Land: The Best Asset For Your 'Inflation Hedge' Portfolio

by: Nairu Capital

Investors today are finally starting to buy hard assets in order to fend off inflationary pressures.

A 50-50 land/gold portfolio has generated very strong and stable returns since 1975 despite falling inflation.

By investing in the top five largest open land-owning stocks, an investor can gain exposure to this asset class without the manual labor of buying land.

Many of these land-owning companies are undervalued from a book value perspective.

By combining land-owning stocks with gold and TIPS bonds, investors can have portfolios that have generated stable returns and offer a great hedge against inflation.

(Source - Pexels/Anton Atanasov)

Investors today are clamoring for opportunities to diversify away from high systemic risk assets, particularly toward those that offer a hedge against currency instability and inflation. This year, precious metals and cryptocurrencies have skyrocketed in value, but both seem to be hitting some short to medium-term resistance. One asset that is highly undervalued and often forgotten by public market investors is land.

It is admittedly difficult to see land in itself as an asset class as the value of land varies widely depending on its use. Metropolitan and residential land is extremely valuable, while non-developable land, such as most of Tejon Ranch's (TRC) holdings, is far less valuable.

It may come as a surprise to many that land has actually been a better investment than gold over the years. I got estimated average land prices/acre in the U.S. via the American Enterprise Institute and constructed a portfolio of 50% gold and 50% land:

(Data Source - AEI, FRED)

The total returns of land since 1975 are 14.8X (CAGR: 6.3%) while only 7.4X (CAGR: 4.6%) for gold. Remember, this is in a period wherein inflation fell from nearly 15% in 1980 to under 2% today, so these returns are quite impressive. The max drawdown of gold is 60% (trough: 1997) and 50% for land (trough: 2011).

As you can see, land and gold have a very interesting relationship where they are very tightly correlated in some periods (70s-80s) and negatively correlated in others (2000s). This is great because we can combine the two and create an excellent "inflation hedge" portfolio that shares in the upside but has mitigated downside (dark brown line). Indeed, it seems that the gold rally from 2006-2011 may have been due to money pouring out of land value.

The resulting "50-50" portfolio has a total return of 10.7X (CAGR: 5.5%) and a much lower maximum drawdown of 29% (trough: 1982) and only saw a max drawdown of 15% in 2009.

The next question is "is there an easy way to invest in land to take advantage of this?". The answer: essentially, yes.

The Big Five Land Controlling Stocks

Considering there are ETFs for just about everything these days, I was pleasantly surprised that no fund manager has created a "land" ETF (yet). Of course, direct investment in land is not possible for an ETF, but investing in stocks that derive most of their value from land certainly is.

I have narrowed down five stocks that fit the mold well. They all generate income based on activities in their land, but still are mostly "book value" companies as most generate very low earnings yields.

Here are the landowning picks:

Ticker Name Income Industry State Estimated Land (Acres)
TRC Tejon Ranch Company Residential Development/Ranching/Mining California 270,000
(TPL) Texas Pacific Land Trust Oil & Gas Texas 900,000
(JOE) St. Joe Co. Residential Development/Timber Florida 567,000
(WY) Weyerhaeuser Co. Timber Pacific NW/ South East 12,400,000
(PICO) PICO Holdings Inc. Water Resources Nevada/ South West ~440,000
Typical 567,000

Market Cap (Million)

MktCap/Acre "P/E" Beta % 52 Week Low
TRC $428.00 $1,585.19 92.74 0.97 2.81%
TPL $5,210.00 $5,788.89 17.22 1.28 64.32%
JOE $1,050.00 $1,851.85 59.33 1.01 38.16%
WY $20,060.00 $1,617.74 NA 1.67 30.99%
PICO $196.00 $445.45 191.63 1.14 9.72%
Typical $1,050.00 $1,188.60 43.99 1.214 29.20%

Note, acreage estimates may differ as companies buy and sell property, PICO Holdings in particular which owns long-term BLM leases. Also "typical" is harmonic mean for "PE" and "Mktcap/acre". (Data Source - Google Finance/Wealthdaily/Company Annual 10K's)

Overall, land is very cheap for many of these companies as their market cap per acre is well below the national average, even for non-developable land. In particular, I have looked closely at Tejon Ranch and found that the company is trading far below book value by up to 70%.

Of course, the type and exact ownership status/usage rights differ enormously among these companies. That said, they all have low debt levels and trade at high earnings multiples which signals that most of the companies' value comes from its assets instead of income.

Accordingly, these companies depend heavily on the average price per acre in the U.S. Below is a chart of the land index performance vs. an equal-weighted portfolio of these five stocks (this can be thought of as a rudimentary "land" ETF):

(Data Sources - Google Finance/AEI)

As you can see, the index of these five companies and of land prices is tightly correlated. When the stocks stray from the index, they are yanked back down and vice versa. Since January 2000, the "big five stock index" has risen 2.25X while land prices have risen 2.35X. I admit that the stock index is imperfect as it does not hold many companies, but I am still happy with the accuracy of these results.

"Big Five Land Stocks" Asset Class Exposure

The primary reason for my interest in these five companies is their exposure to land and how that can add diversification value to a portfolio. I am a long-term bull on hard assets as I expect the very long drawn out in the era of low-interest rates to end in a period of higher inflation and potential monetary instability as the U.S. government is wholly unable to keep a lid on deficit spending.

The index of these five land-owning companies, like gold and bitcoin, is another way to bet on that trend. However, unlike those two assets, these companies generate positive income and potential dividends.

Here is the asset exposure of the daily returns of the index to other assets found via least squares:

(Price Data Source - Google Finance)

Importantly, the fund has a negative exposure to the U.S. dollar and to long-term treasury bonds. Both of these assets are necessarily deflationary, so because the index has negative exposure to them, we can be certain that our stock index will rise with inflation. We can also see that the index actually has a pretty low correlation to the S&P 500 and offers a nice amount of equity diversification.

To compare, here is the same data for gold:

(Price Data Source - Google Finance)

Both the "land-owning index" and the gold index share a negative correlation with the U.S. dollar index, but gold has a positive correlation with long-term treasury bonds. This is likely because land has many industrial uses so it is more correlated to GDP. This is seen in the "big five" index's higher S&P 500 (risk-on) exposure and gold's higher Treasury bond (risk-off) exposure.

Most importantly, both can be used as a statistically significant hedge against inflation.

The Bottom Line

As you may have noticed, I did not dig into the fundamental details of the five companies chosen for their land ownership, so I will refrain from rating the individual stocks (though I maintain my "buy" rating on TRC). That said, they all look pretty undervalued from a price-to-book perspective at first glance.

I have an overarching theory that value investors should focus primarily on book value and secondarily on income value today. This goes against a lot of value investing wisdom, but traditional value investing has been underperforming the market for quite some time.

Low "P/E" companies today usually have very high debt and other risks. We live in a high "P/E" time because interest rates are so low (which directly lowers cost of equity and debt), thus true income-based value stocks are hard to find.

Alternatively, the value of hard assets has been weak over the past decade due to low inflation and atypical investor interest in "yielding" investments. Well, now that yields have finally been pushed below inflation, hard assets generate a real yield and can be expected to rise as the financial system takes note. Thus, the market value of companies' fixed assets is likely to rise.

An interesting way to visualize this is by dividing the S&P 500 CAPE ratio (cyclically adjusted PE) divided by the S&P 500 average P/B ratio. Price cancels out. The net result is "S&P 500 book value/earnings". When the ratio is high, it signals fixed assets may be overvalued/overestimated. When it is low (as in today) the opposite is true. Put simply, when the ratio is high, value investors should focus on income and, when low, focus on book value. Here is a chart of this statistic:

Chart Data by YCharts

As you can see, this metric is very low today compared to its historical level and has fallen at the fastest rate since 2008. In my opinion, this is yet another of the many signs that all point to "buy hard assets".

Finally, one way this can all be incorporated into "long inflation" portfolio can be done through a risk-parity type allocation strategy. I plugged the following five "long inflation" tickers into Portfolio Visualizer's risk-parity portfolio generator and got this result:

(Source - Portfolio Visualizer)

As you can see, the portfolio has generated relatively consistent returns (CAGR: 5.6%) with a max drawdown of only 18% in 2009. As inflationary fundamentals and currency instability rise, I'd bet the performance will be even better.

Disclosure: I am/we are long TRC,TIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.