Adding Wood to Your Portolio: A Worthwhile Investment

Are you interested in generating returns that consistently on-average beat the S&P 500, have a low correlation with other assets, and have low volatility of returns? Looking to get into the commodity markets, but worried that crude oil, natural gas, coal, and the soft food commodities have gotten ahead of themselves? No need to worry. We have the perfect investment for you - wood. No kidding, wood. And when I say investment, I mean investment. Waiting around for trees to grow is not for active day traders.

As reported by IndexUniverse, it turns out that timber investments have outperformed stocks, bonds, and commodities over the long run. In fact, the NCREIF Timberland Index, which is the standard benchmark for this asset class, increased 18.4% last year, versus a 5.5% rise for the S&P 500. Over time, the Timberland Index has beat all the major asset classes, except small-cap stocks.

From 1992-2006, returns for timber were 12.2%. During the same time, large cap stocks returned 10.6%, small cap stocks returned 15.4%, international equities returned 8.2%, and corporate bonds returned 8.0%. When you consider volatility using the Sharpe Ratio, timber has the highest risk-adjusted returns, even beating small cap stocks (the Sharpe ratio for small cap stock was 0.63%, while reaching 0.84% for timber). Since 1987, the timber index has had only one down year in 2001 (-5.25%). During the same time frame, the S&P 500 has been down four times (as low as -22.10%).

Timber as an asset class also has a very low correlation to other asset classes given that its primary driver (biological growth) is not as affected by sub-prime woes, dot-com meltdowns, or the next Enron. The trees just keep growing. Also, with timber there is always the threat of physical damage. (Who among us has not seen a California wildfire on TV recently?) Yet for a diversified portfolio, physical losses usually only decrease returns by 0.1% annually, on average.

What are the downsides? First, timber has been attracting more attention lately, so some investors have been paying up for assets. There is a lot of institutional and private money chasing a limited number of trees, at least those open to harvest and investment. Some investors are now even looking overseas. As with any investment, overpaying can certainly lower returns. Second, trees are not liquid investments given that much of their return requires patience. When you look at the profits from trees, about 61% comes from biological growth, with 33% from the price of timber, and 6% from land appreciation. Selling at the right time, and waiting for the trees to get big enough to command top dollar, are key. Patience truly is a virtue for timber investors.

So where to invest? George Nichols, who authored the original IndexUniverse article, does a great job outlining the pros and cons of current "timber" investments in an article located here. I put quotes around the word timber because, as Nichols points out, many proclaimed timber investments are not what they seem. Two popular timber ETFs are the Claymore/Clear Global Timber Index ETF (CUT) and the iShares S&P Global Timber & Forestry Index Fund ETF (WOOD).

If anything, these ETFs have easy to remember tickers. The problem with these ETFs is that they do not provide investors with direct access to the timber asset class - which has all the return, correlation, and volatility benefits mentioned earlier. Each is broadly focused on forestry/paper stocks, such as International Paper (IP). Instead of investing in an asset class, investors end up investing in a sector, one of which ironically may suffer with higher raw material timber costs. According to Nichols, WOOD appears to be a little better than CUT for correlation to timber, primarily due to its REIT exposure (more below). Nonetheless, it is also still not perfect, or really that good as a timber pure-play.

An alternative to ETFs are timber REITs. Nichols mentions three in his article: Plum Creek Timber (PCL), Rayonier (RYN), and Potlatch (PCH). Plum Creek has 8 million acres of forests, making it the country's largest non-government owner of timberland. Unfortunately, like the ETFs, the REITs are also not pure-play timber companies since each has manufacturing operations, giving significant exposure to sawmills and paper mills. Of the three mentioned, Plum Creek Timber has the highest timber exposure (71%), yet still suffers a low correlation to timber. Nonetheless, it is expected that correlations will increase in the future as firms continue to divest manufacturing assets, giving the funds a higher pure-play timber focus. Potlatch recently announced that it was spinning-off its pulp-based businesses.

So what to do? Nichols believes that in theory timber is an attractive asset class that should be considered as part of a portfolio. Unfortunately, in practice, getting some timber in your portfolio is more easily said than done. Of the group, PCL is the most attractive, even if not a perfect proxy for timber. Waiting for more divestment of manufacturing operations from each of the REITs may be necessary to fully see the benefits that timber investment offers. Who ever thought wood could be this profitable, and for that matter, so difficult to buy?

(Note: For those interested in more details beyond this summary, please refer to both articles written by Nichols. Each is well written and researched, providing both the pros and cons to timber investment, along with data to support his conclusions.)

Disclosure: None

Comments

[rudi]

Hi,

I created the table stated below (I hope its not too screwed up), showing correlations of CUT and PCL to commodities and S&P500, based on daily returns.

Mind that CUT (0.68) and even more PCL (0.78) represent the movement of the stock market and are both not correlated with commodities as one would suspect.


CUT RJI RJN SPY PCL
CUT 1.00 0.22 0.07 0.68 0.48
RJI 0.22 1.00 0.89 0.02 -0.15
RJN 0.07 0.89 1.00 -0.09 -0.22
SPY 0.68 0.02 -0.09 1.00 0.78
PCL 0.48 -0.15 -0.22 0.78 1.00

I suggest to use RJI to diversify a portfolio. It includes 1% lumber, but I think that wood prices are anyhow highly correlated with the rest of RJI, especially oil and gas.

Where do you get historic data of wood prices?

Rudi

[xmplary]

As an investment this may be good, but is this the right thing to for the environment? At a time when we are seeing increased natural disasters across the globe, cutting down more trees may not be the best solution :-(

[User 101825]

"but is this the right thing to for the environment?"
======================...

Let's think about that. The trees fall down, or burn, anyway. And, is it better to have homeless people roaming the streets? Is forest cutting not a managed thing in this regard?

The fundamental disturbance to the environment is the fact there are just too many people chasing too many things with too many corporate interests providing such at the lowest possible cost while shirking their envirnmental responsibilities. A balance must be found.

Read James Lovelock's book "Gaia" for a good understanding of what may happen if that balance is not reached.

[fatpitch2]

xmplary:
I agree that any "net" deforestation is a bad thing; but do remember that most timber companies are really "timber farmers" and that as they do harvest their "crops" they replace them with new saplings in a continuous rotating cycle. If they did not do this they would eventually run out of product to sell. While it is not all roses, many timber companies at least are good stewards of the land as it is in their best interests as well to replant and tend to the land ... just like more "traditional"... farmers ;-)

[GeorgeNichols]

Professor Enke, thanks again for your writeup on my timber article! I'm glad it was worthwhile reading. :)

Thanks, Rudi. What were the start/finish dates for your correlation period? Regarding your question, historical lumber prices are available, but my correlations were based on the NCREIF Timberland Index. It reports returns of selected TIMOs (timber investment management organizations) on a quarterly basis.

Xmplary, interesting point. There are certainly environmental and aesthetic ramifications to consider. Just from a carbon standpoint, I'm told harvested trees may release *some* carbon back into the atmosphere (versus all of it from naturally decaying deadwood). And, as the other poster noted, areas harvested by timber managers are almost always replanted, which creates future carbon sinks.

On a related note, carbon credits are starting to make up a small, but significant, portion of investment returns for a few timber managers.

- George

[theinvestingspeculator]

Get call. Jim Rogers told me if you want to succeed in these markets, you better trade commodities.

[gordon]

rudi- RJI is the clear winner, those etfs are headed to their previous lows, CUT only trades 7K shares a day, that's suicide to buy! PCL trades close to the XLB(materials). I wouldn't buy PCL, RYN, PCH until the bottom of their trading channels, ($38-40), these are classic channeling stocks ($40-48) and they broke their recent uptrend lines.
finance.yahoo.com/q/bc...

[mkreisel]

Your RJI will go to ZERO if the sponsoring entity ELEMENT goes bankrupt. I have no idea about its financial health as of today.

[optionsgirl]

What about Deltic Timber (DEL)? This one has huge land reserves that are rich in shale and nat gas...

[rudi]

DEL is also not a diversification to stocks. Its correlation with SPY is 0.66. There is no correlation to commodities.
I used data from around 12.11.2007 (listing of CUT) until today.

@mkreisel: as far as I know, the capital in ETFs is secured. Otherwise one would see deviations between different ETF providers, since the ETF price would include the risk of bankruptcy. e.g. YYY never showed such a behavior, when there were rumours about their situation.

Better look for some other interesting asset classes, not timber.

cheers
Rudi

[Joe Fedacsek]

If you want a good primer on Timber, listen to the Brookfield Asset Mgmt (BAM) conf. call. They own, and manage, institutional timber funds. As prices are down now, they are just letting the trees grow -- nice part about this business, if prices are low, you hold back the harvest, and the trees will only grow larger -- and thus, more profitable over time.

[squashnut]

The collapse of the Easter Island society has been blamed on the fact that cut down all their trees, probably in an attempt to house everyone.

[secmaven]

Ditto the Mayans to make slack lime to whiten their structures.

[Nate C]

If you are interested in a good timber reit, take a look at Timberwest (TWTUF.PK).

[d_teller]

There have been a lot of editorial postings about the 'timber/lumber/forestr... ETFs and one of Claymore's (for Canadians only ) closed end funds {CLO ca. $30.00/share}...so many in fact that I can't give a complete list: But there was an excellent 'How-It's- Made' type of posting, article # 76762..."Pulp Facts...", and a listing of significant U.S. and Northern European pulp companies; another earlier one on "Lumber and Forestry..." # 66850, etc.

The powers that be at SA might consider gathering the set of >24 postings, along withhundreds of comments to a single grouping under "Commodities"... beause some compare timber and paper, some timber vs. infrastructure; some CanRoys vs U.S. Reits, and searching for them maens looking under Timber; Lumber; Forestry; Paper; etc.

A set of Brazilian Companies may warrant some interest: Aracruz Cellulose (ARA) and Vorantrim (VCZ) are notable, been around for years.

Others in overseas listings are also available via OTCBB {heavens-to-betsy, grey market) listings on the PinkSheets...even though they are on major national (Toronto, London, Brussels) exchanges...they don't list at BONY_Mellon, due to costs and difficulties keeping up with Sarbanes-Oxley. Some are Large, SinoForest and Canfor (CDN); others are weeny and expensive (KEWL.PK)..but there are many that are Timber/Lumber and others that are Wood products, but not paperproducers or land companies.

[cameronm]

Timber companies do not deforest the land they own. They typically harvest 1-2%/year, and as mentioned above when prices are low they might harvest less. It takes 75 years for a douglas fir tree to reach optimal maturity and as little as 8-10 years for cottonwoods and cypress trees (in the southeast). Timber is valuable so it is a well managed resource. The Boy Scouts of America for instance harvests 1-2% of the timber on the land they own each year. Timber is such a good business that we have seen a net re-forestation of North America. There is as much or more timber growing today as there was in 1870. That is precisely because it is managed and the economic value helps ensure that land that can support timber, does.

BTW, Science magazine has run a couple articles about North America being a net carbon sink because of the vast amount of trees and timber -- that is that North American forests actually absorb more carbon than is produced.