Timber's knotty promise for investors

By BRENT SHEATHER

Not long ago, forestry investment basked in the sort of popularity that residential property now enjoys.

At seminars we learned that by investing a small amount today we could be assured of a huge sum tomorrow.

Timber prices had historically grown rapidly in real (after-inflation) terms, the trees themselves kept growing and, last but not least, a tree's value apparently increased disproportionately as it grew into larger grades with more valuable uses.

All this translated into projected returns of 13 per cent a year after inflation, and higher.

For some perspective, global shares have averaged only 5.6 per cent a year in real terms over the last 102 years.

Throw in tax deductions, a constantly weakening kiwi dollar and an impending worldwide shortage of timber and this was nothing short of investment nirvana.

Accordingly, many Mums and Dads embraced the forestry story and based their own super schemes on forestry partnerships, or occasionally shares in forestry companies.

Unfortunately, it has not turned out quite as the computer models suggested. Wood prices have plummeted over the last 10 years. Meanwhile the exchange rate against the US dollar has risen, as have costs, particularly shipping costs.

The economics of forestry investment have probably never looked worse.

The greenies might call it poetic justice - many of the investors who financed the destruction of thousands of hectares of native bush will be lucky to earn more than savings bank returns on their capital.

The consistent bad news has led to many forestry companies cutting price forecasts, raising cost estimates and making adjustments to better reflect the high volatility in the log markets.

This progressive downward reassessment of a forest's value reached something of a climax last year when Fletcher Forests devalued its trees sharply before putting them up for sale.

The subsequent agreement to sell its huge forest estate to a syndicate of local investors means that a new, low, benchmark has been set for the valuation of New Zealand radiata pine forests.

It might be interesting to see how the investment numbers which that syndicate - including some of New Zealand's wealthiest businesspeople - found attractive compare with what is on offer today for small investors, via forestry partnerships and syndicates.

Valuing a forest might seem a straightforward exercise - count the trees and multiply by the price of wood - but it isn't that easy. Forests are "long duration" assets which means that the cash flows or profits they produce generally don't occur immediately - it takes 25 years or so to grow a tree to maturity. That means we first need to estimate the future price of wood and, second, we have to work out what the future cash flows are worth in today's dollars.

Working out the future value of wood might seem easy - just assume the price trend over the past five, 10 or 20 years continues.

Problem No 1: the price trend of sawn timber, for example, has been very volatile. Over five years the trend has been down but over 20 years it has been up. Which of these very different growth rates is appropriate for the next 25 years?

Problem No 2: the exchange rate against the US dollar has been jumping around.

And if you thought determining the cash flows was imprecise, what about trying to work out what return adequately compensates investors for the risk of investing in forestry and for having their money locked up for all those years?

Whole forests have been consumed by the writings of experts trying to answer those questions.

No wonder forestry valuations can vary widely. There is yet another potential bias: if you were selling your own forest, what figures would you use?

Personally, I would be trying to maximise the sale price so I would think that, for example, the 20-year growth rate was appropriate.

And if I had a valuation done a while back when prices and exchange rates were more favourable I wouldn't be rushing to get it updated.

But how many Mums and Dads, when looking at a forestry proposal, compared the alternatives on the basis of their forecast internal rate of return assumptions and so on?

Or do most decisions rely on gut feeling, the quality of the colour pictures and whether the salesperson appears trustworthy?

The chances are that, even in the unlikely event that the key variables were correctly outlined in the sales process, Mum and Dad merely smiled and nodded.

Because lumber prices have plummeted and the exchange rate has risen, the simple fact is that existing forests aren't going to be worth as much as originally thought and investment returns will be much lower than forecast 10 years ago.

So much for the past. What about forestry as an investment today?

Specifically, given the price that Fletcher's zillions of hectares of forests sold for, how do the valuations of current offerings of forestry partnerships compare?

The short answer is that the buyers of Fletcher's assets appear to be getting a much, much better deal than your average forestry partnership offers. Indeed, given the poor economics of forestry today, there aren't a lot of new forestry investments available.

Perhaps the best way of appreciating the huge gulf between the latest valuation of New Zealand radiata forests and what the partnerships offer is to compare the forecast internal rate of return of the partnerships with the "discount rate" used to value Fletcher's forests.

Fletcher Forests' valuation, as set out in its June 2003 annual report, uses a real discount rate of 9.75 per cent. What this means is that - based on the assumptions used - someone buying Fletcher's forests for the price at which they were valued in the report could have expected a real return of about 9.75 per cent.

In contrast, the most likely scenario for one forestry partnership now being marketed projects a mere 5 per cent return, before inflation and before tax.

Another comes up with a nominal, pre-tax return of 7.8 per cent. A third projects a return of 7.1 per cent, which sounds reasonably encouraging until you read that their analysis uses an exchange rate of 59USc. Today it is 64 USc. From the buyers' point of view, the Fletcher deal looks infinitely better than what is on offer via your average partnership.

Unfortunately, Fletcher (now renamed Tenon) is getting out of forest ownership, so only the consortium doing the takeover can invest in forestry this way.

What does this all mean for people who bought 10 or 20 years ago on the promise of 10 to 15 per cent annual returns?

Don't dwell on it and keep saving is the likely answer - that forestry block may sell for a lot less than you originally expected.

Of course this could be the low point in forestry values; often a big transaction marks the low or high in a market.

Lumber prices may recover and the New Zealand dollar may fall but, just in case they don't, the best bet for existing forestry investors is to understand what rate of return is likely given today's reality And as far as new money is concerned, diversify.

* Brent Sheather is a Whakatane investment adviser.