Timber: The Ultimate Growth Investment

By MoneyWeek Editor-in-chief Merryn Somerset Webb Oct 18, 2007

Merryn Sommerset

The press hasn´t been kind to Britney Spears recently. Since her split from her husband Kevin Federline in November, her partying ways have led to her being referred to as "self-absorbed", a "Louisiana hick", an unfit mother and, along with her friend Paris Hilton, a "cheap slapper". But there´s one area where Britney can´t be criticised: money management. Spears appears to be very good at making and hanging on to her cash. She had Federline sign such a cast-iron pre-nuptial agreement that he is leaving their union with little more than half the value of their Malibu home and her current net worth is thought to be around £65m. Some of this cash is invested in predictable ways (Spears owns four houses in the US, for example), but some is not.

Of particular interest is the fact that a few years ago the pop princess spent $3.1m buying up forest land in her native Louisiana. Forestry is hardly a mainstream investment, but Spears has already made good returns on her land. She is in excellent company. US fund manager Jeremy Grantham thinks timber is the best long-term investment there is, and last year the Harvard Endowment Fund invested $500m in forestry in New Zealand, says Barry Riley in the FT. In the UK, both Guy Hands and Nick Ferguson - super rich giants of the private-equity industry - are heavily invested in the sector. Smaller private investors, such as publishing entrepreneur Angus MacDonald, are also getting in on the game: MacDonald has recently bought two dense Sitka spruce forests in the southwest of Scotland.

Investing in timber: money does grow on trees after all

So what´s so good about trees? According to Grantham, forestry is the only low-risk, high-return asset there is: it has, he says, risen steadily in price for 200 years and has returned an average of 6.5% a year for the last century. It is also counter cyclical - it has been the only asset class in existence that has risen in three out of the four market collapses of the 20th century, says Grantham. That´s not to say there haven´t been short-term blips in the fortunes of forestry investors. There have.

Until 2003, points out Macdonald, UK timber prices had spent more than seven years in freefall, thanks to a flood of cheap imports. In the UK, 85% of the timber we use comes from Scandinavia and the Baltic states of Estonia, Latvia and Lithuania, so UK prices are very much determined by international prices (our prices fall to the level of the cheapest tree you can import) and, when Eastern Europe opened up, prices fell across the board. At the same time, a decline in UK processing capacity meant local demand for timber fell and the boom in paper recycling also hit demand for newly felled trees.

Today, Raymond Henderson of forestry agency Bidwells tells me, real soft timber prices in the UK are still 50% below those of 1996. But that shouldn´t be the case for long. Over the last three years, prices have recovered by around 11% (according to the FIM Timber Index) and that is a trend most experts see continuing. Why? The answer is the usual one: thanks to the rise of the emerging economies and their massive middle class, the supply/ demand balance is working very much in favour of the timber price.

On the supply side, note that deforestation continues apace across the world (one tenth of global forest has disappeared in the last 25 years, due to urban development, agriculture and illegal logging), while in eastern Europe all the easy-to-get trees have already come down and the cost of transporting what remains has gone up substantially (fuel and freight prices have both risen in the last few years). The days of cheap imports are all but over. Indeed, says FIM, not only are the usual supplier´s not exporting like they used to, but they are seeing shortages at home: Scandinavian firms are having to turn to Russia to top up their own supplies.

Why timber prices will continue to rise.

Still, it is not so much tightening supply in Europe that is set to keep prices rising; it is that global demand for timber is rising fast. Take China. On current forecasts, its urban population will increase from 530 million people to 875 million people by 2030. To house them, the equivalent of almost 50 cities the size of greater London will have to be built over the next 20 years. That´s going to need a lot of timber. And wood is needed for every stage of development all over Asia. Let´s not forget that the paperless office never happened. In every office around the world, everyone who wants to read something properly prints it out. As China and India grow, that´s going to mean a lot more paper.

But Asia´s new middle classes are also going to want new furniture, more books, daily newspapers, delivery pallets and Christmas wrapping paper (apparently much of China does celebrate Christmas). Chinese lumber consumption doubled between 2000 and 2003, and its demand is forecast (by the WWF) to grow 30% in the next five years. Add it all up, says FIM, and global forecast demand is "equivalent to finding another source of supply of timber with five times the output of the UK each and every year".

Why forestry will benefit from green energy demand.

Closer to home, there´s another reason why demand for wood will keep rising - the nation´s new obsession with green energy. The largest sustainable energy supply in the UK comes not from wind power, but from bio fuels. And one of the best bio fuels is wood, burnt as pellets or chips (wood is a renewable source of energy that creates little polluting waste). It is a fast-expanding sector: there are bio-energy projects that would use 3.6 million tonnes of wood fibre a year at "feasibility stage" and three of these have received planning permission, or are already under construction. The result? There is now a demand for low-quality timber in quantities that simply didn´t exist a few years ago. Biomass demand should entirely replace the demand lost to recycling, for example. All in all, says Angus MacDonald, "the macro issues look right" for timber prices and hence for investing in forestry.

A rising timber price is of course a good thing for investors, but it´s not all there is to it. As Jeremy Grantham points out, if no one offers you a good price for your trees at harvesting time, you can leave them to grow on the stump and get more valuable until you can get the right price for them. So while timber prices may be volatile, the price of forestry land itself tends to hold its value: from 1992 to 2005 the FIM Timber index declined by more than 50%, but the Property Databank UK Forestry Index returned an annualised 3.7% over the same period.

Over the last few years the price of forest plots has become slightly divorced from the price of timber in the UK, says Raymond Henderson. In some cases, prices have risen to levels that cannot be justified by the potential returns from timber sales. Valuing woodlands used to be easy: you looked at how much money you were going to make from growing and selling your timber, applied the appropriate discount rate (defined on page 40) and that was that - the result showed you what the woodland was worth. But today, people are paying more in the expectation of making large capital gains from the land itself, or just for the satisfaction of owning land. This is something that has already happened in the agricultural land sector and that shows no sign of coming to an end: as Henderson points out, you don´t spend £3,000 an acre on farmland in the UK in the expectation of making an appropriate return on it from growing barley. So why should woodland be any different?

Other advantages of forestry: tax breaks and carbon credits.

It´s all sounding good, isn´t it? But there´s more. First, there is tax: there is no income, capital gains or inheritance tax on woodland (see the box below for details). And finally, there is the prospect of finding ways of making secondary cash flows from the land. At one of Macdonald´s forests there is a possibility that the Forestry Commission will pay to move timber through from their adjoining land, and there is always the chance of getting paid to have mobile-phone masts on your site.

But what is really getting the pound signs flashing in forester´s eyes is the carbon-emissions business. There are endless arguments about whether planting a tree counts as a carbon offset (i.e., can it compensate for the emissions you produce by driving your child to school in a Porsche Cayenne?). Sceptics point out that trees lock up carbon only when they are alive (cut them down and it´s released again) and WWF, Friends of the Earth and Greenpeace all say they "do not support forestry projects to offset carbon emissions", according to The Guardian.

However, whether it works or not, lots of people think it does, and that means there´s money in it. In emerging markets, entrepreneurs are already setting up projects in the hope of creating carbon credits that can then be sold under the EU´s Emissions Trading Scheme to offset corporate emissions. And in the UK there are hopes that, at some point in the future, an individual carbon trading scheme may be set up, where we all have a carbon allowance we have to stick to, but which we can top up by buying credits, possibly from the owners of well-managed woods. This is still a distant prospect (and I think will remain so), but were it to happen it could be good news for forestry.

So how can you buy into the boom? You can buy direct: forest in Scotland costs around £2,000 an acre upwards, but while you can buy in small amounts (Henderson has just sold four acres in an isolated Scottish wood for £12,000), to have the scale to make money on it you should be investing around £200,000. FIM also manages forestry funds, the latest of which, the FIM Timber Growth Fund IV, closes at the end of January next year and targets a (tax free) 4% compound return over its ten-year lifetime through investing in properties growing Sitka spruce ("the UK´s most productive conifer species with the greatest diversity of end uses"). If timber prices rise beyond current levels (which it´s reasonable to assume), the returns "would be enhanced".

On the downside, note that these funds are pretty illiquid investments - you might not be able to get out of them until they are wound up, so only buy in if you are prepared to do so for the long term. There´s also a minimum investment of £20,000 and an upfront fee of 6%, which seems a bit on the high side to me. Another way in is via the equity markets. We look at the stocks you might buy to get exposure to forestry both at home and abroad below.

The best stocks to gain exposure to forestry.

It isn´t easy to find pure forestry plays listed in the UK, although there are a few Aim stocks with exposure. The best known is Fountains (FNT), which maintains parks and railway lines, but which also manages and harvests woodland here and in the US. A small percentage of the firm´s revenues come from forestry, but management difficulties have meant Fountains has had a lousy year: the shares have been recovering slowly since the summer, but are still off 20% year to date. Another Aim option is Radicle Projects (RDP), which listed in 2005 with a view to taking advantage of Australia´s tax breaks and investing in horticulture and forestry projects across the country. It´s growing its assets, making a profit and paying a dividend, but it isn´t a pure play: so far it has invested in grapes, almonds, olive and citrus fruits production, as well as its stake in a forestry business. Also consider Highland Timber (HTB), which, although loss making, has forestry projects in the UK and New Zealand and should benefit from renewed interest in forestry investment.

The UK´s first quoted timber fund, a Guernsey-registered closed-end investment company called Phaunos Timber Fund (PFT), is scheduled to list next week. The fund has raised $100m, which will be used to make timber and timber-related investments (possibly including derivatives). Investments will be diversified globally and by forestry types, with no more than 40% of the portfolio in one region. The fund is aiming for long-term capital gains, so investors should not expect regular REIT or income trust-sized dividend payouts.

In the US, a number of publicly traded timber firms have become real estate investment trusts (REITs) to maximise their tax breaks. REITs distribute all profits to investors, so these firms offer decent dividend yields and are probably the best way to invest in timber. The first of these REITs was Plum Creek Timber (NYSE:PCL), the largest private landowner in the US. Plum Creek owns more than eight million acres across the country. Another well-known play is Rayonier (NYSE:RYN), which owns two million acres of timberland, mostly in Georgia, Florida and Alabama. It has a joint venture in 350,000 acres in New Zealand and manages another 100,000 in Australia. In the last year, two smaller firms have also converted to REITs. Potlatch (NYSE:PCH) owns 1.5 million acres in Idaho, Arkansas, Minnesota and Oregon. Around 300,000 acres have recently been assessed to have higher value in timberland uses and are likely to be sold, potentially freeing up cash to return to shareholders. Smallest and newest is Longview Fibre, which owns 600,000 acres in Washington and Oregon. Two private-equity firms have already made rejected approaches and a sale of the firm is still under consideration.

Update: Longview Fibre was acquired by Brookfield Asset Management in 2007.

In Canada, the most attractive of the timber plays are income trusts: like the US REITs, these also distribute all profits to investors and offer hefty yields (although some of their tax breaks are scheduled to cease in 2011). TimberWest (TSX:TWF-U) is the largest owner of private forests in western Canada, with 800,000 hectares. The firm is in the middle of a long-term restructuring to divest several non-core operations and become a pure timberland play. Acadian Timber (TSX:ADN-U) owns around 1.1 million acres and manages another 1.3 million acres of state-owned land.

There are also a number of Australian firms with substantial timber interests, although most of them are semi-diversified agri-business groups rather than pure plays. Major players include Timbercorp (ASX:TIM), Great Southern Plantations (ASX:GTPA), Gunns (ASX:GNS) and Willmot Forests (ASX:WFL). However, after several years of rapid expansion, Australian timber stocks have slumped over the past year or so as investors became concerned about potential gluts of supply in some products. There are also uncertainties regarding possible changes to tax legislation.

Editors note (Jeff Duda PTF): For the smaller investors smaller specialty timber companies such as Panama Teak and Forestry provide returns more than twice that of the above stocks. Be sure to research the companies before investing in the smaller companies.

Investing in timber makes tax sense.

Timber also makes sense from a tax perspective. Commercially managed woodland in the UK can be passed on free of inheritance tax once it has been owned for only two years; it qualifies for capital gains tax rollover relief (you can avoid the tax by reinvesting capital gains from the sale of a business asset into forestry); and income derived from commercial woodland is free of income and corporation tax. So a return of 5% from woodland is the equivalent of a return of over 8% from any other investment to a higher-rate taxpayer.

At current prices, forestry management group Fountains says that new timber investments should make annual returns of around 5% (so 8%-plus for higher-rate payers). But if you think timber prices and forest prices will rise, the return will be much greater. And with the industry being so tiny and at a low, it is "unlikely greedy Gordon will plunder it any time soon", says Angus MacDonald. So if you´re a high flyer with a full pension pot, buying forest that can be harvested over 15 years, after you turn 65, is pretty attractive: you´ll get a good tax-free income and the chance of capital gains (50%, even if prices only return to 1996 levels in real terms in the next few years).