Stumped No Longer

10/28/2009 9:34 am EST


Andrew McHattie

Editor, Investment Trust Newsletter

Long-discounted Phaunos Timber Fund shares are up sharply of late. But its trees are still a great inflation hedge, writes Andrew McHattie in Investment Trust Newsletter.

Collins Stewart published a fascinating note on the Phaunos Timber Fund (LSE: PTF) on October 5th, subtitled “psst … want to buy 88,000 acres of forest for nothing?” The note says that timber has delivered exceptional returns, with a high degree of consistency, over the long term. Given its low volatility, defensive characteristics, and low correlation with other investments, Collins Stewart believes it has a key role to play in improving portfolio diversification. The note adds that the current rating on the shares—trading on a 40% discount to the net asset value as [of] June 30th—is an anomaly. [Shares have rallied more than 30% this month; spurred by the Oct. 13th announcement of a review intended to "address" the steep discount to net asset value—Editor.]

The brokers say that since its inception in 1987, the compound annual growth rate of the NCREIF Timberland index is 14.7% versus 8.6% for the Standard & Poor’s 500 Index, with low volatility. Over the past 22 years, this index has fallen in only one year, with just five negative quarters out of 90. Returns have been lowly correlated with those of other asset classes. The unique characteristic of trees, in that they grow, regardless of underlying economic conditions, has been a key driver.

Meanwhile, when timber prices fall (as they have done in the past year), the manager can simply defer harvesting, with value “stored on the stump,” and indeed returns are compounded by in-growth (whereby trees turn into higher value products as they mature). With recent actions by the authorities likely to re-ignite inflation, timber has proved to be an effective hedge against inflation over the long term.

The managers of Phaunos Timber, FourWinds Capital Management, have a rigorous due diligence program and since [their] launch in late 2006 (the trust then greatly expanded in 2007), they have adopted a conservative approach towards new investment—being a cash buyer in these capital-constrained times has worked in their favor. At the end of June, the total portfolio commitment was $698 million, of which $212 million was drawn down. Drawdowns are now expected to accelerate, with most of the cash invested by mid-2010. The aim is to construct a highly diversified portfolio, by region, species and age, and the focus is on the less developed markets of Latin America, China, and Africa, where the company is more likely to access prime properties in a less competitive environment.

“Somewhat inexplicably,” the note says, “the market capitalization is currently less than cash on the balance sheet: Although the fundamentals of this emerging alternative asset class are compelling, an anomalous rating makes Phaunos an even more attractive investment. We would note that the market capitalization of $296 million is less than the $333 million invested in cash and treasury bills at the end of June.”

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