Kent Croft, President of Croft-Leominster and CIO of the Croft Funds
Russell Croft, Vice President of Croft-Leominster and Portfolio Manager of the Croft Funds

Manager's Commentary - 1Q 2011

Investment Opportunity: Timberlands

We see timberlands as an attractive long-term investment opportunity. U.S. housing market weakness over the last 5 years has depressed demand for timber end-markets as well as the equity valuations of producers. Although the housing and commercial construction markets have yet to rebound, we believe there are a number of compelling reasons to invest in timber companies now.

Timber assets are constantly growing in size and thus growing in value. As trees grow, both per-unit price and volume increase at the same time; harvestable tonnage per tree increases and the value of each ton increases as larger logs have more valuable uses. Together, these factors, even using depressed current prices, lead to nearly a 10% average annual growth rate in the value of a typical southern yellow pine tree from years 13 to 24. Timberlands have very low capital requirements; all that is required is planting and periodic harvesting. Low capital requirements lead to strong cash flow, allowing good dividend yields across the group. Furthermore, companies including Plum Creek and, most recently, Weyerhaeuser have converted to REITs to improve their tax rate and maximize cash return to shareholders.

Timberlands are also an attractive inflation hedge. An unprecedented amount of money has been pumped into the worldwide economy over the past three years and the danger of inflation over the next few years has grown. Timber, as a "hard asset," tends to increase in price along with inflation. Timberland operators may also exploit the mineral rights (the ownership of underground minerals) they have retained on their land; these rights also tend to appreciate in an inflationary environment. Weyerhaeuser, for example, owns land in the Haynesville Shale, an area known for large natural gas deposits.There is also the potential for timberlands operators to see some long term benefit as providers of inputs for cellulosic biomass, an alternative energy source (Weyerhaeuser currently has biomass-related JVs in place with Chevron, Mitsubishi, and other smaller partners).

We believe that the supply/demand outlook for timber is positive for the long term. While others may hope for a rebound in housing and commercial construction, we acknowledge that a recovery may not come quickly. Over the last year, however, Chinese demand for lumber has partially filled the domestic demand vacuum and is expected to grow briskly for the next several years. The value of North American softwood logs and lumber shipped to China is estimated to have reached $1.6 billion in 2010 compared to $125 million in 2005. There are also positive trends on the supply side of the equation: First, the mountain pine beetle has killed up to 80% of British Columbia's mature pine forest since the mid-1990s and is expanding into Alberta and the U.S. Dead trees rot and become unusable for lumber. This has the potential to ultimately reduce North American supply by 12%. Secondly, Russian export duties on timber have limited the rest of the world's access to this large supplier and buoyed prices for competitors selling to China and other emerging markets reliant on imports.

The risks associated with this investment theme include further deterioration in the housing market, natural disasters in lands owned by specific companies (i.e. forest fires, floods, etc.), and the overall cyclical nature of the end markets that, in a downturn, could lead to lower demand and lower pricing for timber products.

Information in this commentary regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date hereof.  These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that any market forecast or trend discussed herein will be realized. Although the information presented herein is based on sources believed to be reliable, such information is not guaranteed to be accurate and is subject to change.

This material should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before making any investment decision.