Why I’ve Passed on Keweenaw Land Association (so far)
Trey had a good question in response to my Keweenaw Land Association article:
“Are you willing to share your reason for not investing at this time?
My first pass analysis leads me to also not choose to invest at this time. For me, it’s a matter of opportunity cost. Simply beating the S&P500 is insufficient. Since the S&P500 is projected to return much lower than its historic rates of return, my current opportunity set is much better.
That’s really always been my hesitation with owning something like timberland. I’ve been interested for diversification reasons, but in order to achieve double digit returns over long periods of time, you have to really buy at a large discount.
While I agree with the analysis that downside looks limited here, I struggle to come up with a scenario where a long-term owner (10+ years) could earn 10%+ returns. I understand though, that if the company is sold in a shorter amount of time for a premium, you could earn that hurdle rate over a shorter period of time. With that said, I think purchasing below $75-80 per share would offer the additional 2%/year return that I need for a 10 year holding period.
Sure. So, it’s easy to imagine a scenario where a long-term holder of timberland makes 10% plus returns. All you need is high inflation. Timberland’s long-term returns should be driven by: the cash flow produced by the annual harvest, the biological growth, the rate of inflation, and then also there tends to be some return – at least historically this has been true as countries develop – of competing uses for the land. This last factor is not important in Upper Michigan. But, there are places in the U.S. where it is. There’s nothing nominal about any of the factors driving returns in timberland. All the factors driving returns are real factors. So, if you had 6% inflation or higher – it’s likely timberland would return 10% or more a year for as long as that situation continued. You can check the historical record for periods of high inflation in the U.S. and see how timberland performed versus stocks, bonds, commodities, etc. during that period. The answer is good.
Over periods as short as 5-10 years, the factors driving timberlands returns would really just be the purchase price you were getting in at (if you’re buying a timber stock – this means both where we are in terms of timberland pricing and where the share price is versus the appraisal value of its timberland) and then whether demand for housing increases while you hold the timber stock. There are other uses for timber, but the most cyclical use for the more profitable trees is housing. So, when you see a low projected return for the S&P 500 versus a high projected return for timberland over the next 5 or 10 years, what the forecaster is really saying is: stocks are relatively more expensive than timberland right now, home construction is relatively low right now versus what it’s going to be, and inflation is relatively low right now versus what it’s going to be.
The reason I decided not to invest in Keweenaw has to do with the discount to my appraisal value. In the article I wrote, I tried to be conservative. You’re right that if you’re buying timberland at 100% of its market value your returns aren’t going to be impressive if you hold the stock for long. However, it’s easy to underestimate the combination of buying a stock at a discount to its asset value and those assets compounding in value while you own it.
Let’s say you were somehow 100% confident of two things: you were buying Keweenaw’s timberland at a 20% discount to what it’s really worth and that timberland would return 6% a year for as long as you owned it.
In that scenario, you would make 10.8% a year over a 5-year holding period or an 8.4% return over a 10-year holding period or a 7.6% return over a 15-year holding period.
That may not sound impressive. But, consider a few things. One, I usually sell a stock within 5 years. So, if the value gap closed faster than 5 years – and it often does in value stocks even without proxy battles, etc. – you’re talking about returns well above 11% a year.
Two, I can’t be 100% confident that timberland will return 6% a year as an asset class or that Keweenaw’s timberland is really worth at least $125 a share (this is a 20% margin of safety if you can get shares around $100 yourself). But, those are not high hurdles to clear. I couldn’t get a value quite as low as $100 for the company even using the absolute most conservative estimates I could come up with for the timberland (like an immediate tax hit). It really might be worth $125 a share instead of $100 a share. I certainly wouldn’t be more sure of a $100 appraisal than a $125 appraisal.
So, if you have a holding period of 5-15 years you’re expecting returns of 7.6% a year to 10.8% a year. I’ve made good annual returns in stocks that only return 7% to 11% a year over 5-15 years, because I sold them sooner than 5 years.
It’s just difficult to find assets you have any kind of confidence will return 7% to 11% a year right now. So, you can wait in cash till you find situations where you do have confidence. You can wait in the stocks you already own but know won’t return that much (like I’m hanging on to BWX Technologies despite it now being an expensive stock). Or, you can buy things that only look likely to return 7% to 11% a year as long as those things seem safe and certain.
My reason for not buying Keweenaw Land Association isn’t that timberland is a low returning asset. It’s a good asset. And I’d love to own it at a 35% discount to my appraisal value.
In the case of Keweenaw: maybe my optimistic appraisal value might have put the current stock price at more like a 25% or 20% discount to appraisal value. And my pessimistic appraisal value might have put it at more like a 0% discount to my appraisal value.
This is a moving target. The board gave us some information about the appraisal they got after the timber cruise. But, it’s not as full as the information I’d normally like to see. And they were using that information to score points in their proxy campaign. If you take the last appraisal value we had 3 years ago and try to incorporate information about the results of the timber cruise – you can easily end up with an estimate of the fair market value of this timberland (especially if we’re not talking about selling the whole company right away) of well over $100 a share.
In other words, I felt Keweenaw really might only be worth $100 to $125 a share instead of $150 a share. If I felt sure it was worth $150 – I’d buy it. I have no problem buying an asset that might only return 6% to 8% a year if I’m getting in at two-thirds of its face value so to speak and it’s a solid asset in terms of inflation protection, the risk it’ll return less than 5%, etc. For example: I’d be interested in a super predictable insurer with an 8% return on equity if I could get the stock at 0.65 times book value. If you hold such a stock forever you’re only going to make 8% a year. It’s not an ideal long-term holding. But, if that 8% return is sure and the discount to book value is sure – it’s a pretty good combination.
So, the issue here for me is that I just wasn’t sure I was buying in at anything like a 35% discount to what the stock’s worth – and I try never to touch a stock unless I believe I have that margin of safety.
In the article, I was very unfair to Keweenaw’s timberland in terms of what it might be worth. I did this because this is how I think when analyzing a stock for myself. I start with some pretty tough assumptions, and then if the stock still looks good given those assumptions – I start to get more realistic. But, in the early stages of analyzing a stock, I’m looking for quick ways to eliminate the idea.
I may have made it sound like I think Keweenaw is only worth $100 a share now in terms of the value of the timberland. I don’t. What I think is that there’s no way the timberland is worth less than $100 a share.
I’d recommend Focused Compounding members read what the board has said about the timberland’s value, what Cornwall Capital has said, and then also read the annual reports (it’s one report every 3 years that includes an appraisal of the timberland – I think the last annual report that included an appraisal was 2015) to see the actual values given by the appraiser for the timberland using different methods.
I don’t want to make it sound like the timberland is really worth $100 a share or $105 a share or something like that. It’s not. I was just proving that the current share price can’t possibly be higher than the underlying timberland.
However, the reason I passed on the stock is that the price is $100 or higher while I’m not confident the timberland is worth $150 or more per share. So, there’s not the margin of safety (35%) I like to see.
Talk Keweenaw Land Association (KEWL) with your fellow Focused Compounding members.