We don’t succeed in business or investing by falling in love with our own ideas. We profit through comparing our prior decisions to actual results in order to calibrate our “model” of how the world works and improve future decisions. One reliable way to underperform as an investor is to buy timberland assets or stocks at the top of the market. What gets priced up ultimately falls, adjusts or reverts to the mean thanks to arbitrage and horse trading. Alternately, outperformance thrives on the upside of undervalued assets, such as cash-generating businesses and real estate products.
Prime candidates from 2018 include publicly-traded, timberland-owning real estate investment trusts (TREITs). What is the current situation with timber REITs? How could investors evaluate the opportunities in the timber REIT sector for 2019?
Timber REITs Tumble in 2018
Public timber REITs, along with the balance of the stock market, delivered truckloads of heartburn to investors, especially in the second half of 2018. For the year, the public timber REIT sector lagged far behind the S&P 500, which had its worst year in a decade. (In 2008, the S&P 500 returned -38.5% and the FTR Index returned -25.4%).
Even at the individual firm level, each stock underperformed the S&P 500. For comparison, timberland-owning Pope Resources, a master limited partnership (MLP), kept up with the broader market and outperformed timber REITs.
We note that the timber REIT sector gained nearly 16% during the first month of 2019, reflecting the start of a sharp recovery. For investors considering timber REIT stocks, it helps to have an approach. In forest finance, we apply specific tools to make the “best” investment decisions possible. Investing, whether in trees or Turkish bonds, requires a “probabilistic” mindset that acknowledges uncertainties.
Forest Finance Framework
The application of finance in forestry addresses three sets of investment questions related to how we deploy and allocate capital:
- First, how do we identify, screen and value timberland acquisitions or businesses, or forest management decisions? This set of questions deals with the “investment decision” and includes proper valuation (appraisals) and the ranking of different forest management plans, such as comparisons of seedling types, thinning strategies and fertilizer applications.
- Second, how do we pay for this investment? This deals with the “financing decision” and addresses the relative advantages and disadvantages of applying debt, paying with cash, or issuing equity. This often includes conversations with our accountant or banker.
- Third, how and when is the appropriate time to divest – sell – the property, or to harvest timber to maximize profits? We refer to this set of questions as the “exit decision,” which includes how to evaluate “woods run” or “special” prices in a given local market.
When evaluating the risk and potential returns of investments in public timber REITs, we start with an ROV framework, applied in this order:
- Regulations: is the firm in danger of losing its REIT status with the IRS? Will changes in tax laws, if any, affect the attractiveness of owning REITs?
- Obligations: is the firm generating sufficient cash for key obligations? (Think “debt and dividends.”)
- Valuations: how are assets valued and performing relative to its current share price and over time?
The framework acts as a systematic screen that first addresses key regulatory and credit risks, followed by relative return potential and attractiveness. Does the firm’s share price imply that it’s under or over-valued relative to the value of its assets and future prospects? When valuing timberlands and timberland-owning REITs, estimating value is a function of estimating and, ultimately, discounting cash flows. If a timber REIT exhibits strengthened cash flows over time, this leads to expectations of higher distributions, high values and higher share prices.
The biggest risk for a potential investor is paying too much to get in. The biggest risk for a current investor is sub-optimizing the assets under management. The price of an asset can vary from its fundamental value over time because of uncertainty associated with future cash flows or from different investment theses and priorities. In forestry, financial analysis supports our efforts to estimate this value while making decisions related to the optimal (economic) rotation, when to harvest, how to manage (silvicultural), and the buying and selling of timberlands.
This guest post is courtesy of Brooks Mendell, Ph.D., President and CEO at Forisk Consulting, a Georgia-based firm that specializes in forest-industry, timber-REIT, bioenergy, and timber-market research. For more information, visit www.forisk.com.