By Richard Davidson
Where does forestry fit into a traditional asset allocation matrix? Some investors classify it in the “alternative assets” category, covering everything from private equity to hedge funds. Some have a stand-alone natural resources weighting.
For me the closest parallel is with commercial real estate – both are real assets that have a positive correlation with inflation, generate cash and are not realisable overnight! However, there are many differences that illustrate the benefits of having both in a diversified portfolio.
Trees grow – One of the unique aspects of investing in forestry is that trees grow regardless of what the economy or the FTSE100 are doing. The mild and wet climate of the British Isles makes it one of the best softwood conifer growing areas in the world. In an average year, a Sitka Spruce (the main softwood timber species grown in the UK) will add 4-5% of timber volume. This ability to grow without the need to harvest annually means that value can continue to compound “on the stump” especially in years of weak product prices. In contrast GDP growth and job creation are undoubtedly key driving factors in the demand profile for real estate.
David and Goliath – The value of the commercial private sector resource is around £4bn. In contrast, according to IPF, the value of UK commercial property is £ 683bn, with roughly 60% of that being “investable”. This gap is enormous, but it doesn’t mean building scale in UK forestry is impossible. In 2015 c.£150m of forests changed hands in the UK with additional turnover in farms for conversion to forestry.
Product price volatility – Timber is a commodity product with the price volatility that brings. In contrast, property is an investment where pricing is more about steady compounding with occasional drops in recession. This contrast would often favour property, however, we believe UK timber price volatility risk is to the upside. Over the next 15 years, UK timber supplies are forecast to peak and fall by c.35% in the following 20 years. At a time when demand for wood products in construction and biomass is growing, this should put upwards pressure on UK timber prices, which today are still only half what they were in the late 1980s in real terms.
Regular and Irregular yields – As low interest rates have dragged down bond yields, investors have turned to the higher and steady yield offered by commercial property – the IPD All Property Index initial yield currently stands at just under 5%. Forests too offer a cash yield in the form of harvesting income, although the cash flow is lumpy and dependent on timber prices. However, a portfolio of different aged forests can significantly smooth the cash flows to the degree that annual yield from UK forestry could be between 2-4%.
A premium for illiquidity in both – Higher risk should equal higher return. One such risk is illiquidity which forestry and commercial real estate share. All transactions are individual, non-screen based and subject to marketing and legal processes that can take several months. However, that backs up the common sense of an appropriate weighting within a diversified portfolio and makes both assets suitable for long term investors. Looking at total returns over the 10 years to the end of 2014, UK forestry and commercial property have returned 18.8% and 6.2% respectively p.a. against 6-7% for stocks and bonds.
Conclusion – The benefits of timberland investments are also well known in parts of the world such as the US. The UK forestry market is smaller but the reasons to diversify a portion of real asset allocations into this asset class are sound, especially for UK investors. A well-structured forestry portfolio can add an uncorrelated, real asset that delivers yield and inflation protection.
Richard Davidson is a fund manager at Gresham House.
