August 1, 2001

Natural Hedge

Now for something completely different: Send those

Over the course of the last six years, the Dow has gone crazy, rising from around 2,500 to where it now stands at more than 10,000. Yet along with this growth has come uncertainty about where an advisor can place clients' money without fear of overpaying for an asset. For instance, notwithstanding any further erosion in corporate profits, the price/earnings ratio of the S&P 500 is 24, while its historical average from 1926 to the present is only 14.

For the past several years, Jeremy Grantham, investment strategist for the Boston-based money management firm Grantham, Mayo, Van Oterloo & Company (GMO), has been making just this point at various trade shows. Thirty-dollar stocks like Intel, he points out, are only set to earn 50 cents this year--and only marginally more in 2002. So what's an advisor to do? Grantham suggests institutional investment in timberland.

Initially this might sound like a harebrained scheme. Why would anyone want to get involved in such an unknown asset class? Who wants to invest in trees? But timberland is worth a second look. Historical studies show that timberland has actually had a higher return than U.S. equities over the last 40 years--between 9% and 15% a year--while maintaining a very attractive dividend structure and much less volatility. To top it off, the asset class has a built-in natural advantage that allows it to continue to deliver solid returns even when the overall economy turns sour. So grab that plaid flannel shirt, pick up your saw, and start learning about this exciting asset class.

Investing in timberland is not as easy as just buying up tracts of land, cutting down the trees, and sending them off to market. This is the fundamental premise behind the asset class, but describing the intricacies of the equation that will at last determine an investor's final return can be overwhelming. Understanding the market conditions that affect timberland is also no picnic. For instance, you may associate timberland with a sort of rustic, provincial persona, but the people involved are actually employing all manner of high technology to achieve the best possible return.

To start with the basics, after opening the funds and raising the necessary capital, timber fund managers buy tracts of timberland throughout the U.S. and abroad. It may surprise you to discover that a large percentage of our nation--468 million acres out of 2.25 billion--consists of timberland. Managers will scour the country in search of good deals and buy a number of tracts, often in a variety of regions.

The return on the investment is at least partly affected by the price of timber, but while the price may fall in one place, it will remain steady in another. "We try to get some geographic diversity to spread out risk," says Cort Washburn, 42, director of economic research and investment strategy for John Hancock Renewable Resource Group, which manages $2.7 billion and three million acres.

Once the land is purchased, the main thing to do is wait, and wait, and wait. About 60% to 70% of the return in timberland is made through the actual growth of the trees. "You have to understand that a tree that is one size will bring a certain price at market while a much larger one will be worth a great deal more," says Peter Mertz, 50, managing director for UBS Timber Investors, which has $1.5 billion under management. "So really you have to just wait for the trees to grow." Deriving returns from tree growth sounds fairly safe, but there is a drawback: It takes a long time.

So most timberland funds have a 10- to 15-year holding period before they can start to sell off the assets and return principal to investors.

The Liquidity Issue

But if all that is required is to simply wait for the trees to grow, why would anyone agree to sell timberland in the first place? "In addition to the holding period, you have illiquidity," says Mark Seaman, 49, whose Wachovia Timber Investors manages some $1.2 billion. Indeed, once invested in a fund, there really isn't any way to get out. Why? Timberland funds (run by TIMOs, timberland investment management organizations) are set up like closed-end mutual funds whose shares cannot be redeemed for cash. As with closed-end mutual funds, you can sell your shares, but the problem is that no one has ever heard of an instance where a buyer has been found. "It just doesn't happen," says Seaman.

The reasons for this are fairly obvious. For one, TIMOs are able to buy timberland at a relative discount per acre because they are buying such enormous tracts. According to a 1999 John Hancock research note, fully 100 basis points in annual returns can be realized simply by buying larger pieces of timberland and then selling them off in smaller packages. "If we can do this, why would anyone want to miss out on that later markup?" asks Hancock's Washburn.

Furthermore, in most instances an investor also must tie up a very large piece of capital. Historically, investment minimums for TIMOs have been in the neighborhood of $20 million for a separate account or between $2.5 and $5 million for a commingled fund. For the most part, the reason for this lies in the origins of the industry as a whole. TIMOs didn't really exist until the mid-1980s, when pension fund managers began to feel the full brunt of the passage of the Employee Retirement Insurance Act of 1974, which established new and more prudent rules for the investment of pension funds. "Managers suddenly were very interested in alternative assets that would even out the risks posed by equities," says Washburn. Conveniently, at the same time, many of the major forest product companies like International Paper were looking to liquidate their timberland to realize the appreciation the properties had experienced. "This created a dilemma, though," adds Washburn. "The funds wanted to buy, but they couldn't have their chief customers manage the land. There needed to be a middleman."

Into this void stepped the insurance and banking institutions that had for years financed the purchase of timberland for forest product companies. John Hancock Insurance and First Atlanta Bank--which was later acquired by Wachovia--both set up TIMOs to manage timberland for the funds. "It took a few years to raise the money and actually purchase the properties, but the first funds were running by the mid-1980s," Washburn says. "Really only now are individual investors expressing interest."

With this in mind, a number of funds recently have begun developing vehicles with smaller minimum investments. Seaman, for one, says that he is already working on a fund that will lower the minimum investment from $2.5 million to $250,000. And GMO, which started its timberland operations in 1997, has a mere $100,000 minimum if the investor comes through an advisor.

Due Diligence

Another risk involved in timberland is that the fund's investment advisor may simply overpay for the timberland. "By no means is figuring the value of timberland a perfect science," says Washburn. "In fact, I've been involved in bids with other advisors over the very same property and our prices were more than 100% different." Still, there are some guidelines for determining what a piece of timberland is worth. For instance, of the three major timberland areas in the U.S., timberland in the Pacific Northwest is worth far more than tracts in the South or Northeast. "The Pacific Northwest is a temperate rainforest and trees grow much, much faster there," says Washburn. Indeed, an acre of timberland in Oregon may go for $2,500 when one in Maine is worth only $300.

That said, within regional price boundaries there is still a lot of pliability. Eva Gregor, managing partner at GMO and head of its timberland division, says that managers will actually count trees. "We use aerial photographs, computers, and instinct," she says. "The point here is that not every advisor is the same, so you have to do some due diligence on your own when picking one out."

A good timberland advisor can impact the actual growth of the trees. Seaman compares it to farming crops. "The return is based on growth, so it's important to have a good farmer," he says. Indeed, Seaman might plant 350 loblolly pines on a given acre in the South, fertilize them, and then do what is known as "thinning" on the trees' 10th birthday. "You want to get rid of trees that don't grow right so the others will have a chance to spread out and grow faster. It's a science."

The Biggest Risk

A good advisor, though, is not going to be able to compensate for what is far away the greatest risk associated with timberland: a drop in timber prices. The value of the trees and the underlying timberland is roughly based on timber prices. It's important to note that the main reason timberland has done so well over the last 40 years is because the price of timber ha

Into the Woods
Given their incredibly high investment minimums, institutional timberland funds are a bit exclusionary in a pecuniary sense. Yet there are two other public timberland investment vehicles available to those with less financial muscle.

The first is the only timberland REIT, the Plum Creek Timber Company, which almost predominantly focuses on timberland operations. The company owns 3.1 million acres of timberland across the country and is set to increase that number to 7.8 million through its coming merger with Georgia-Pacific's timberland operations, called The Timber Company.

Plum Creek (ticker, PCL) has risen from around $10 per share when it was formed as a limited partnership to its current price of $28. It trades at around 14 times earnings and has an attractive 8% yearly dividend.

Yet there are other things to consider here. For one, the company has an enormous debt: $559.7 million compared to $1.25 billion in total assets. According to its 10-K filing for 1999 (the switch to a REIT a year later has skewed recent accounting figures), the company had $736 million in revenue compared with $61 million in interest payments.

The problem with this, according to several TIMO managers, is that the debt at least partially negates the inherent advantage of timberland. For instance, when the economy sours and timber prices drop, TIMOs, which do not have debt, will be able to refrain from selling trees or property while still getting healthy returns from biological growth. But a highly leveraged REIT might have to sell at low prices to service its debt.

Furthermore, Plum Creek does not focus entirely on timber production, but also maintains forest product facilities like saw mills. This leaves the company exposed to economic dips, since lumber prices are more volatile than timber. Forest products also do not have the inherent natural advantages of timber, as mentioned above.

The other public method for investing in timberland is the limited partnership. While there are a number of timberland LPs, they have the same faults of Plum Creek. Most are highly leveraged--more so than Plum Creek--and many maintain forest product facilities.--Mike Jaccarino

s risen steadily over that time. Timber Mart-South, a timber price recording agency, says the cost of American pines in the South has risen from $10 per ton in 1976 to its current price of about $34 per ton. Similarly, in the Northwest, a comparable agency, Log Lines, reports that the price of Douglas firs has risen from just over $300 per million board feet (about three tons) in 1989 to over $500 per million board feet today.

The most dramatic price increase came in 1992 and 1993 when the government retired much of its Pacific Northwest forest preserves to save the spotted owl. Because that land had also served in the past as a great source of timber, the price of timber in that region skyrocketed to $800 per million board feet. Accordingly, timberland investments in the Pacific Northwest yielded a 60.5% return in 1992 and a 27.3% return in 1993.

Still, timber prices can fall. Take, for instance, this admission from the recent 10-K published by Plum Creek Timber Company, the only timberland REIT. "Composite indices for commodity lumber prices were 20% lower in 2000 than in 1999, primarily due to the slowing U.S. economy and excess lumber production. U.S. housing starts during 2000 were 4% below the prior year while at the same time lumber production remained strong." The recent economic woes in Japan--a major importer of timber from the U.S. Northwest--did not help matters, either.

This stands in stark contrast to what many timberland neophytes have asserted--that the asset does not correlate to the economy as a whole. They will point to the fact that timber prices have risen during the three great bear markets of the last century, and that timberland returns over the last 41 years have negative correlation coefficients with the S&P 500, corporate bonds, and Treasury bills. This is misleading, however. "If the economy goes bad, so will timber prices and, thus, timberland returns," asserts Gregor. "It's really just a matter of the leading and lagging nature of some asset classes." Timberland will suffer with slumps in the economy, but possibly not during the same year.

That very fact emphasizes the great natural advantage of timberland: Even though the economy might sour, trees still grow. "Just as long as you don't sell until prices have recovered, you're still getting the same return," says Mertz. Indeed, marketable trees (15 years old and higher) grow 10%-15% annually until they reach their 20th birthday, and then between 7% and 10% a year until reaching maturity at age 80. In fact, the price increase is roughly correlated with the percentage growth. For instance, if a tree was worth $1,000 on its 22nd birthday, chances are that after growing 7%-10% over the following 12 months, it will be worth between $1,070 and $1,100. Now apply this to a scenario involving a slumping economy and falling timber prices. You have a tree whose value suddenly plummets from $1,000 to $750. Prices remain depressed for five years but then recover to the same price they were before. Your tree, which has grown 10% per year in size, will now bring $1,610.51. "This is the beauty of timberland," laughs Mertz.

So let's tally the scorecard. For what amounts in the industry to about a 13% annual return, you're taking on the risk of illiquidity, the risk of stupidity on the part of the timberland advisor, and the risk that timber prices may fall irrevocably, never to return to their present values. On the flip side, you have Intel yielding 1.6% this year in retained earnings, with the chance the company may warn again any day. Sounds like Grantham may have something here.

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