The Dichotomy in Timberland Valuation

The issue in today’s post concerns why the transaction price of timberland has shown little or no decline in value but the stock price of the publicly traded companies that own timberland has declined dramatically. I will also look at what I think is happening in the timberland market today and how I see the market for timberland investment. But first, let’s set the stage.

In January, I did a post that included some graphs developed from my timberland transaction file. I was looking to see if the data supported a wide-spread belief that timberland values had dropped. The thinking was that housing starts declined, which caused a drop in lumber prices, which caused a drop in stumpage prices (all true), which caused a drop in timberland prices. You can read that post here How Much Did Timberland Values Fall in 2008? The data did not support the logic and did not show any evidence of a significant decline in timberland values. (For those that sent emails saying my opinion was wrong – that was not my opinion, it was just the data). I also wondered what the NCREIF Timberland Index would look like when it was released. The publicly accessible portion of the NCREIF website showed quarterly returns that compound to a 9.5% total return for the timberland in its index in 2008 but the components of the return are not broken out. A recent report by Brookfield Timberlands Management, distributed by Forestweb, shows the NCREIF return broken down by earnings and capital appreciation.

NCREIF TIMBERLAND INDEX

The significant decline in the blue portion of the graph reflects the decline in housing/lumber/stumpage/earnings. The green portion, Capital Appreciation, can be viewed somewhat (not perfect) as a surrogate of the change in timberland value as determined from tract sales and appraisals of tracts – all of which are a part of the index. Note the green from 2000 to 2002. This data certainly contains no indication of a 2008 decline in the price of timberland either.

Below is another graph that I found interesting. It is from the Timberland Report VOL. 10, NO. 2; by the James W. Sewall Company, a highly respected firm with a very long record in the timberland investment community.

From my perspective, the important take-a-way from this graph is that the old correlation between timberland values and housing starts fell apart. We can speculate as to why and we can speculate as to whether the correlation will return but it’s pretty clear that the conventional wisdom has not prevailed during this economic downturn. Another graph in the report reinforces the historical correlations between housing starts and stumpage prices. That correlation did hold as all timber owners know only too well. You can read the entire Sewall report here(recommended).

Now, let’s take a look at the price of common stock in some of the publicly traded companies that have timberland holdings that represent a significant share of the companies’ assets and see how share prices were impacted last year. Ownership structures of these companies include timber REITs, “C” corporations and limited partnerships but for my purposes today, I will refer to them collectively as “timberland companies”. Let’s look at this chart I made from Google.

It’s hard to see but the blue line just above Weyerhaeuser (green line) is the S&P 500. Weyerhaeuser took an early hit because it has such a major direct investment in housing. I read somewhere that it is the 17th largest home builder. The rest of the timber companies fell about the same amount as, and in synch with, the general market. My conclusion is that the timber companies stock price tracks the stock market rather than with the timberland market. Not a “pure play” in the bunch. Down about 50% when timberland prices held pretty steady.

I have long been a skeptic of the “pure play” concept of acquiring timberland companies (or an ETF) as a surrogate for timberland ownership. Even if 100% of the assets owned by the company were timberland, I would still be a skeptic and here is why.

Timberland investors use metrics based on a time horizon of 10 to 50 or more years. The key metrics are based on a discounted cash flow (DCF) analyses over that time horizon. If you would like to read more about timber valuation than you really want to know, you can do that here. The metrics used by those that analyze stock value are usually based on very short term future cash flows of a year or two (no need to discount those!). The inherent assumption is that the stock price will respond to very short term (a few quarters or few years at most) cash flows and that the stock will be bought or sold in that time frame. Some of the most referenced metrics are based on what happened last year rather than what is expected to happen in the future (current P/E for example). The Warren Buffets in the crowd that actually do take a long term view of stock investing are a clear minority today and I’m sure that DCF is an integral part of their valuation. Don’t misunderstand me. I’m not saying that one way is right and that the other way is wrong, only that they produce different results and that creates a dichotomy in value and an opportunity for long term investors. Given all this, is it any wonder that the stock of the timberland companies has fallen dramatically with the general market decline? The value of their timberland portfolio is based upon the very depressed earnings reflecting current stumpage prices rather than the DCF of future stumpage prices!

At this point, I reach two conclusions (and I know that some will not agree)

1. Timberland values have fallen little if any, and
2. The timberland value component of the timberland companies’ stock price has fallen dramatically

And therein is the opportunity.

Here is another stock chart just like the one above except Forestar Group has been added. If ever there was a pure play for timberland/HBU, this is it. Other than some OGM, that is its only asset!

The “Pure Play” Fallacy

In spite of that, the stock price of Forestar dropped over 80% - the worst of the group. So much for the “pure play” concept. If you want to invest in timberland, you need to own timberland, not stock!

Think about this. Is it possible that the assets of Forestar were worth five times as much in June as they were in November? Some folks sure didn’t think so. To name a couple, Holland Ware and Carl Icahn. Both recognize the dichotomy in valuation methodology between timberland and the valuation of the stock in timberland companies! Both made some serious money with that little bit of information and a lot of cash. Buy at $3 - $4/share, offer $15.00 (still undervalued), sell at $12 or so. Not bad. And the $15/share offer? Even that was well under the underlying value of the timberland/HBU asset.

Okay. We understand what happened in 2008. What is happening to timberland prices now and what will happen in the future? I still have seen no significant decline in transaction prices regardless of the emails I get claiming dramatic declines in prices (no transaction details attached). There is a slowing of transactions, at least one announced major transaction (St. Joe) did not close and several tracts that were put on the market were pulled off. What does this mean for the future?

It may mean that prices will fall. It may mean that buyers are holding their cash until this economic downturn, recession, depression, or crisis begins to resolve itself. I don’t know what the future holds but I do know that there is a lot of pension fund and other cash out there that will be invested somewhere. Today it is going into money market accounts and just kind of sitting there. Barron’s reported about a week ago that there was $4 trillion in money market funds which is about one-half the market cap of the entire U. S. stock market. That is a lot of money and I doubt that it will all stay in cash. At some point, some will go back into the market, some to commodities, some elsewhere and some to timberland.

Long term, I remain bullish on timberland but, in the short-term, I think that stock in the timberland companies is a better investment. The downside is less than timberland and the upside is much, much greater. If you follow Holland Ware, you won’t starve. --Brian
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Visit my website at Timberland Strategies
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ETF as Surrogate for Timberland Investment

In the Feb. 18th issue of Business Week, there is an article entitled "Wood Paneling for Your Portfolio". I'll start with a couple of quotes from the article and then I'll disect them.

"Buying timberland is one of the ways big guys running pension plans and endowment funds have diversified their holdings away from financial market trends and earned fairly stable double-digit returns to boot. But timberland has been mostly off-limits to individual investors, because it requires millions of dollars to buy in."

"Enter the Claymore/Clear Global Timber Index ETF. It's a new exchange-traded fund that invests in stocks of companies with the world's greatest exposure to timberland. It amps up the exposure by weighting the 27 stocks in the portfolio not by market capitalization but by actual acres companies own."

"This sort of everyman version of a timberland play..."

Okay, that's enough. I've been reading about this ETF as a surrogate for timberland ownership since its inception and I would like to say very LOUDLY and clearly that this is NOT a timberland play.

First, let's consider the above quote "timberland has been mostly off-limits to individual investors, because it requires millions of dollars to buy in." No it does not. Small tracts of timberland with all of the advantages of larger tracts are available for purchase. The use of a LLC allows investors to combine financial resources to acquire larger tracts. You can even purchase timberland within an IRA. Consulting foresters in all regions of the country are available to assist with appraisals and management. Many of these consultants are the same people assisting the institutional investors with timberland acquisition and management. If you want a timberland pure play, you will have to buy timberland and it is within the reach of most investors. If you want to get an idea of what is available for sale and pricing, just do a Google search on timberland for sale or consulting foresters in your geographic area of interest. If you want to learn more about buying small tracts of timberland, you might want to buy and read Curtis Seltzer's "How To Be a DIRT-SMART Buyer of Country Property". There is a lot of info in it that can put you on the right road. Before you buy, you will still need a consulting forester or someone else very familiar with timber values, land productivity and the local market. If you want to delve into the concept of timberland as an investment, I'd recommend "Timberland Investments" by Chris Sinkhan, et. al. which is pretty much the classic in that field.

So, no, you don't need "millions of dollars" to buy timberland!

Now let's look at the Claymore/Clear Global Timber Index ETF and see why it is not an "everyman version of a timberland play". To be fair to Business Week, they are not the only ones promoting this ETF as a surrogate for owning timberland. I have seen at least a dozen articles with similar comments.

Below is a list of the holdings in the Clear Global Timber Index along with the percentage weighting of each. As you scroll down through the list, ask yourself the following questions.

• Is the primary asset of this company timberland?


• Does this company own any land or has it sold its timberland?


• Is the stock weighting in the portfolio "by actual acres companies own" as claimed in the article?


• Is this company forced to acquire its timber on the open market (or at market price if there is a fiber supply/lease agreement)?


• What level of fiber self-sufficiency does this company have?


• Does this company grow and sell more timber than it uses?


• Is this company the exact opposite of a timberland play?


• Is this index/ETF more reflective of the global pulp and paper industry index than timber or timberland?
  

Clear Global Timber Index
Top Fund Holdings as of 2/13/08

Name/Weight
INTERNATIONAL PAPER CO/5.48%
VOTORANTIM CELULOSE E PAPEL SA/5.46%
ARACRUZ CELULOSE S.A. ADR/5.17%
POTLATCH CORP/4.86%
SINO-FOREST CORP/4.83%
RAYONIER INC/4.78%
SVENSKA CELLULOSA AB-B SHARES/4.77%
SAPPI LTD/4.74%
TIMBERWEST FOREST CORP/4.61%
PLUM CREEK TIMBER CO INC/4.60%
WEYERHAEUSER CO/4.60%
SUMITOMO FORESTRY CO LTD/4.56%
HOLMEN AB SER B/4.55%
MEADWESTVACO CORP/4.49%
GUNNS LTD/4.45%
OJI PAPER CO. LTD./4.33%
SMURFIT KAPPA GROUP PLC/4.28%
GRUPO EMPRESARIAL/3.76%
CHINA GRAND FORESTRY RESOURCES/3.22%
DELTIC TIMBER CORP/2.71%
WEST FRASER TIMBER CO LTD/2.67%
HOKUETSU PAPER MILLS LTD/2.48%
GREAT SOUTHERN PLANTATION/2.13%
CANFOR CORP/1.25%
TIMBERCORP LTD/1.21%

If you answered the questions, it should be very clear that this index is NOT a timberland play but in many cases, it is just the opposite. For example, as timber and timberland prices increase, you would expect the value of the index to increase as well. Here is a quote from MeadWestvaco's news release following its last quarter.

"Higher input costs for wood ...negatively impacted profitability."

The corporate structure of many of the key holdings above is very similar to that of MWV. This ETF may be a good investment, I can't say, but it is certainly NOT a surragate for timberland ownership. It reflects a global pulp and paper play.

So..., is it possible to invest in stock as a timberland play? Maybe, kind of, in a way. At a minimum, we can do a heck of a lot better than this ETF. We'll do it by creating a basket of stocks from the above list that really are backed up by timberland and that have little or no exposure to pulp and paper. Let's also eliminate the bulk of the foreign stocks which, to a degree, have currency exchange risk associated with them (You may think that the dollar will continue to decline so they will be a good investment but that is not timberland investing, that's currency investing - then again, you might think that the dollar is about to turn around...).

Let's start by putting check marks by Plum Creek, Potlatch and Rayonier. All have significant timberland acreage, little or no exposure to pulp and paper, and a tax efficient corporate structure (REIT). The timberland in these three stocks provides plenty of geographic, species and market diversity. That diversity substantially reduces many of the risks associated with both timberland and stock investing. I believe that this basket will come as close to owning timberland as you can get. If you want to add a few more, consider Deltic Timber (timberland and lumber mills), Pope Resources (a MLP), and Weyerhaeuser (six million acres but pulp and paper, lumber mills, currency risk, and inefficient tax structure). Weyerhaeuser is a particularly interesting addition because its current market cap is less than estimates of the timberland value. In addition, a probable change in the tax structure will likely result in a significant increase is share price. So let's create a basket with three to six of these stocks and forget the ETF. It will be more reflective of a timberland investment.

But remember, too, that it is NOT timberland. It is stock - be that good or bad. On the positive side, the stock basket is much more liquid than a timberland investment. The stable, continuously rising value of timberland will be absent. Daily values will change with the stock market. Value will rise and fall with major market influences like housing. Quarterly profit will impact the stock price (no matter how foolish). Last week an analyst reported that Potlatch was a better buy than Plum Creek. I checked the stock prices for the two of them and Potlatch was up about 3.5% and Plum Creek was down by 3.5%!!! The value of the timberland at neither company had changed one penny but the difference in value of the two companies was 7%! These types of moves may be foolish but they are also reality.

So..., this may raise a couple of questions in your mind. First question: How can we do a better job at selecting stocks to "kind of" mirror timberland investments than a professional investment firm like Claymore? Answer: Due to laws and regulations that apply to mutual funds and ETF's, they are restricted from taking a position that exceeds 5% of the fund. That means that they must take a bare bones number of 20 different companies in the ETF and there are not 20 companies out there that even approach being true timberland plays. We win not because we are better but because we are blessed with more flexiblity.

Second question: How could Business Week's assesment be so far off? Answer: ?? --Brian