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$CUT(ting) the $WOOD
Successful investing is about capital preservation as much as it's about generating gains. If the market loses 15% and you return 0%, you’ve actually won. The key to investing through recessions is to preserve your capital first, and grow it second. Preservation is growth, because it enables growth. Bearing this in mind, it’s impossible to avoid talking about sectors that seem boring.
Yesterday we mentioned Industrials and Materials as a “recession-proof” sector, citing its relative outperformance against the S&P 500, and the strength of its constituent subsectors. Importantly, we expressed a view that Timber and Forestry is a much stronger subsector than analysts will have you believe.
So what’s so special about timber? The forest products industry was once integrated, with firms owning all of the components of the process: trees, pulp mills, and sawmills. More recently there has been a separation of those processes, which is good for investors.
A key concept of timber fields is rotation, or the length of time from planting to harvesting, which can last from 25 to 80 years depending on the tree. Those rotations are also closely tied to futures markets managed by the CME, which will soon offer smaller contracts on random length framing boards from a variety of regions, making harvesting and selling more convenient.
There are three ways to own timber. First, by owning stock in timber-producing firms like Weyerhaeuser ($WY). Second, by owning the two major timber ETFs $WOOD and $CUT. The two ETFs have a combined market value of roughly $300 million, track different indexes, and have returns that can differ substantially. And third, through the aforementioned random length lumber contracts on the CME. Some traders believe the new contracts could increase trading volumes tenfold, inevitably growing the NAV of ETFs and Timber related companies.
Timberland offers three key benefits. (1) returns that have a low correlation with traditional stocks and bonds; (2) flexibility in the timing of its harvesting to match market conditions; and (3) timber may serve as an effective inflation hedge.
The biggest risk is that timber values are tied to cyclical industries like housing that can experience significant downturns. However, homebuilders are continuing to deploy stock effectively (housing starts are around their mean-level of 1.6MM per month), and demand for new homes hasn’t completely eroded. Some homebuilders, like other market participants, still believe that rates will be cut moving into a 2023 recession.
While it isn’t a subsector that tends to feature explosive growth, here are some key return facts about timber. Keep in mind, that although ETFs might have larger drawdowns, it isn’t reflective of timber values in the broader market.
- Low historical volatility relative to equities.
- An attractive Sharpe ratio of 0.6.
- A very mild maximum drawdown of -6.5%
- A large one year lag in recognizing changes in value
- A tendency toward long-term mean revert
Only Degenerates and its analysts have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.