Timber Investments Student: Davíð Steinn Davíðsson - PDF

Department of Economics September 2008 Timber Investments Student: Davíð Steinn Davíðsson Advisor: Dr. Gylfi Zoega, professor University of Iceland Department of Economics Oddi, Sturlugata, 101 Reykjavik

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Department of Economics September 2008 Timber Investments Student: Davíð Steinn Davíðsson Advisor: Dr. Gylfi Zoega, professor University of Iceland Department of Economics Oddi, Sturlugata, 101 Reykjavik Web: Ritgerð þessi er skrifuð til BA-prófs í hagfræði við Hagfræðideild Háskóla Íslands. Ég þakka leiðbeinanda mínum, dr. Gylfa Zoega prófessor, fyrir hvatningu og góðar ábendingar. Þá vil ég einnig þakka Ólafi Ísleifssyni lektor og Vilhjálmi Bjarnasyni aðjúnkt fyrir gagnlegar ábendingar. Reykjavík, 16. september 2008 Summary In recent years, institutional and individual investors have increased their portfolio allocations to alternative investments, including timberland. The aim of this dissertation is to provide an overview of the timber asset class and to explore the effects that timber investments may have on well diversified portfolios using modern portfolio theory. Timber investments possess some unique characteristics that differentiate them from investments in other asset classes, the most significant one being biological growth of trees. The value gain from biological growth is two-dimensional, as trees do not only grow in volume with age, but they also grow exponentially in value as their diameter increases. Using historical return data for various different asset classes, a theoretical investment universe was created to assess the impact that timber investments have on the portfolio frontier. The study clearly reveals that timber investments offer significant diversification benefits. When timber is added to the set of available risky assets, the portfolio frontier shifts and changes shape, reflecting improved risk-return combinations. Whether the maximum allocation to timber investments is restricted or not, results indicate that the standard deviation of the portfolio, for various fixed return targets, falls significantly, in most cases by several percentage points. In sum, results suggest that there are substantial benefits to be achieved by including timber investments in a portfolio. 1 Table of Contents 1. Introduction 4 2. On Timber Investments Growth Characteristics of Timber Investments Sources of Returns 13 Biological Growth 13 Timber Prices 14 Land Value 15 Other Factors Asymmetric Return Structure Risk Factors 24 Price Risk 24 Natural and Environmental Risks 24 Regulatory Risks 21 Illiquidity Risk Timber Investment Performance Measuring Timberland Investment Returns Historical Return of Timber Investments Emphasis on North America Timberland Investments in an Institutional Portfolio Rudiments of Modern Portfolio Theory Allocation Model: A Theoretical Portfolio 32 Return and Volatility 33 Timber Correlations 37 Efficient Frontiers with and without Timber Conclusion 47 Appendix 1 50 Appendix 2 51 A2.1 Time Series 51 A2.2 Cumulative Returns 53 A2.3 Quarterly Returns 55 A2.4 Mean Returns and Standard Deviations 57 A2.5 Sharpe Ratio 61 A2.6 Portfolio Frontiers 62 Bibliography 71 2 Figures 2.1 Wood Volume Over Time Price of Timber Aggregate Value Over Time Value and Volume Over Time Return Structure with and without Flexibility Options Annual Returns of Timber and Global Stocks NCREIF Timberland Index Annual Returns NCREIF Timberland Index Histogram of Annual Returns Portfolio Frontier Cumulative Returns, Q Q Return VS Volatility, Q Q Sharpe Ratios Historical Annual Correlations with Timberland Returns, Portfolio Frontier with and without Timber, Short sales restricted Portfolio Frontier with and without Timber, Short sales permitted Portfolio Frontiers With and Without Timber, 20% limit on timber allocations, Short sales restricted Portfolio Frontiers With and Without Timber, 20% limit on timber allocations, Short sales permitted 45 Tables 3.1 NCREIF Timberland Index Asset Classes Available in Study Coefficients of Variation Incremental Benefits of Allowing Timber Allocation in the Portfolio Incremental Benefits of Allowing 20% Timber Allocation in the Portfolio 46 3 1. Introduction Alternative investments, such as hedge funds, private equity funds and artwork, to name only a few, have gained popularity over the last several years as both institutional and individual investors seek new ways to mitigate risk and improve returns on investment portfolios. The gradual increase in institutional investors allocations to alternative investments is the result of over two decades of abundant liquidity and low interest rates in most major developed economic areas around the world. Under such economic circumstances, several investors find it hard to achieve their return targets and thus turn to alternative asset classes that is, alternatives to publicly traded securities in their search for yield. Globalization is also a force behind the surge in alternative investments as it has caused more traditional financial markets, such as stock markets and bond markets, around the world to become more interconnected. The same events and news now affect stocks and bonds globally and thus in order to mitigate risk and fully diversify their portfolios, investors now must look beyond the realm of stocks and bonds. Although there is no formal definition of the term alternative investment, it is generally seen as encompassing investments in most or all asset classes that are not traded in traditional, liquid markets, such as the stock market or the bond market. The spectrum of alternative investments is therefore a very broad one, ranging all the way from investor shares in venture capital funds to rare postage stamps. The whole universe of alternatives may be divided into two broad categories: financial instruments and real assets. Financial instruments include assets such as hedge funds, private equity funds and mortgage-backed securities, to name only a few examples. Real assets, on the other hand, include natural resources such as precious metal mines and oil 4 fields, as well as real estate and other physical assets, including timberland, on which the remainder of this dissertation will focus. In this paper, the term timber investments refers to the direct ownership and management of timberlands. The definition thus assumes that investors purchase and hold timberland directly, either alone or in collaboration with other investors, and that the property is then actively managed, which includes the harvesting and sale of timber products. There are of course other (and perhaps easier) ways to gain exposure to timber assets, such as the purchase of stocks of paper companies, but these clearly expose the investor to a wide range of additional risks which are unrelated to timber assets. 1 Although investing in timberland is certainly not a new phenomenon, it was only in the mid-1980s that institutional investors in the United States, such as pension funds and university endowments, began exploring this asset class as a potential alternative investment. Before this time, most timberland in the U.S. was owned either by national and state forests or by forest-product companies. 2 The growth in timber investments by institutional investors was spurred in the mid-1980s when pulp and paper companies sought to divest their forest assets to reduce debt. The creation of specialized asset managers, called Timberland Investment Management Organizations (TIMOs), also facilitated institutional investor participation in the timber asset class by collecting institutional and private money to purchase the forest assets that were being divested. 3 Since the establishment of the first TIMO in the United States in 1981, institutional timberland investments have grown substantially. It is estimated that institutional investments in timber have grown from a mere one billion USD in 1990 to roughly 50 billion as of early Throughout this dissertation the terms timber investments and timberland investments will be used interchangeably. 2 Goar, Jinny St., Into the Woods, Bloomberg Wealth Manager, 2001/ Laplante, Julien. Timberland Investments: Once a US territory, now a global one, Bfinance, Merrill Lynch. Timber Survey: What will institutional investors do next?, Timber is a renewable resource with a relatively stable product demand and as an investment it possesses several desirable characteristics for asset allocation purposes. Timber assets possess a unique and attractive return structure and, from a portfolio theory perspective, there are substantial benefits to be achieved by investing in the timber asset class. In fact, historical timber returns are higher than for other traditional asset classes such as equities. 5 The potential benefits of including the timber asset class in an institutional investment portfolio are further strengthened by the fact that timber investments exhibit a low or negative correlation with other traditional asset classes, such as stocks and bonds, but a relatively high correlation with inflation, which suggests that it can serve as a natural hedge against inflation. The reasons for including timber assets in a portfolio can also reach beyond potential financial gains, as investors who are inclined toward socially responsible and environmentally friendly investing will find even more to like in timber. Trees, for example, replenish the earth s oxygen by taking greenhouse gases out of the atmosphere as they grow. Also, if properly managed, a forest is a sustainable natural resource. For some investors, these are important intangible benefits which do not show up on the books as additional revenue. This dissertation focuses on timber investments and attempts to shed light on how such investments affect institutional investment portfolios. The following chapter provides a general introduction to timber investments and provides an analysis of the most important aspects of the timber asset class, such as its growth characteristics, return drivers and risk factors. The third chapter takes a look at timber investments historical performance and discusses how returns from timber assets are measured and assessed. The fourth chapter explores timber investment performance relative to that of other asset classes and analyses the effects of including timber investments in an institutional investment portfolio using modern portfolio theory. This study is carried out by constructing a theoretical U.S. portfolio using real return data for various different asset 5 Over the past two decades, the NCREIF Timberland Index, which measures the return on timber assets, has delivered a higher cumulative return than both U.S. and global equities, as measured by the S&P500 index and the MSCI World index, respectively. 6 classes, including - but not limited to - domestic and international equities, government bonds and real estate. The aim is to determine how the portfolio frontier shifts and changes shape to reflect different risk-return combinations when timber investments are added to a portfolio. All data used to carry out the study are provided in appendices. Results are summarized in the final chapter followed by concluding remarks. 7 2. On Timber Investments This chapter provides an introduction to timber investments. The growth characteristics of timber are explored in the first section, followed by an analysis of the major return drivers and the unique return structure of timber investments in sections two and three. The last section takes a look at some of the major risks associated with the timber investment class. 2.1 Growth Characteristics of Timber Investments The value of timber and therefore the return earned from holding timber investments is, as for any other commodity, in part a function of supply and demand. However, timber assets are different from other commodities - and perhaps from all other investments due to a combination of two different but related factors: (1) constant biological growth of trees and (2) a term called product class step-ups 6, sometimes referred to as ingrowth, which describes the fact that large trees are worth significantly more than small trees due to the fact that they can be transformed into higher value products. 7 As trees grow, they add both volume and value. They add volume as there is quite simply more wood; and they add value because increasingly higher value products can be created from increasingly larger trees (class step-ups). Simply put, a tree that is twice the volume of another tree of the same kind can be several times more valuable as higher value products that can be made from it. 6 Corriero, Timothy, Thomas Healey and Rossem Rozenov. Timber as an Institutional Investment. The Journal of Alternative Investments, vol. 8 (winter 2005), pp Fund Evaluation Group (FEG). Investing in Timber, As a result of biological growth, timberland can easily increase in value even if timber prices and land prices remain constant because the volume of timber on the land will increase. This volume increase can also help timberland maintain its value in an environment where timber prices and land prices are falling. Consequently, it is clear that if timber is harvested at the same rate trees grow, timberland can assuming other factors remain constant - generate constant income without loss in value to the asset. Biological growth can therefore be viewed as a sort of natural hedge against the economic factors that affect both timber and land prices, or as one timber investor puts it: Trees don t read the Wall Street Journal. They do not concern themselves with events like the war in Iraq, or statements from the Federal Reserve Chairman. 8 In figure 2.1, wood volume over time on a hypothetical Southern pine plantation (one acre) has been drawn. 9 The volume has been split into three categories of timber in this market: pulpwood (5-8 in diameter), chip-n-saw (8-12 in diameter) and sawtimber (12 + in diameter). 140 FIGURE 2.1 Wood Volume Over Time 120 Volume (tons per acre) Tree thinning temporarily reduces volume of trees Age (years) SOURCE: Forest Investment Associates Pulpwood Chip-N-Saw Sawtimber 8 Laplante, Julien. Timberland Investments: Biological growth pays off, Bfinance, The figures used are based on real prices for Southern pine in the U.S South from Forest Investment Associates. 9 Pulpwood is timber grown with the principal purpose of making wood pulp for paper production. Chip-n-saw trees are large enough to make small-dimension lumber and they can also be used to create various wood-based products. Sawtimber consists of larger (and older) trees, which can be used to create large, high-end wood products such as furniture. As the chart shows, tree volume drops suddenly in year 9. This is due to a process called tree thinning, whereby low quality trees are removed to create better growth conditions for the remaining trees. Price (USD per ton) FIGURE 2.2 Price of Timber 27,5 43 Pulpwood Chip-N-Saw Sawtimber SOURCE: Forest Investment Associates Sawtimber is significantly more valuable than pulpwood and chip-n-saw, as higher value products can be made from it. Figure 2.2 displays recent average prices for each of the three categories for pine wood in the southern United States. These prices clearly reflect how significant the in-growth characteristic of timber really is: sawtimber, for this particular species, is roughly five times more valuable than pulpwood. In figure 2.3, by combing the aggregate volume information in figure 2.1 and the average prices in figure 2.2, a chart illustrating total value growth of one acre over time has been created. This is done by multiplying the volume for each product by the average price and then aggregating the value for the three product classes. 10 FIGURE 2.3 Aggregate Value Over Time 7000 Value (one acre, USD) Tree thinning temporarily reduces volume of trees Age (years) Figure 2.3 shows that the value of the acre does indeed grow faster as the trees grow larger and older (time scales in figures 2.1 and 2.3 are the same). To further emphasize the difference between volume growth and value growth, information from figures has been combined in figure 2.4 below. The value per one acre (left axes) and the volume per one acre (right axes) have been plotted on the same chart. It clearly reveals that over time growth in value is significantly steeper than growth in aggregate volume. Simply put, over a period of several years, a tree that grows twice in volume will appreciate far more than twice in value. 11 EXHIBIT 2.4 Value and Volume Over Time Value (one acre, USD) Tree thinning temporarily reduces volume of trees Volume (tons per acre) Age (years) Value Volume This unique natural growth pattern exhibited by forests is clearly a very important driver of investment returns for timber investments. These returns the growth rates of forests vary according to a wide range of variables, including soils, silvicultural treatments, species composition, wildlife patterns, pest control and fertilization, to mention only a few. Biological growth is also not constant throughout the lifetime of a tree. Old trees grow slower than younger ones. Very young trees put most of their growth into height, adding little volume; whereas older trees will put less growth into height and more into diameter, contributing more volume to the stand. 10 For the timber investor (or his forest manager) these patterns in biological growth, which are highly predictable, form the basis for developing very precise forest management plans in order to maximize the asset s value. Precise mathematical growth models have been developed for all commercially important tree species, and since most of the variables that affect growth rates of trees can be controlled - or at least heavily influenced 10 Lutz, Jack. Biological Growth Rates and Rates of Return, Forest Research Notes, Vol. 2, No. 3 (3 rd quarter 2005). 12 by the forest manager, these variables appear as control variables in the valuemaximizing optimization problem. 11 This suggests that intense management of timberlands can vastly improve returns on timber investments. In fact, research shows that the difference in growth between an actively managed forest and a natural stand of timber can be tremendous; perhaps twice as much timber can be produced in half the time in intensively managed plantations than in an unmanaged plantation. 12 Evidence that intense management pays off when it comes to timber investments is therefore irrefutable, which is certainly not the case with many other asset classes such as stocks, where the value of active management is still subject to heated debate. 2.2 Sources of Returns There are three primary drivers of timberland investment returns: (1) biological growth, (2) timber prices and (3) changes in land value. Of these factors, biological growth is by far the most significant one. John Caulfield, a professor at the University of Georgia School of Forest Resources, has conducted a detailed study on the relative importance of timber investment return drivers. His findings indicate that biological growth has typically generated 61% of total investment returns on timberland investments, 33% is related to timber prices and the remaining 6% stem from changes in land prices. 13 Each of the three return drivers will now be discussed in more detail. Biological Growth This component is by far the most important factor driving timberland returns and it is the one that separates timberland investments from most other investments in natural resources. Biological growth has a two-dimensional effect on returns as trees do not only 11 See for example Heikkinen (2003), Wear & Parks (1994) or Berck (1979). 12 Corriero, Healey & Rozenov (2005), pp Caulfield, Jon. Timberland Return Drivers and Investing Styles for an Asset that Has Come of Age. Real Estate Finance, Vol. 14, No. 4 (1998). 13 grow in volume over time, but they also turn into higher value products (in-growth), as explained in the previous section. Biological growth is a very attractive feature from an investment perspective as it is
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