Timberland: A True Growth Asset

Timberland, also referred to as forestry, provides a sound long-term investment in both low and high-inflationary environments.  A major attraction of investing in timberland is the competitive returns it offers in comparison with other asset classes on a risk-to-return basis. Timberland income can be used as a tool to balance returns from other asset classes such as stocks, bonds, real estate, private equity and hedge funds.

Forests are historically linked to long cycles and economic growth. Timberland prices have historically appreciated above the rate of inflation.  It is a tangible, cash-generative real asset.  It can form an effective diversification tool as part of any institutional investor’s long term portfolio.

Returns from timberland investments exceeded the S&P 500 Index for 11 of the past 20 years from 1990 through 2009. During that period, timberland compounded at an annual return of 11.75% versus 8.20% for the S&P500.  In addition, the returns from timberland offered lower volatility in comparison with the equity market.

Timberland investments can be local, regional, national or global in nature.  For example, there are opportunities to invest in timberland in Europe, North America, South America, Africa, Russia, Asia and Oceania.  Global wood consumption is expected to increase by 60% over the next 25 years.

The asset value of growing timber accumulates over time (assuming no adverse events) and apart from thinning and normal forest management will occur without any significant human or technological involvement.  The revenue stream is also flexible as the timing of harvesting and profile of the timber can to some extent be matched to market conditions and investor’s needs. 

A key feature about timberland is that biological growth accounts for more than 60% of historical returns.  Timber and land prices constitute the balance with about 15% each.

While some pension funds in the US and Europe have been substantial players in timberland for some time, it is still little understood and under-represented in most institutional investment portfolios.

Timberland can also provide environmental benefits as trees absorb carbon during their life and may therefore help counter global warming.  The carbon can remain locked into timber used for construction and other products being one of the few renewable raw materials used in construction.  When used as a fuel in place of coal, oil or gas, the use of timber can be effectively carbon negative.

Timberland investing sets out to achieve long term capital appreciation through the identification, acquisition and effective and effective and sustainable management of forestry.  It offers institutional investors:

·         The potential for long term capital appreciation;

·         A reduction in portfolio volatility by having a low correlation with equities;

·         Low correlations with other asset classes;

·         Effective inflation hedging;

·         Socially and environmentally responsible investment;

·         Tangible real assets; and

·         Secure land title

In addition to pure financial returns, significant quality of life benefits can accrue from timberland investing including:

·         The protection of the natural environment and timberland heritage by ensuring the role of forests and forestry in soil protection, erosion control, water regulation, carbon capture, improvement of air quality, mitigation of climate change effects, and conservation of biodiversity.

·         The promotion of the sustainable development of the forestry sector as a contribution to rural development and, in particular, to the creation and preservation of jobs in rural areas.

·         To enhance renewable forest management, such as increasing the use of sustainably produced wood and other forest products, as environment-friendly and climate-neutral sources of materials and energy.

Pension plans and other institutional investors have been putting timberland into real asset or inflation-hedging asset allocations, alongside infrastructure, commodities and inflation-protected bonds.  It could also be categorized as a sustainable or renewable investment allocation.

Building on significant scientific advances in silviculture, forest management practices depend on experienced professionals to integrate the biology of growing forests with financial management to achieve attractive economic returns for clients. Importantly, this must be done while managing the timberlands with a dedication to the stewardship of the land, water, and wildlife resources that have been entrusted to us all.

"Own-Self Do It"

When my wife was a little girl, her parents and siblings would often offer to help her to do things.  Her response was usually, "own-self do it!" This sense of independence, self-competence and self-confidence has served her well in her life.

As we look at single family offices and family controlled businesses and how they have faired in the financial crisis, the rather limited and selected group that I interact with have generally done better than the private banks, wealth managers and funds of funds.  Why?  I believe it is down to an "own-self do it" attitude on the part of these families.

Having built significant businesses in a range of industries such as agriculture, oil & gas, media, mining, real estate, retail, shipping, software, technology and transportation, it should not be surprising that these families have the confidence to make investment selection and allocation decisions that are in tune with their specific needs and outlooks.

They have seen and heard enough inflated promises from financial service providers over the years, that a healthy scepticism is alive and well among family offices.  This has helped them to preserve their own capital, when the private and investment banks, and funds of funds have been found lacking in performance and exposed to frauds such as Madoff, Bayou and Stanford.

In fact, from my informal observations, the higher the proportion of in-house investment decision making by a family office, the better and the more consistent their returns.

This healthy scepticism has also helped family offices to avoid the financial engineering gadgets and leverage that benefitted the investment banks at the expense of their client's capital.

Hats off to the single family offices that have stayed with the control and transparency they need, so that "own-self do it" has been a winning strategy.

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Global Economic Outlook: 101

The monthly OECD composite leading indicators (CLIs) give a good warning of the upswings and downswings of industrial cycles, both regionally and globally. The most recent CLIs point to diverging patterns of economic growth across major economies.

The CLIs show signs of continuing expansion in the United States, Germany, Japan and Russia, while pointing to a moderate downturn in the United Kingdom, France, Italy, Canada, Brazil, China and India.

To understand what is going on with global economic activity, it is also important to monitor the behavior of commodity prices. Commodity prices contain "real time" information and at present their behaviour confirms the expansion of industrial momentum world-wide.

World trade growth is intensely cyclical and has seen substantial fluctuations during the past 20 years. Reflecting globalization, exports and imports account for an ever-increasing share of GDP on a world-wide basis. This process is likely to continue as a more closely inter-linked global economy raises world income by improving competition and encouraging specialization. It also magnifies the economies' exposure to overseas demand fluctuations. Indeed, foreign trade multipliers are a lot more powerful than they were in the past.

The upward move in oil prices and the quantitative easing by developed nation central banks have worsened the inflation outlook. This has led to the upward price spiral in other commodities (including precious metals such as gold, silver and platinum) and increased the volatility in the currency markets.

Futures, Forwards, Options and Exchange-Traded Funds

Investors are using futures, forwards, options and Exchange-Traded Funds (ETFs) in a wide variety of contexts. For example, borrowers are using futures contracts to lock in borrowing costs for anticipated needs. Lenders are using such instruments to lock in lending spreads in anticipation of receiving cash to invest in the future. Fixed income portfolio managers are using financial futures to hedge portfolio holdings and expected cash flows, and/or to facilitate the orderly sale of securities during asset mix changes. Equity portfolio managers are using index futures and ETFs to shift asset allocations in anticipation of buying and/or selling of the physical securities associated with an asset class, an industrial sector or a geographic region.

In addition, for portfolios of large agricultural real estate investments, agricultural commodity futures contracts for corn, cotton, soybeans and wheat are used to sell short the commodity futures contract to protect against a price decline in an agricultural commodity in which the investor has or expects to have an inventory of those particular crops.

In these particular examples, we are talking about 'hedging', and not speculation, because there are risks associated with the underlying investment securities and/physical products. These instruments, when used for hedging, can be used to offset potential declines in the value of portfolio securities. They can also help facilitate large securities transactions and reduce the risks associated with security-specific and market-specific risks as well as exogenous variables such as political, monetary, weather and currency uncertainties.

Risk, But Not as Many Know It

A basic and undeniable fact: Risks exist in many forms.

One of the basic fallacies of modern portfolio theory is the belief that risk can be defined and measured by variability in the price of securities. However, this is only a partial measure of total risk.

I would define risk as the exposure to the possibility of loss.

A taxonomy of risk was outlined by former US Defence Secretary, Donald Rumsfeld, in a press conference in 2002: ‘Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.’

To some, this may seem an unlikely source for insights about market risk as well as general risks. We still do not have precise quantitative knowledge of the feedback between financial and real variables.

Known risks are those that are defined by current knowledge. They can be modelled, estimated and the parameters calibrated. Unknown risks are subject to statistical determination based upon what is already known, but the parameters cannot be calibrated. The unknowable risks cannot be known and cannot be modelled.

We humans seem to attach greater significance to specific events that have already occurred when we try to anticipate the future. That type of mental gymnastic is the reason that something that has never occurred gets a low probability when trying to predict or model risk.

Managing risks really means reducing the cost and likelihood of potential perils for a price. Our own approach incorporates behavioural, liquidity and non-linear dynamic factors.

Lifecycle Pension Funds - The Question

When it comes to retirement, I do not believe that most people want to invest in some type of lifecycle pension fund if that fund is worth an uncertain future value at age 65 or 70. 

Would savers have peace of mind that they have the financial wherewithal to live their retirement years in financial security and comfort if, for example, they have been primarily invested in bonds and cash instruments? Well, it depends on their particular circumstances and the timing of these particular portfolio allocations. 

Stocks, bonds, real estate, private equity, commodities, cash and hedge funds have all generated attractive returns in different time periods.  However, which asset classes will generate attractive returns in which years is a key issue to deal with. The years and the returns (or losses) can vary considerably.  For example, in 2001, real estate and hedge fund returns were a helpful offset to a dismal year for stocks and commodities.  In 2003, stocks and private equity had strong gains in comparison with those of bonds.  However, in 2008, government bonds and cash were the only places to be for positive returns as the financial crisis hit with full force against all the other major asset classes. 

Questions regarding what the future may bring in terms of inflation, market performances, currency movements, personal health circumstances, etc., all have an important impacts on the size of the pension nest egg that will be needed for savers to feel assured that their financial needs will be met in retirement as a result of their decades of personal savings and investments.

We will examine this in more detail in future blogs.