The Relative Returns from Timber Investments
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Since I began I have been tempted by a number of different types of investments at different times throughout my career. One of the most interesting for me that I’ve looked at recently is timber. My reasoning for turning my eye in this direction is the obvious instability of the western banking system and the unsustainability of the government fiscal positions in the U.S., Japan and the E.U. periphery, though, frankly, Germany’s position does not fill me with a tremendous amount of enthusiasm either. In reviewing John Pugsley’s classic The Alpha Strategy, led me to look at the returns on timber.
The basic argument for timber runs something like this: for as long as the sun shines and the rain keeps falling trees will grow at a relatively constant rate. That rate is between 6-8% per year. Assuming constant prices for wood products in all of their various forms that is a pretty solid return. The average inflation rate in the U.S. over the past 25 years has been just under 2.9%, still a good real return on investment.
Roots to Branches
There is only one real problem with that view; it’s wrong. The real prices for timber over time, especially pulpwood prices, have outpaced inflation by a substantial margin. Pulpwood prices have more than doubled since 1999. Actually, since 2007, timber prices have recovered completely and then some since the housing market in the U.S. revealed itself as one of the great bubbles in history. Currently, the demand for new housing in the West is still moribund and does not look like it will recover any time soon. The latest data was awful. New homes sales in the U.S. dropped to 4.48 million, down 2.8% year to year. Inventory stands at a more than 6 month supply, up 4.3% YoY. This is not at all surprising since the first-time homebuyer tax credit has ended which was one of the main factors propping the market up. Foreclosures are rising and social security revenue is falling, a clear sign that wages are deteriorating.
I have seen numbers of timber returning on average more than 14% since 1971. I could not confirm that for this article but I did grab the data from the largest REIT in the U.S., the NCREIF Timberland Index. The NCREIF REIT is invested primarily in timberland and not a mix of land, mills and paper product manufacturers like many of the timber ETFs out there, like Plum Creek Timber Company Inc. (NYSE: PCL), which is only 42% exposed to timberland directly. For this reason their returns are not a good proxy for the return on the growing the wood itself as there is a fundamental difference between the costs structure of running a lumber mill and a tree farm. The NCREIF data is reported quarterly and the data goes back to 1987.
Returns By the Board Foot
For a comparison I then looked at the returns from the S&P 500 SPDR S&P 500 Index Fund (NYSEMKT: SPY), compounding it quarterly based on a 55 day moving average of the price. The NCREIF REIT returned on average per quarter 3.18% vs. 2.52% for the S&P 500, this takes into account reinvesting dividends quarterly, similar to the NCREIF. So far so good right? A $10,000 investment in both at the beginning of 1987 would then have grown to $228,584.75 for the NCREIF vs. $113,317.59 for the S&P 500, a relative difference of 202%.
Leaving out the crash of 1987 the data does not improve all that much with the NCREIF still outperforming the S&P by 89%. The data gets even worse for stocks when one considers the relative volatility of stocks vs. timber because the relative difference of the quarterly returns of stocks to timber is also about 3 to 1. In other words the S&P 500 is three times more volatile than that of the NCREIF. This is not to say that the NCREIF’s returns are the model of stability. They aren’t. The standard deviation of the quarterly return is 39% higher than the average return, but the S&P’s standard deviation is 370% higher. Any instrument with that kind of volatility should not be considered an investment but rather a trading vehicle, which is why passive index investing, in my mind, is a long-term losing strategy.
So, with that in mind I went ahead and calculated the actual returns of that original $10,000 with the quarterly data from both investments. The final numbers are $211,559.21 for the NCREIF and just $88,040.81 for the S&P 500. Since the Dot-Com bubble burst in 1999 an investment in the S&P 500 would have returned 11%, all of that coming from dividend reinvestment while the timber investment would have more than doubled. This is just how powerful the bear market in stocks has been in the U.S. Equity markets. When one factors in the change in prices since 1987 the real value of your investment has been cut in half. Since 2007, where my example investment peaked for the S&P 500, it would have lost 20% compared to a 9% gain by the timber investment when indexed for inflation.
I think, from this data it is very clear that any attempt to argue the long term effectiveness of a buy and hold strategy for equities is a bad strategy. It is not one where risks are minimal and volatility is low. Timberland is the closest asset class I have found so far that fits that description.
The Motley Fool owns shares of Plum Creek Timber Co., and has the following options: short MAY 2012 $33.00 puts on Plum Creek Timber Co., short MAY 2012 $33.00 puts on Plum Creek Timber Co., and short MAY 2012 $38.00 calls on Plum Creek Timber Co. Peter Pham has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.