Forestry Investment and Forestry Funds
The past several years have seen forestry investment as an asset class receiving much more attention is it attracts the attention of institutional and private investors alike. There is a variety of choice as to what vehicle forestry investment can be made through and we will look at the strengths of timber investment as an investment class and forestry funds as an investment vehicle. We will cover the specifics of forestry investment such as its historic performance in terms of returns and correlation with other asset classes. We will also highlight the factors, which are likely to influence trends that will be crucial to the performance of timber investments over the coming years.
Why Forestry Investment?
Many of the strengths associated with forestry investment make the asset class particularly appealing in the current economic environment. Timber investment has shown historically strong returns in comparison to tradition asset classes over the past two decades, as well as low correlation to them. We’ll explore in a little more depth the figures of these returns as an argument for timber investment as a strong stand-alone investment. We’ll also explain the strengths of forestry investment as a stabilizing asset class in a portfolio due to its high correlation to inflation making it a good diversifier and inflation hedge.
Timber Investment as Low Risk
Timber investment can be generally considered low risk due to the fact that it is underpinned by the tangible assets of both the timber itself, as a non-perishable agricultural crop, and the timberland. This means that in a worst case scenario there is recoverable intrinsic value, in the real estate and physical commodity. This safety net makes timber investment through forestry funds an appealing prospect to institutional investors such as pension funds. Harvard Management Fund has had well publicized success with its timber investment strategy, beginning in the late 90’s, when forestry investment was very much a new asset class.
Although timber has obviously been a commodity since the dawn of human civilization, it has only been an invested in asset class since the 1980’s, making it very new as such. Prior to that point, timberland assets were held almost exclusively by private landowners and forestry companies. This meant that the focus was to feed the mills and maintain cash flow. Independent investors are more able to choose to wait and allow the trees to grow for longer, creating higher value products. As a general rule, the thicker a trunk, the more valuable the timber products from the tree.
The fact that trees gain in value the longer they are allowed to grow is another risk mitigating factor in favour of forestry investment. In the event of any dip in the market, the investor can wait for market conditions to improve, and they always do. The opportunity cost of realising the cash value of the asset is offset by its continuing biological growth adding value to the timber.
Favourable Indicators for Future Trends in Forestry Investment
Timber’s character as a consumable asset means that future trends in supply and demand are linked strongly to global population growth and GDP per capita. As can be seen from the graph below, global population growth, specifically in developing economies, is spiking rapidly.
The second graph also shows World Bank figures on current economic growth and Price Waterhouse Cooper’s projections for global trends up to 2050. We see clearly that economic growth is by far the strongest in developing economies, particularly those of Asia and South America.
Consumption of timber products is strongly correlated to GDP per capita, as the graph below shows, which is in turn strongly correlated to urbanization and city dwelling.
The final graph shows the urbanization trends in South-East Asia. As well as the highest projections for GDP growth globally, the region also shows the highest urbanization rates. China’s urban population currently stands at around 50% of its population. By 2025, China’s urban population is projected to increase to 926 million, around 70% of total population, and to one billion people by 2030.
These trends suggest that demand for timber products will grow exponentially over the coming decades.
Current trends in supply are, conversely being restricted. A huge problem in the forestry industry has been, and still is, illegal logging in the tropics. Mid-20th century tropical rainforest accounted for around 14% of the earth’s total land surface. This has been more than halved in the interim period by logging, much of it illegal, with rainforest cover currently standing at around 6%. There are very realistic fears that without strong intervention now that remaining 6% could be wiped out within 40 years.
The international community has woken up to this reality and resources, both financial and organizational, are being harnessed in a concerted attempt to strangle the market for illegally sourced timber products. Although the problem is far from being solved, clear progress is being made. International cooperation on ensuring certification of all timber products traded internationally as legal and sustainable is having the desired effect. Stronger domestic policing in the tropics is also reducing the trade in illegal timber products within national borders.
The result is that supply lines are being stretched and mills in the tropics are struggling to maintain a regular supply or raw material for processing and exports are suffering as a result. As international controls on illegal logging tighten, the gap in supply must be filled by sustainable forestry investment. In view of the trends already outlined showing the likelihood of strong future growth in demand, the industry requires significant investment.
Return Characteristics of Timber Investment
While looking at possible future factors is crucial, so is historical performance of an asset class. Perhaps even more so as the one is, no matter how logically derived, speculation, while the other is fact.
Over the past two decades, returns in US timberland have only been negative twice and returned an average 12.7% annually between 1990 and 2008. This is significantly better than the return of 7.32 % over the same period that would have been achieved investing in the S & P’s 500 index. It puts returns from forestry investment over that period in the same bracket as private equity and venture capital, which showed annualized returns of 14% and 17% respectively. The risk involved in any individual investment however is clearly far higher than is the case with forestry investment.
If we look at ‘Sharpe Ratios’, of reward to risk factor, or variability, forestry investment has also performed very strongly in comparison to other asset classes. Forestry investment has historically yielded greater returns per unit of risk than the other asset classes in the table below.
Correlation of Timber Investment to Other Asset Classes
Generally speaking, investors in non-traditional asset classes are looking for low correlation to their other investments as well as good returns. The fact that the unique aspect of timber investment is the balance between the land as a commercial real estate asset and that the commodity grows and dips in market value can be waited out while value continues to increase, makes it an ideal choice from this aspect. Tim Cayen of Hancock Timber Resources Group has noted that over the past two decades the asset class has lost value only twice and has shown relatively little correlation with other asset classes. It has also historically shown a tendency towards positive correlation with high inflation. This makes it an excellent stabaliser and diversifier to an investment portfolio as well as the good historical returns proving its worth as a stand-alone investment.
Weaknesses of Timber Investment as an Asset Class
The most obvious weakness of forestry investment is that it is by nature relatively long-term and illiquid. Investors have to show patience and it is certainly not an in and out investment strategy, requiring a number of years, to decades, to mature. Particular funds may have a mechanism for early exit, or buying tradable shares in a timberland REIT may provide an earlier exit strategy, but as a general rule, forestry investment should be viewed as long term.
Lower construction demand in the developed world mean that in the past couple of years timber prices have dipped calling into question the claims of very low volatility that have always supported forestry investment. However, as mentioned, such dips can be waited out while value is added to the commodity and population growth and economic indicators in the developing world suggest that demand will recover and go far beyond pre-recession levels in coming years.
Current market conditions do mean that there is potential for investments in undervalued industries and stocks and shares that could yield far higher returns than forestry investments can realistically provide. Forestry investment is certainly a case of solid slow and steady low-risk returns rather than offering the potential of making spectacular gains over the course of months or a couple of years.
Forestry Funds vs. Project/Direct Investment
There are a number of potential vehicles when considering forestry investment. Forestry funds as the vehicle for forestry investment offer both strengths and drawbacks. A primary strength of forestry funds when considering timber investment is diversity reducing risk. Because forestry funds invest in thousands of hectares of timberland, often spreading ownership over a variety of timber types and geographical locations, it means exposure to separate risks such as price fluctuations, economic trends, political instability, fire and illness etc. are reduced across the portfolio of timber investment. Direct investment in a single timberland holding necessarily exposes the investor to the full risk of anything that may happen to the detriment of that particular type of timber, timberland or geographical region. On the other hand, if all is well, the returns are not weakened by poorer performance elsewhere as is the case in the diversified portfolio of forestry investment invested in through forestry funds.
As a result of their scale, forestry funds also make the most of economies of scale, which are an important factor with regards to timber investment. Expert human resources and the ability to hire top forestry management companies for large holdings is a definite plus associated with the kind of large scale timber investment forestry funds generally make. Forestry investment is sensitive to good quality management with returns potentially showing significant divergence relative to the level of expertise of the management company.
Another benefit of forestry funds is that funds, even unregulated funds as forestry funds invariably are, are subject to controls and regulation of their accounts and practices. This also brings the downside of associated expenses and management fees can often eat into returns significantly.