As I noted in a previous article, timber has outperformed stocks, bonds, and commodities over the past several decades. But in practice, no suitable pure-play timber vehicle exists for retail investors. Timber real estate investment trusts (REITs) are the most commonly used substitute, but how timber-like are they?
Unfortunately, none of the three timber REITs -- Plum Creek Timber (NYSE:PCL), Rayonier (NYSE:RYN), and Potlatch (NASDAQ:PCH) -- are pure plays. Rather than divest their manufacturing operations, the REITs have merely moved them into taxable subsidiaries. Thus, REIT shareholders are stuck with significant exposure to sawmills, pulp mills, and paper mills.
For instance, timberland-related revenue (which I define as timber harvesting plus real estate gains from forestland sales) constituted merely 17% of total sales for Potlatch in 2007, while the other 83% came from manufacturing. Timber constituted a slightly greater proportion (28%) of revenue for Rayonier. Plum Creek had, by far, the highest timberland exposure (71%) and is the only REIT that I'd have no reservations calling a timber company.
The REITs' exposure to manufacturing negates many of the benefits conferred by timber. Manufacturers exhibit highly cyclical results and are subject to high tax rates compared to what REITs pay for their timber harvests. Mills also spend heavily on labor, energy, equipment, and facilities. As such, they are characterized by low operating margins, depreciating assets, and substantial debt.
By contrast, trees are relatively low-maintenance assets. After all, trees have grown successfully for nearly 400 million years without human assistance. The key ingredients for tree growth -- soil, sunlight, air, and water -- are readily provided by Mother Nature at no cost. Timber may be the only asset in existence that reliably exhibits physical growth for decades with no involvement from the owner.
Timber REITs have historically generated solid returns, but are they a good proxy for timber? If so, their returns should strongly correlate with the returns of the NCREIF Timberland Index. Ideally, a proxy would score between 0.80 and 1.00. Unfortunately, my analysis of annual returns since 1997 showed only a mildly positive correlation for the three REITs (ranging from .06 to .33).
While this indicates returns haven't been very timber-like in the past decade, I suspect correlations will increase significantly in the future as these firms continue divesting manufacturing assets and increase their focus on timber. For instance, Potlatch recently announced a proposal to spin-off its pulp-based businesses, which I will discuss in a forthcoming article.
However, investors need to be aware that even if these REITs eventually become timber pure-plays, they are unlikely to show a very high correlation to timber due to the various economic factors that specifically affect stocks and REITs, but not timber. (Such factors explain why the stocks of commodity producers capture only some of the diversification benefits provided by commodity futures contracts.)
So, what are the implications for investors? Among all timber vehicles available to retail investors, I believe Plum Creek is the most attractive option. Other vehicles suffer from high manufacturing exposure, illiquidity, tax issues, or other drawbacks.
Plum Creek, the largest non-government owner of timberlands in America, will reap the benefits of this asset class by virtue of its 8 million acres of forests. Shareholders just need to realize that Plum Creek isn't a proxy for direct timber ownership and its performance will not closely track the NCREIF Timberland Index.