Timber: How to Play It and Why

 |  Includes: CUT, PCL, RYN, SNOFF, WOOD
by: Jeffrey Dow Jones

Raise your hand out there if you’ve ever considered trees as an investment. Anybody?

I see a few of you Jeremy Grantham disciples with your hands up. We talked a little about his latest predictions back here. Timber has long been a favorite asset class of GMO’s legendary value-hound. Grantham is fond of pointing out that timber was the only asset class that didn’t lose its value in the Great Depression or the 1970′s. He currently forecasts a 7.5% annual rate of return for the next seven years.

Perhaps the rest of us should grab a little wood?

Don’t laugh, wood is an awesome resource. It’s naturally occurring and extremely strong relative to its weight. Would you believe that Balsa has a higher strength-to-weight ratio than steel or titanium? There’s a reason it’s used in model airplanes and full-scale light aircraft. Since wood is so strong, light, and inexpensive, we use it to build all sorts of things from pencils to desks to houses.

General construction accounts for half of all timber consumption. Most of the rest gets turned into pulp and paper products and about 10% is used in various wood composites and as fuelwood. Timber has been an important resource for pretty much all of civilized history and that’s not going to change in any of our lifetimes.

It’s sustainable too. Major timber companies don’t just chop down trees and move along to the next site, leaving Mother Nature to sort out the wreckage. Having grown up on and around Lake Tahoe, I can speak from personal experience about respecting the natural beauty of our mountains. Before Nevada was admitted to the nation, the Tahoe basin was nothing more than a source for cheap lumber to ship over the mountain to the mines in Virginia City. We’re still recovering from the clear-cutting and mass de-forestation that occurred over 150 years ago. If you can find a copy of E.B. Scott’s The Saga of Lake Tahoe pay whatever it costs to pick it up, especially if you’re a local. It’s a beautiful pictorial history of the region that we Nevadans are so proud to be a part of. I wonder if the loggers in those early photographs had any idea about the eden of wealth and majesty that Tahoe would eventually become.

So, these major timber producers adhere to some sort of sustainable forestry guidelines that are set forth and audited by third-party organizations. Basically, these guidelines boil down to a) planting more trees than they harvest each year and b) being sensitive about specific tracts of land that certain groups and communities deem valuable for non-economic reasons. Check out the Sustainable Forestry Initiative or Forest Stewardship Council if you’re interested in that sort of thing.

For companies that are engaged in the business of chopping down trees, timber producers don’t have as bad a track record with environmental groups as you might think. These guys are experts at growing trees in efficient ways and since the growing cycle is long-term, it’s certainly not in their interest to destroy the environment that powers their inventory. Oil companies or miners don’t have their interests aligned with the environment the way timber farmers do.

The Investor’s Perspective

There are a few big reasons why investors should be interested in timber as an asset class.

The most important is that it doesn’t really correlate with equities. From 1987 to 2009 the correlation coefficient between the NCREIF Timberland Index and the S&P was about 0.3. Statistically speaking, that’s not very meaningful and a wonderful thing for investors. Remember that the ultimate goal of portfolio construction is to combine assets that each make money over the long run and don’t correlate with one another. Around here we get excited about things that don’t correlate with other things. Maybe that makes us big nerds. But we use these things as tools to lower our overall volatility and increase our portfolio’s return per unit of risk. Nothing nerdy about that.

Timber has interesting cash flow properties too, similar to a long-term zero-coupon bond. You plant the trees for a really cheap price, wait a long time for the trees to mature, and then sell them for a lot of money. If you’re smart about rotating your timber stock (or laddering your bond portfolio), you can time these cash flows so they arrive on a steady and predictable basis.

Since wood is a commodity, it also acts as a hedge against inflation. As prices rise over time, so does the value of your timber stock. Inflation is a good thing if you’re in the business of growing trees! Deflation can be a short-term problem, but we live in a world of central bankers who are haunted nightly by the grim visage of deflationary specters. So that kind of thing never lasts for very long. Plus, another advantage of managing inventory with a 15-30 year life cycle is that if there’s a year where lumber prices collapse, it isn’t that big a deal. You just let your trees keep growing and then harvest them next year when prices have recovered. What business out there can afford to let inventory sit idle for years?

On top of all that, timberland is a long-term bet on land prices. Until we figure out efficient interstellar travel the supply of land will remain fixed. There’s only so much of it to go around on Planet Earth and each year more and more people are born who demand this fixed supply. That’s a good thing for the balance sheets of these timber producers; basically the entire asset column consists of something that will always have a large amount of intrinsic value. The same cannot be said for the bank stocks. What is the intrinsic value of a CDS or a bag of dodgy loans? Give me a few acres of forest instead.

Sounds pretty cool, huh?

Here’s How to Play It

The big boys do it through private partnerships. Institutional pools of capital will get together and they’ll go out and purchase actual timberland. It requires a lot of money to do it this way, and a lot of knowhow. Grantham’s GMO manages a few forestry partnerships. Some super-wealthy investors do it on their own.

For the average investor, the easiest and most direct way is through a couple of specific stocks or an exchange traded fund.

Plum Creek Timber (NYSE:PCL) and Rayonier (NYSE:RYN) are the two biggest, publicly traded timber producers in the US. In fact, Plum Creek is the largest private landowner in the nation with over 7 million acres of timberland on its balance sheet. Here’s a chart of PCL since 1989. The S&P 500 is the green line.

Click charts below to enlarge

Not too shabby. It’s outperformed the market by a long ways.

The last 10 years have been tough for the market and for most investors. Here’s a 10-year chart of Rayonier. The red line is the DJIA.

As you can see, they did pretty well too and are almost back at a new high. It’s been a much better decade for the timber industry than the rest of the economy. But what about the years to come?

Plum Creek currently trades about 5 times gross sales and 4 times book value, which isn’t cheap. It’s structured as a Real Estate Investment Trust (REIT) which means that it doesn’t pay any corporate taxes and has to distribute at least 90% of its income. This structure makes traditional valuation a bit more difficult since net earnings work a little differently. Plum Creek has always traded at a fairly high multiples but that valuation has been justified by outstanding returns on assets and equity as well as historically large profit margins.

The stock also pays a 4.5% dividend and they just finished up a $200 million share repurchase program. I like companies that send a sizable chunk of their earnings back to their investors and use some of the rest of their excess cash to make investments in their own stock. These guys have demonstrated the ability to reallocate capital in productive and shareholder-friendly ways.

Rayonier tells a similar fundamental story and it pays a similar dividend. They don’t own as much land and they’re about half the size, but their business is a little more diversified. They’re a little more engaged in developing their higher-value land as real estate and they also manufacture cellulose fibers for various high tech uses. Rayonier correlates very closely with Plum Creek.

With investments that aren’t fundamentally cheap but have strong and stable long-term prospects, I find the following strategy useful. Scale your way in slowly. Pick up a little bit whenever you feel ready. After that, wait for events during which to acquire more shares. I fully expect a few more deflationary mini-panics in the next year or two, finite windows where investors sell whatever they can get their hands on and commodity prices plummet. When that happens you can increase your position when these stocks are trading at more of a discount.

A Few More Ways to Do It

There are a couple of other options out there. Take a look at Sino-Forest (OTC:SNOFF). At present, they only carry about $1 billion of debt against about $2.7 billion of land. With a market cap of only $4 billion, you’re buying the rest of the $250 million/year business rather inexpensively.

The intriguing thing about Sino-Forest is that they are one of the biggest forest owners in China. They have grown like crazy over the last decade as they’ve struggled to keep up with bottomless Chinese demand for building materials. Sino-Forest is also one of the largest holdings in the Gabelli SRI Green Fund, whose positions must adhere to “a broad base of socially responsible and sustainability criteria.” China isn’t what comes to mind when I think of environmental friendliness, but it goes to show that sustainable forestry isn’t that bad from an environmental perspective.

Claymore also offers a Timber Index ETF with the clever ticker symbol CUT. This fund offers globally diversified exposure to the sector, but CUT has underperformed both Plum Creek and Rayonier since the fund’s inception in December 2007 and it’s done it with more volatility than the S&P. That’s a small sample size from a very unique window in time, so I still think it merits watching. iShares offers a timber ETF as well, WOOD. It has a greater weighting towards domestic producers and contains more pure-play timber names instead diversified re-sellers of wood- and pulp-based products.

Keep in mind that timber is a long-term play. It’s sort of a “buy-and-forget” investment. I think that’s also why I like it. My brain thinks in terms of long-term cycles — I have no idea what to do about the day-to-day fluctuations of the market — so the multi-decade cycle of a timber farm naturally appeals to me.

It’s also an easy business to understand. Plant trees. Wait. Harvest trees. If I learned one thing from listening to Warren Buffett over the years (and also from managing our own hedge funds), it’s that people should invest in things they understand. There’s nothing complicated about the timber business.

Disclosure: No positions