energy is also creating demand for lower-quality timber that simply didn't exist a few years ago.

So where should you invest? Well, North America pretty much dominates global timber investment. It may only account for 17% of the world's forest area, but its forests contain about 80% of the world's industrial wood plantations. And if you are looking for steady returns on your money, you could do worse than buying a share of these towering coniferous and hardwood forests. The NCREIF Timberland Index, the standard benchmark for American timber, increased 18.4% during 2007, against a 5.5% rise in the S&P 500. It has still delivered positive returns (0.9% in the last quarter) even as stockmarkets have plunged.

Of course, the housing crash has hit timber demand in the US hard. Near-month lumber futures have already dropped 35% this year to $193 per 1,000 board feet (mbf). But there is a "big slug of money in institutional vaults by some estimates, $10bn slated for investment in US timberland," says Chris Mayer. "This provides a solid floor of demand." Unlike Canada, the world's second-biggest harvester of timber, the US government hasn't saddled its forestry industry with heavy taxes just as the price of lumber has fallen below the cost of production. Canadian mills, for instance, must pay a 15% duty to ship lumber to America.

However, that's not to say the American industry is free from government interference. Washington's efforts to conserve the country's forests are contributing to a growing scarcity of quality timberland. Each year, the US sets aside 1.4 million acres of timberland for conservation. Which would be fine, if American forests weren't currently being devastated by an infestation of rapacious mountain pine beetles. Vast patches of purple among the green forest canopy can be seen from the air. Even centuries-old lodgepole pines on the most elevated ground, once thought impregnable because of the extreme cold that usually kills the beetles, are dying. And as the dying trees dry out, the prospect of wild forest fires during the summer months looms large. North America, which accounts for two-thirds of the world's investible timberland, will lose about 20% of its spruce, pine and fir lumber over the next five to eight years.

That suggests that there will be a lot of investor money chasing a lot less timberland in only a few years' time. But having dropped this year on concerns about the housing market, many US forest stocks (see below) look good value when you add in the income payments. And as Asif Suria notes in his Sin Investment newsletter, with lumber prices having slipped so far it now trades below a 12-year trading range of $200 to $450 per mbf you could argue that the soft demand is already included in the price. Once the American housing industry recovers an event that's certainly some way off the price will recover quickly and the patient investor will benefit. The RISI forestry research group is pricing in a leap from $193/mbf to over $500/mbf for southern sawtimber over the next five years.

It's exactly those kind of prospects that have awoken Russian Prime Minister Vladimir Putin's interest in timber. Russia is the third-largest forest harvester after Canada and the US, accounting for 22% of the world's volume of wood trade. But its hopelessly inefficient forestry industry its ancient machinery makes little impression on the trees as Soviet sawmills are left to rust in the dense forests has ensured that Russia only produces about a third of the government's annual allowable cut of 576m cubic meters. In response, Putin lifted taxes on exported Russian logs from 6.5% to 20% last February in an effort to pour money into the country's domestic industry. He's since raised it to 60% and now wants to lift it to 80%. That might have seemed like a nice little earner for Putin, but as with most such tax hikes, it has backfired as those importing Russian logs have gone elsewhere. Exports to Europe have dropped 44% in a matter of months.

China, which sourced 46% of its logs from Russia, has been quickest to adjust. With little forestry of its own forest covers just 18% of the country's total land area China has become dependent on importing timber to feed its furniture industry and infrastructure ambitions. Log imports had grown at an average rate of 26% per annum over the last decade. Wary of deforestation after the Yangtze burst its banks in 1998, claiming the lives of 3,004 people and costing the economy $24bn, Beijing has put serious restrictions on harvesting the country's natural forests.

But now the Chinese government is doing everything it can to boost its own wood industry. Firms that plant and own forests in China are reaping the returns. Eucalyptus plantations, which can be harvested after six years, have sprung up around the country. China will be one of the biggest growth areas for forestry over the next decade, says Robert Hagler of ForestEdge International. With severe winter storms knocking over a tenth of China's fragile forestry earlier this year, log prices should rise 5%-7% a year in the next few years, according to Richard Kelertas of Dundee Securities.

Just as Finland is scouring the rest of Europe to replace its Russian timber imports, China has turned to New Zealand and America for hardwood, according to Forest2market research. There are even bigger opportunities on the horizon in Latin America as governments move to privatise their forests. Latin pulp capacity will grow by nearly 40% between now and 2015, and will account for nearly 35% of the global market, says Kurt Akers of Global Forest Partners. We look at how to profit from these opportunities below.

Forestry has drawn a lot of investor interest this year. As of June, investors had put roughly $80m into the Wells Timberland real estate investment trust (REIT), while the assets of the Claymore Global Timber Index ETF (NYSE:CUT) had reached nearly $60m. But investors are buying the wrong stocks, says George Nichols. Both the Claymore ETF and S&P Global Timber & Forestry Index Fund ETF (NASDAQ:WOOD) have too much exposure to paper, wood manufacturing and distribution companies to warrant their reputations as plays on timber. When you break down some of the REITs that have become popular, you find they are really only half-timber plays, because of the paper mills they own.

So how can you get a direct play on timber? The purest play is through one of the UK-listed timber funds that buy up forestry around the world. The Phaunos Timber fund (LSE:PTF), a Guernsey-based closed-end investment company, is well diversified globally and by forest types, owning forests in seven countries, China, Brazil and America included. It also has $2.5bn in the pipeline for further investments. The fund charges a management fee of 1.50% and trades at $0.79, below its net asset value of $1.02. The Cambium Global Timberland (LSE:TREE), also has forestry projects spread across the world. The fund charges a management fee of 1% and takes a 20% cut of returns above 8% (as does Phaunos). It's important to note that both aim for long-term capital gains, so don't expect regular dividend payouts.

Plum Creek Timber (NYSE:PCL) is the closest thing to a pure-play timber REIT.It owns nearly eight million acres of timberland, across the US. It trades on a p/e of 24, but with a dividend yield of 5.15%, it's worth picking up for the regular income. Potlatch (NYSE:PCH) is a smaller land owner, with 1.7 million acres under its control. It's spinning off its pulp-based business and will become the second most timber-focused company after Plum Creek. The shares trade on a forward p/e of 17, but offer a dividend yield of 8.2%. Rayonier (NYSE:RYN) controls 2.6 million acres of forest territory, including 343,000 acres in New Zealand, which, like the States, is increasingly supplying wood to China after Putin's meddling with timber exports. It's less of pure play, and trades on a forward p/e of 17.7, but offers a 6.9% dividend yield.

North America has the largest private timberland base today, but the big opportunities over the next decade lie to the South. The UN reckons Brazil has more than 493 million hectares of forest, and Bolivia and Colombia, 60 million hectares. Brazil has been growing forests fastest, with 81.2 billion cubic meters of forestry growing in 2005, against 35.1 billion cubic meters in America. Robert Hagler of ForestEdge International believes corporate holdings across Brazil will be the main targets for timber investment groups this year.

Keep an eye on Brazilian timber and paper group Votorantim (NYSE:VCP), says Gabriel Micheli of Pictet Asset Management. It's benefiting from consolidation in Brazil and could dictate lumber prices in that market. The most exciting development may come with carbon credits. With 10% of the world's forests vanishing over the last 25 years and illegal logging rampant in much of Asia, there is lots of government support for putting a cash value on forest maintenance. A voluntary forest carbon credits market already trades in Australia and America. It's early days, but this is one field to keep an eye on.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.