This blog will chronicle the developments and point to future opportunities in Sustainable and Responsible Investment. To begin my postings, I would like to talk to you about the merits of investing in timberland as an SRI.
As you all know, trees are inherently valuable to the environment and the well being of humanity. Through the process of photosynthesis they recycle carbon dioxide into oxygen for us to breath.
Traditionally timber is used as a building material and in pulp and paper production. There is a strong and robust correlation between increasing population and economic growth and demand for wood. Additionally, developing countries such as China and India, which have limited supplies of their own, depend heavily on timber imports.
There is also a supply squeeze with ever growing demand putting pressure on existing forests areas, and plantations won’t be able to fill the gap for some time to come. Deforestation is occurring at a rate of 12.9m ha/y per year while the growth rate of plantations is occurring at only 2.9m ha/y. Importantly linked to the decrease in trees, is the rise in carbon dioxide with deforestation account for 18% of global CO2 emissions and climate change discussions are advancing the role of forests as carbon sink through reforestation.
Furthermore, government policies are advocating biomass as a renewable energy source to decrease carbon dioxide emissions. Technologies are being developed that use enzymes and acids to turn cellulose fibers of plants into fermentable sugars that can produce ethanol. There is an opportunity for timber to act as a bio fuel as it has a high energy efficiency and does not compete with food crops as opposed to traditional bio fuels.
There is also increasing interest in wood as a substitute for non-renewable materials in construction as it is superior in terms of energy efficiency, versatility and recyclability.
Characteristics of Timberland
The defining attribute of timber is its steady, long-term biological growth. A tree’s wood volume tends to increase 2% to 8% annually (varying by climate, species, and age). Compounding the effect of this biological growth, trees yield price gains when they grow into bigger product classes. For instance, a small tree that is only suitable for paper products may eventually grow into saw timber, where it can fetch dramatically higher prices per ton and be used for products such as plywood or telephone poles.
An academic study found that biological growth drives more than 60% of total returns, while timber price changes and land appreciation account for the remainder of returns[i].
Figure 1. Determinants of Timber Returns
Advantages
A major attraction of investing in timberland is the competitive returns it offers compared to other asset classes on a risk-to-return basis.
Benchmark: NCREIF (National Council of Real Estate Investment Fiduciaries) Timberland Index Historically, the performance of timberland as an investment is most often measured by the Timberland Index, published by the National Council of Real Estate Investment Fiduciaries, or NCREIF. The index is analogous to the Property Index that NCREIF also publishes for the commercial real estate market. The sample of properties in the Index includes tree farms in the South (Virginia, North Carolina, South Carolina, Georgia, Florida, Alabama, Mississippi, Louisiana, Texas and Oklahoma), the Pacific Northwest (Washington, Oregon and California), and the Northeast (Maine, New Hampshire, Vermont, NewYork and Pennsylvania)[ii].
Returns from timberland investments, as measured by the NCREIF Timberland Index, exceeded the Standard and Poor's 500 Index for 9 of the past 16 years from 1990 through 2005. In the period from 1990 to 2007, the NCREIF Timberland Index annual compounded return was 12.88% versus 10.54% for the S&P500 (Table 1). Yet, the returns from timberland offered lower volatility (standard deviation) of 9.29% against the equity market's 16.91%[iii].
Table 1. Comparison of returns from the NCREIF Timberland Index against the Standard & Poor 500 Index (1990 - 2007).
Sharpe ratio based on a 3.0% risk free rate.
Source: NCREIF, Ibbotson Associates
Figure 2. Comparison of returns of different common asset classes with timberland, as measured by the NCREIF Timberland Index (1990-2007).
Alternate Benchmark: IDP UK Forestry Index The IPD Forestry Index is calculated from a sample of private sector coniferous plantations of predominantly Sitka spruce in mainland Britain. By the end of 2004 the 161 forests in the index had a total capital value of £74.4m. New figures show the IPD UK Forestry Index returned 31.6 per cent in 2007, six times higher than equities (5.3%) and five times higher than bonds (6.4%) and at the other end of the spectrum to commercial property, languishing at -3.4%[vi].
As illustrated in Figure 3, timber a exhibits a moderate correlation to inflation, suggesting timberland assets may serve as a good long term hedge against un-anticipated inflation[iv]. Timber can also improve a portfolio’s risk-adjusted returns by virtue of its fairly low correlation to most asset classes. This low correlation reflects the fact that the primary driver of returns—biological growth—is unaffected by economic cycles.
Figure 3. Timberland Correlation Analysis[v]
Disadvantages
Timber is an illiquid investment and is difficult to sell quickly, which is why timberland is strictly an asset class for long-term investors. Trees generate most of their returns through steady biological growth, and harvesting cycles are typically 15 to 40 years.
Physical risks—such as damage from fire or insects—can inflict significant losses, but not to the extent that many investors fear. Such losses usually erode returns by 0.1% annually, for timberland holdings that are well-diversified by geography, age, and species.
The greatest risk however, is overpaying for timber assets as an influx of money from institutional investors is chasing a limited number of forests, causing more opportunities to exist overseas.
Conclusion
The major attraction to investing in timber is its lower volatility and higher overall return compared to equities.
There are many additional benefits to the environment as timber serves as a carbon sink and decreasing deforestation will decrease CO2 emissions and reduce the effects of climate change.
There is an opportunity for timber to act as a bio fuel as it more energy efficient and does not compete with food crops as opposed to traditional biofuels.
[i] http://www.investmentmoats.com/etf/timber-agg-1-dream-asset-class/
[ii] http://www.htrg.com/pdf/rn_ncreif2002.pdf
[vi] http://www.forestry.gov.uk/pdf/IPDUKForestryIndex2007results.pdf/$FILE/IPDUKForestryIndex2007
results.pdfhttp://www.greenwood-management.com/forestry-index.html
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