- Timber offers an uncorrelated, high-returning asset class for diversification and long-term income.
- Two ETFs offer exposure to the broad sectors that are exposed to timber.
- Four stocks are setup as Timber Real Estate Investment Trusts (tREITs).
- We like the dividend growth story of the larger players.
When we build portfolios, we look how the various components and underlying exposures would perform under differing scenarios. We hunt for productive assets (that produce income) while constructing a portfolio that has high amount of diversification among the asset classes and individual securities. This is meant to produce a durable income-generating portfolio that can weather the storms of the markets, especially today.
Often time, one asset class can be in a bear market (like oil recently) while others can be booming [Tech]. We are not buy-and-hold investors but attempt to acquire assets that are trading at value prices, often as contrarian investors with a holding time horizon of at least six months.
We think one asset class that is undervalued and ripe for growth is timber. If the reflation trade is truly back on, timber should be a prime beneficiary.
The Case For Timber
Timber is a fan-favorite of Jeremy Grantham and Harvard University, both of whom have significant investments in the space. Grantham's firm, GMO, publishes a seven-year asset class real return forecast each quarter. Below is the last that had an "other" category which is where they housed the timber asset class.
Their track record over longer periods of time has been fairly accurate, although can be off significantly short term. The table shows the extended valuations we are experiencing today in the equity and fixed income markets. Emerging market stocks and timber are the only two asset classes that offer any significant real return over the next seven years according to their forecast.
Grantham's research noted that over the past hundred years, timber has returned 6.5% annualized. Over the last forty years, the returns have been in the low teens annualized. The National Council of Real Estate Fiduciaries (NCREIF) reported nominal annualized total returns of 12.6% over the past 28 years.
Meanwhile, Harvard's endowment fund has a large 10% allocation to timber as very long-term investors seek greater diversification and returns.
As a real and hard asset, timber performs very well during periods of rising prices. This is the reason the sector generated low-teens returns over the last forty years when inflation was more prevalent in the U.S. Supply continues to be outstripped by demand globally as forests need to be relatively close to population centers or production facilities to be economical.
The correlation of timber, simply because of its unique qualities of growth of trees unrelated to what is happening in the capital markets, is low to most other asset classes.
Volatility is also below that of equities and closer to that of bonds. As primarily value investors who seek high-probability returns by Hitting Singles and Doubles, the risk of timber is roughly in line with most of our Core Portfolio holdings, with about 200 bps of additional return.
Outside of the inflation protection and diversification benefits, the case for timber is made through biological growth. That is, the physical growth of the trees themselves. These growth rates depend on the type of trees plants but can range from 2% to 5%+ according to the U.S. Department of Agriculture. Using a midpoint average of 3.75%, minus the long-term 'loss' rate due to natural causes of 0.5%, organic return estimates are 3.25% placing a long-run floor to the investment.
There also potential risks from investing in timberland. Outside of the traditional supply and demand drivers for wood prices and acreage values, other risks include fire, insects, weather, and disease. Proper maintenance of the land, called 'silviculture' helps to mitigate the risks.
Timberland is also an illiquid asset, with relatively few market participants involved in the sector. Most timberland is still privately owned through private placements, but that is slowly changing. The long-term investment aspect of the class - it can take up to five years for the capital investment phase before another five to eight years for growth. That is a long runway before the payoff can begin through harvesting.
How To Invest
Up until recently, investing in timber was relegated to the qualified/accredited or institutional investor. There were few avenues for retail investors to access the asset class. The ownership of US timberland has changed dramatically over the last three decades. Today, we have two ETFs to choose from that offer exposure to the sector.
- iShares S&P Global Timber & Forestry Index ETF - (NASDAQ:WOOD)
- Guggenheim MSCI Global Timber ETF - (NYSEARCA:CUT)
The correlation between the two ETFs is extremely high.
These are globally diversified funds with approximately 40%-45% exposure to the U.S. The rest of the country weightings come from Finland (~11%), UK (~7%), Australia (~6.5%), Japan (~4%), Canada (4%), and Brazil (4%).
In terms of individual stocks, there are a number to select depending on the exposures desired. The main categories are:
- Paper and Forest Products
- Containers and Packaging
- Real Estate Investment Trusts (REITs)
It is the last category that is of the most interest as income-seekers. In that category, there are just four primary names:
- Weyerhaeuser REIT- (WY), yield of 3.72%
- Rayonier REIT- (RYN), yield of 3.61%
- Potlatch REIT- (PCH), yield of 3.31%
- CatchMark Timber Trust- (CTT), yield of 4.59%
The thesis of these stocks is a play on higher lumber prices driven by several drivers:
- Increased new housing starts.
- Rising repair and remodel capital expenditures.
- Canadian market share decline.
In terms of demand, housing is the main economic driver for the business. Each new house uses between 15,000 and 17,000 board feet of lumber for the average frame of a 2,400 sq. ft home. Another 10,000-15,000 sq. ft. of other wood products are also used.
Housing starts continue to climb as the market heals from the financial crisis.
The total number of housing starts is still well below the levels reached in 2006. While that figure was likely inflated due to the bubble, the drop during and after the financial crisis compensated for that over-building. We continue to climb back with Goldman Sachs predicting a 9% rise in 2017.
The National Association of Home Builders/WF Index sentiment jumped to 71 in March, the highest since June 2005. Typically, when the reading is above 50, the market is expanding well.
Canadian Import Restrictions
The prospect of higher lumber has been increased thanks to the new administration's tough stance on trade. The catalyst is the way Canadian provinces charge for stumping - the cost a private firm pays for the right to harvest timber.
Forests in Canada are owned by the provinces, whereas in the U.S., they are owned by private landowners. Clearly, here in the U.S. the market determines the stumping fees, but in Canada, they are set by the provincial government. The U.S. argues that those prices are set artificially low and therefore equate to a subsidy to Canadian timber companies.
Any tariff imposed by the U.S. government would lead to higher import prices for Canadian lumber, giving an advantage to U.S. producers. For every 2% of market share that the U.S. gains over Canada, it equates to 1 bbf of lumber demand.
Lumber futures were already up before the announcement of tariffs. Prices hit $400 before backing down to $365 as of the end of June. That compares to $310 at this time last year.
US producers will likely increase production to offset the Canadian supplies that will no longer be imported, but they are unlikely to cover entire amount in the near term. Supply could be constrained a bit and help push up prices.
The timber space is an interesting one and an area most investors ignore. But the commodity can offer one of the best risk-rewards for patient long-term investors. We like the ETFs for broad diversification, but both ETFs have over half of their revenues derived from outside of the U.S. adding currency and regulatory risks. The individual timber REITs can give investors better upside potential without those risks, but a lack of diversification.
In the second part of this report, we will highlight our pick for playing this space and our thesis behind that position.
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