Based simply on what we know and where we are, we can identify value-destroying exposures and viable empire building opportunities that could disrupt the forest industry as we know it.
The first post in this series summarized the current economic situation in the U.S. and implications on timberland investment valuations. The second post introduced a simple approach to organize our thinking around the magnitude and duration of potential disruptions on forestry or mill investments, good or bad. This third post localizes the approach and applies it to sort a broad range of potential disruptions for developing business and investment strategies.
Local or Global?
The previous post referenced the limitation of simply asking our two screening questions (“Big or small? Long or short?”) when evaluating potential disruptions. Some events affect businesses or investments locally, but not the entire industry or market and vice versa. Big changes can affect us locally, globally, or both. As we have long taught and written, timber markets are uniquely local. For strategy development, we want to specify the context of the disruption to best understand its absolute and relative risks, whether positive or negative.
Finance offers a useful analogy by distinguishing between systematic and unsystematic risks. Systematic risk, also called “undiversifiable” risk, refers to exposures and potential losses affecting the entire market or system, such as interest rates and recessions. Unsystematic risk includes “diversifiable” exposures specific to a given firm or industry. We have little, if any, control over systematic (global) risk, while unsystematic (local) risk can be mitigated and managed through diversification, insurance and other approaches.
Consider our example from the previous post of Hurricane Katrina, a Category 5 event. The summary evaluation of the disruption concluded:
- Big or small? Big event locally; devastating to some forests and damaging to many.
- Long or short? Short-term increase in supplies; negative impact on value.
Figure 5 further refines this assessment of a major hurricane and reinforces the point that, while severe and impactful, it remains an operational exposure and requires a tactical response rather than affecting our strategic view of the sector.
Figure 5. Ranking Disruptions: Example of Hurricane Katrina
This high-level framework prioritizes the relative importance of potential disruptions. It separates the local, tactical issues from the global and strategic. Now we apply this approach to a broader set of potential disruptions.
Ranking Disruptions for Forest Owners
All timberland investment strategies can basically be summarized as efforts to match, model and exploit cash flows from wood markets and forest supplies of varying levels of maturity over time. When investing in U.S. timberland, we either invest in established forests with mature wood markets, or we invest in areas that require development of the forests and/or wood markets. And we must evaluate potential disruptions relative to the specific assets, market and strategy under consideration.
Our current research into forest industry and timberland investment strategies includes analysis of over 30 actual and potential disruptions relevant to physical, economic, legislative, technological, market, and geopolitical exposures. The work combines qualitative and quantitative analysis, and the application requires meaningful discussions and scenarios of whether or not an impact applies to “our” firm or assets in “this” market or sector.
Figure 6 summarizes an analysis and ranking for ten selected disruptions based on a forest owner point of view (as opposed to a wood user or manufacturer). This ranks first for global (strategic) exposures and second for local impacts. Each assessment has a “story” that changes based on the profile, objectives and assets of the firm.
Figure 6. Ranking Ten Select Potential Disruptions (Forest Owner View)
Even at this level, the relative ranking highlights critical themes.
- Tax and environmental policies matter. Overall, forestry is a strategic asset and a low margin business that requires long-term commitments. Changes in how forest management costs get expensed or capitalized materially affect the profitability and attractiveness of these investments. And environmental policies that recognize forest benefits without constraining property rights can enhance these values materially.
- People matter. Without people to work and to consume, forests have little economic value. Anything that slows or hinders the growth of the workforce or of a healthy populace, materially reduces the net cash to owners, the long-term demand for manufacturers, and their ability to run a business.
- Technology matters. Technology has explosive potential as a value creator. Consider that pulp manufactured from pine as we know it did not exist 100 years ago. Today, fluff pulp mills have among the strongest ability-to-pay for wood in North America. The number of patents and applications for wood fiber continues to grow.
- Demand matters. From an economic standpoint, trees have no value unless nearby mills exist to buy them and convert them to value added products.
Also, time as a strategic idea remains malleable. Discussions with clients and colleagues about potential disruptions reinforce the arbitrary nature of “short” and “long” term in timber. The space and time required for impacts to realize themselves in forestry is beyond the immediate quarter or year (with respect to what the asset can and should do). Value is created consistently over long periods of time, and to the extent we put arbitrary 1 or 5 or 10-year time horizons on the asset, we constrain its performance and change our understanding of the associated risks.
People mistake forest investments as allocating capital to trees when you’re really betting on the work, needs and preferences of people. We find that most of the frictions identified in a strategic analysis are man-made: trade disputes, tax policy changes and immigration inconsistencies. As a result, for strategic planning, we prioritize the tracking, aggregation and analysis of confirmable physical facts to test ideas and decisions. In turn, this provides additional fuel for applying the questions and approach outlined in these posts to strengthen the strategic positioning for investments in timberland and forest industry mills.