In 1990, Nobel Prize-winning economist Daniel Kahneman and two colleagues published a study documenting how we can “overvalue” things we already own (D. Kahneman, J. Knetsch and R. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem,” The Journal of Political Economy, December 1990). This “endowment effect” applies to investors who may hold on to assets beyond their strategic relevance, failing to account for true opportunity costs, and missing out on opportunities to reallocate that capital to investments that better meet the needs of the portfolio.
Recent reporting in The Economist magazine also highlights the powerful incentives investors have to stand behind the original return assumptions for their investments (“Interest Rates and Investment Returns,” March 2, 2017). Beyond the resistance to accept a potential error, some make the case that low interest rates have reduced borrowing costs for firms, which increase opportunities for outsized returns in the future. In our view, this argument can strain efforts to support return expectations and hurdle rates, and reinforces the importance of firmly making the best investment decisions given our understanding of current values and opportunities.
When we consider investments in forestry (or other sectors), we must look forward. This may require us to adjust our thinking for probable nominal returns.
In forestry, we often struggle with “sunk costs.” When evaluating the current value of our timberland investment against new investment opportunities, we must do so with ice in our veins and clear financial analysis on hand. We, first, ignore sunk costs and, second, evaluate forest investments based on their ability to generate income and returns moving forward. The only time we have complete control over our portfolio is today.
When evaluating timberland holdings, we revisit key questions, such as:
- Do my reasons (my investment thesis) for holding the asset still apply? If the investment helpfully diversifies my portfolio and generates cash as needed relative to other opportunities, then ignore the noise and focus on other issues. Your timberlands are doing what they are supposed to do.
- Have my timberlands reached financial maturity? This is when the owner’s cost of keeping an asset exceeds expected returns. Timber complicates this thinking because a tree is both the “product” and the “factory,” which continues to appreciate over time through adding volume and value. Harvesting trees resets the production process. So we approximate financial maturity in forestry by comparing the annual increase in forest value with the investor’s expected rate of return from other investments of similar risk and duration. If we can do better elsewhere, we should feel compelled to do so. If we cannot, then we should grab a beer, sit on the porch and enjoy the view while we can.
- How do I evaluate short-term opportunities to enhance the performance of this forest asset? Financial analysis often supports the “investment decision” by helping investors rank investment options, evaluate risk, and assess the impact of a given project on the forest. For example, marginal analysis helps assess forest management and intermediate harvest decisions for existing stands. It answers questions of “when to harvest?” and “when does forest management pay?” and “should I accept this ‘woods run’ offer to bring all logs to the pulp mill?” Incremental differences in costs and benefits “on the margin” clarify decision making by focusing on the effects of a specific treatment or harvest decision, not on the entire portfolio or investment.
Click here to learn about and register for “Applied Forest Finance” on March 30th in Atlanta, Georgia. The course details necessary skills and common errors associated with the financial analysis of timberland investments and forest management decisions.