With the bull market now in its sixth year, investors are seeking ways to insulate their portfolio against an eventual downturn. One of the keys is to invest in assets that are not highly correlated with the S&P 500. Timberland is an unorthodox asset class that has been used by large endowments such as Yale and Harvard as part of a diversified portfolio. This article looks at the risk versus rewards associated with timberland. There are three primary ways to invest in timber.
Timber Investment Management Organizations (TIMOs).
TIMOs own and manage over 23 million acres of forests. TIMOs are the vehicles of choice for large institutional investors, pension funds, and large private investors. TIMOs are typically out of the reach of retail investors since most require minimum investments measured in the millions. These organizations are not publicly traded so I did not include them in my analysis.
Real Estate Investment Trusts (REITs) are one of the easiest ways to gain exposure to timber. The fortunes of timber REITs are closely associated with the housing market. A healing economy and improved employment have resulted in an increase in U.S. housing starts. This has spurred the demand for lumber, which bodes well for timber REITS. On the flip side, there are still a number of risks that should be considered including the potential for adverse environmental legislation and the decreasing demand for paper. The strengthening of the U.S. dollar is also making Russian logs cheaper. However, trees are living organisms that will grow about 4-5% per year; so REITs have the option to wait for favorable conditions before harvesting. In addition, timber REITs may choose to diversify their operations and develop their land for other uses. The top four timberland REITs are summarized below.
- Weyerhaeuser (NYSE:WY). Weyerhaeuser is one of the world's largest owners of timberland, owning over 6.6 million acres. Much of the timberland is in the highly productive Pacific Coast region, which is one of the best tree-growing area of the country. In addition to timberland, WY also pursues related business areas including wood products and cellulose fiber. The company operates in over 11 countries with international sales accounting for 30% of the total revenue. The yield is 3.7%.
- Plum Creek Timber (NYSE:PCL). Plum Tree grows and harvests timber and manufactures wood products such as lumber and plywood. It owns 6.5 million acres of timberland across 19 states. About 40% of PCL's land holdings are in the Rocky Mountain and Northern regions, which generally produce less trees per acre than other regions in the U.S. The yield is 4.3%.
- Rayonier (NYSE:RYN). This is the third largest REIT owner of timberland with 2.3 million acres in the United States and over 300,000 acres in New Zealand. The bulk of Rayonier's land is in the South, which is more productive than the North but less productive than the Pacific Coast. RYN stock yields 5.1%.
- Potlatch (NASDAQ:PCH). This company has 1.6 million acres of timberland, primarily in Arkansas, Idaho, Minnesota, and Wisconsin. The company is the largest private landowner in Idaho. It operated in three segments: resources, real estate, and wood products. The stock yields 4.8%.
Wall Street recognized the interest in timber and has responded with two Exchange Traded Funds (ETFs). These funds are not pure plays on timber but instead own companies related to the timber industry. There funds are summarized below.
- Guggenheim Timber (NYSE:CUT). This ETF tracks the Beacon Global Timber Index. The ETF holds 29 stocks from companies that own forested land and produce timber related products such as lumber and paper. The portfolio is international with 29% from US firms, 19% domiciled in Europe, 14% in Latin America, and 10% in Japan. The expense ratio is 0.60% and the yield is 2.6%. This is a relatively small ETF with total assets of 197 million and an average daily trading volume of 36,000 shares.
- iShares S&P Global Timber & Forestry Index ETF (NASDAQ:WOOD). This ETF tracks the S&P Global Timber and Forestry Index. The portfolio is concentrated in 26 companies with 49% domiciled in the United States. In terms of international allocations, 19% of the total assets are from Europe, 9% from Japan, and 9% from Canada. The ETF provides exposure to companies that produce forestry, agriculture, and paper products. The expense ratio is 0.48% and the yield is 1.7%. WOOD has total assets of $293 million but the average trading volume is only 19,000 shares per day. WOOD was launched in June 2008 so it has a relatively short history.
Risk versus Reward
To assess the risk versus reward of these timberland assets, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. I used a risk-free rate of return of 1% for the analysis. To assess performance in both bull and bear markets, I used a look-back period from October 12, 2007 (the market high before the bear market collapse) to the present (June 2015). For reference, I also plotted the performance of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). The Smartfolio 3 program was used to generate the plot shown in Figure 1. WOOD was not included because it was not launched until 2008.
Figure 1: Risk versus reward over the bear-bull cycle
The figure indicates that there has been a wide range of returns and volatilities associated with these timber assets. For example, WY had a high return but also had a high volatility. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each company.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, for easy reference, I also plotted a red line that represents the Sharpe Ratio of CUT. If an asset is above the line, it has a higher Sharpe Ratio than CUT. Conversely, if an asset is below the line, the reward-to-risk is worse than CUT.
Some interesting observations are apparent from the figure.
- Timber REITs were significantly more volatile than the S&P 500 and CUT. This is not surprising since funds are typically less volatile than individual companies.
- All the timber REITs had higher returns than the S&P 500. However, the increased volatility of the REITs resulted in a risk-adjusted performance worse than SPY.
- The timber REITs easily beat CUT on a risk-adjusted basis,
- All the timber REITs had similar risk-adjusted performance. However, WY had the best performance and PCL the worst.
I next reduced the look-back period to the past 5 years to assess performance while the S&P 500 was in a rip-roaring bull market. The results are shown in Figure 2. What a difference a few years made! During this period, WY clearly outperformed all the other timber assets on both an absolute and risk-adjusted basis. CUT had similar performance as WOOD and both the ETFs outpaced all the REITs except for WY.
Figure 2: Risk versus reward over past 5 years
Reducing the look-back even further to 3 years resulted in the performances shown in Figure 3. During this time frame, the timber ETFs (CUT and WOOD) outperformed the REITs but WY was not far behind. The other REITs faltered with RYN actually falling to a negative return.
Figure 3: Risk versus reward over past 3 years
As the last part of the analysis, I assessed how much portfolio diversification you might gain by investing in these timber assets. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the timber assets and the results are shown in Figure 4. I chose to use the 5-year look-back period so I could include WOOD in the analysis.
Figure 4. Correlation matrix over the past 5 years.
The figure presents what is called a correlation matrix. The symbols for the assets are listed in the first column on the left side of the figure. The symbols are also listed along the first row at the top. The number at the intersection of the row and column is the correlation between the two assets. For example, if you follow WY to the right for three columns you will see that the intersection with PCL is 0.703. This indicates that, over the past 5 years, the price of WY and PCL have been about 70% correlated. Note that all assets are 100% correlated with themselves so the values along the diagonal of the matrix are all ones.
The matrix shows that timber REITs are moderately correlated with the S&P 500 and also with the timber ETFs. This was a little surprising since the price of timberland is only 11% correlated with the S&P 500 (as reported by the Hancock Timber Resource Group). However, the profitability and price of timber-related companies are dependent on much more than just the price of the real estate. In the current global environment where many asset classes are highly correlated, a moderate correlation is not bad. This data indicates that timber assets provide good (but not great) diversification.
No one knows what the future may hold; but over the time periods analyzed, WY had the best reward versus risk among the REITs. If you would rather invest in an ETF, then CUT would be your best choice.
Disclosure: The author is long WY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.