Brent Sheather: Pension funds like our trees

If you asked 10 financial advisers which investment class was most likely to underperform in the medium term, forestry would probably make it onto many lists. It seems like just about every listed company that owns a decent stand of trees in New Zealand has sold them or is trying to.

Last year Fletcher Forests sold its entire forest estate, Carter Holt has said that a big chunk of its radiata empire is on the chopping block and Evergreen is following suit.

Similarly, 10 years ago forestry partnerships were hugely popular. That market, too, is deathly quiet.

The track record of the listed forestry sector makes for depressing reading with Fletcher Forests and Evergreen turning $1000 into $225 and $350 respectively over 10 years.

These bad vibes are likely to get the contrarian investors' whiskers a-twitching. When everybody hates something its often a great buy signal.

Indeed, outside of New Zealand a number of very large and experienced institutional investors are getting quite excited about forestry in that they believe that it can, as part of a diverse portfolio, solve a few tricky long-term investment problems.

For the members of the United Kingdom National Association of Pension Funds (NAPF) their biggest difficulty is reconciling the increasing longevity and investment expectations of pensioners with the low returns from their traditional hunting grounds of bonds and shares.

Pension fund managers are desperate to buy long-term, low-risk assets which they can match against their long-term obligations to provide pensions and annuities.

Once a year the NAPF members, who manage about 650 billion ($1670 billion in assets - that is around 50 times the size of the NZX - converge on Edinburgh, Scotland, for their investment conference.

Forestry investment was one of the features of the programme along with sessions on hedge funds, property, gold and commodities.

Consider the pension fund managers' predicament - in the UK interest rates on long-term Government bonds have been forced down as funds have been required by law to have high weightings in safe long-duration assets.

In fact, in response to this demand the Government had announced the UK treasury would soon be issuing 50-year Government bonds.

This bit of good news apparently worked the NAPF crowd into a high state of excitement. The session on forestry presented by the United States-based Hancock Timber Resource Group and Fidelity Pensions Management also went down rather well.

One does not have to venture too far into their presentation to see why the pension funds are giving forestry such a warm reception.

The first graph shows that, on the basis of long-term historic returns, forests stack up pretty well against the traditional asset classes, offering better returns than US shares over 30 years, with less risk.

The Timber Index representing US forestry returns has apparently returned around 13 per cent per annum in 1974-2003 compared with around 11 per cent for international shares. But returns are only part of the attractions of forestry. Equally important to the long-term provider of pensions is forestry's low correlation with share returns and positive correlation with inflation.

Pension fund managers are afraid of having to sell when the price of everything is low, so the fact that forestry and share values have moved somewhat independently is seen as a big plus for forestry.

Further into the presentation is a graph that could well send a shiver down the spines of former Fletcher Forest shareholders. This suggests that owning NZ forestry assets over the long term has not only been a smart move it has been better than owning US forestry assets.

While being more risky than those in the US, New Zealand forests have more than compensated for this with an almost a 50 per cent greater historic real return, at around 10.5 per cent a year.

Ominously for former Fletcher shareholders if you read the company's last forest valuation report you will see it used a real discount rate of 9.75 per cent.

The final price paid for the forest was close to valuation, which suggests the buyers will get a real return of 9.75 per cent. That's 9.75 per cent plus inflation of say 2.5 per cent.

Compare that with the 3.3 per cent real on offer from NZ inflation indexed bonds or the historic, and highly unlikely to be repeated any time soon, average of around 7.0 per cent real from international shares.

For the NAPF members who must reconcile low returns from bonds and shares with the reality of lower pension payments, promises of 11 per cent annual returns from hedge funds or active equity managers cut little ice. They look at the UK bond market and see 10-year Governments yielding a meagre 4.5 per cent or so.

Compared to this, New Zealand forestry's 9.75 per cent real discount rate must look like a godsend.

It will take many years to find out whose view of forestry is correct, the sellers or the buyers. But local shareholders need to remember some of the purchasers of New Zealand forest assets have extremely good track records.

Even an asset with a poor outlook can fall in price to such an extent that it can generate high returns in the future. Why were we selling all those forests again?

* Brent Sheather is a Whakatane-based investment adviser.

Falling returns

Market value of $1000 invested in May 1995

* Fletcher Forests $225
* Carter Holt Harvey $781
* Evergreen Forests $350