Followers of the blog and investors in our funds will know that we use listed alternatives such as real-estate investment trusts (REITs) and infrastructure to improve diversification.
Our latest addition to the band of listed alternatives is forestry. In this slightly longer than usual blog, I define the asset class, look at its characteristics and also cover how we implement exposure to this asset class in our portfolios.
Start with the roots
Let’s start by defining the asset class. What does it mean to be invested in forestry? We define investment in forestry as investing into timberland companies, which own forests and the associated lands as their main assets. As such, the success of these companies depends on their ability to manage their resources in a sustainable way.
When we consider their drivers of returns, parallels can be drawn with real estate. Forestry’s return drivers can be broken down into two: growth in the value of the asset, timber; and growth in the value of the land on which the asset sits. Over the very long term, both tend to keep up with inflation, making forestry a real asset.
Starting with land value, a larger forest tends to lead to higher land values. But when dealing with a natural asset such as forestry, there is also a strong emphasis on the health of the forest: healthier forests improve the quality and yields for timberlands. When looked at this way, there is natural alignment between forest care and a timberland’s success. Timberland companies are incentivised to ensure sustainable management of their land.
Now let’s consider factors that drive the value of the asset, which leads us to a unique component of the asset class. The value of timber grows over time, independent of economic cycles, as the trees grow larger in size and number. This independence from the economic cycle, and dependence on time, gives the asset class a unique trait compared with other listed alternatives.
There is one further element of differentiation, namely optionality in harvesting which can also support timber values. Generally speaking, there is a minimum age but not much of a maximum age before a tree can be harvested. As such, timberland operators can optimise their harvest, usually choosing to do so when prices are favourable.
Timbers are processed into wood products, such as lumbers and wood panels, raw materials for homebuilders, and pulp to produce paper and tissue. Supply and demand dynamics for these wood products act as an additional component to the overall return from timber.
This demand tends to follow economic activity closely. For example, as homebuilding activity increases so does the demand for lumber; as ecommerce picks up, demand for packaging and thus pulp increases.
Demand does not go in just one direction, however. The move from paper to digital content has resulted in a structural decline in paper demand. Demand has also been affected by the recent trade war between the US and China, as many of the established and larger timberland firms are based in the US and export to China. Lumber exports fell as the trade war increased global growth uncertainty.
Supply, on the other hand, is driven both by the optionality in harvesting, as described above, and by natural factors such as wild fires or pine beetle infestation. To give you an idea of the impact of the latter, such infestations have affected more than 18 million hectares of forest in British Columbia alone. According to the local government, this equates to 58% of the province’s pine volume, and is the main reason why supply from Canada has been restricted.
Mixing trees with other asset classes
Put all of this into the context of historical returns, and we find that over the long term forestry has lagged wider equity markets. Is this a bad thing? Not necessarily.
Similar to other listed alternatives, forestry has a lower beta to equities. What is the price of lower beta? As we can see from the chart below, there is underperformance versus stocks in periods of positive performance for equities, but outperformance in periods of negative stock-market performance.
For example, from the peak to the trough of the global financial crisis, forestry outperformed broader equities by circa 10%, offering investors better downside protection. A similar dynamic was also at play during the dotcom bubble in the early 2000s.
It isn’t just the lower beta characteristic that roots us to this asset class. Forestry also exhibits low correlation and betas to our other listed alternatives, which means its addition our portfolios can improve their overall diversification.
How we do it
A common way of investing into the asset class is through private investment vehicles. These offer a more ‘direct’ exposure and don’t show as strong an equity linkage (though that may just be a result of their pricing approach). However, the drawbacks are very low liquidity and a long investment period (8 to 15 years).
For those who prefer more liquid options, there is the choice of forestry ETFs and active funds. Both invest in timberland companies but also in other companies further along the timber value chain, such as paper and packaging companies. As a result, investors will also be exposed to more cyclical factors, which can offset the timberland exposure they seek.
Then there is the option of investing directly in the timberland companies, which is our preferred choice for our funds. In our opinion, this offers us a better, more direct exposure to forestry as well as control over the companies to which we want exposure. Compared with private vehicles, this option will have higher volatility in the short term but we expect the overall return over the long term to be broadly similar to private vehicles as the underlying exposures are the same (more details for those who are interested can be found in Martin’s blog here).
A growing tree is for the long term
Trees are a renewable resource that offer a sustainable solution to many products that the world demands. Responsible management of forests doesn’t just protect the trees, but the wildlife and ecosystems that depend on them. It takes somewhere between 20 to 30 years for a tree to mature. Investing in forestry is for the long term.