Author: S.C.
April marks the 1-year anniversary of the launch of the Timber Finance Forest-Based Construction Tracker. The tracker delivered a performance of +5.35% since launch, net of fess, as of end of April 2024.
1. Solid performance in a challenging macroeconomic environment
The performance over the last year was solid despite the fact that during the period Western economies, where the tracker invests, have gone through a complicated period characterised by
- Normalising but still relatively high inflation in both Europe and North America
- A strong, in some cases extraordinary, slowdown in the European construction sector
- A moderate slowdown in the U.S. construction sector
- Shifting market expectations with respect to the possible normalisation in monetary policies
It is interesting to look at the drivers of performance. Right after the launch, long-term interest rates started to rise, with the U.S. 10-year yield rising from 3.5% in April to 5.0% at the end of October. And this, despite the fact that inflation had rapidly come down and was starting to stabilize slightly above 3%. The rapid rise in long-term interest rates led to some panic and selling across the equity complex. The homebuilding sector was not immune from the sell-off, and the tracker corrected sharply, also for fundamental reasons: rising long-term interest rates have a major impact on housing affordability and slow down the construction sector.
Figure 1: Tracker Performance and US long-term interest rates. Sources: Bloomberg, ZKB.
After the Federal Reserve decided at the end of October to keep interest rates at the same level for the second consecutive meeting, equity markets rallied on expectations that monetary policy was going to finally normalize. Yields fell back below 4% towards the end of December, and equities kept rallying until the end of the year.
2024 started on a different tone, with market sentiment shifting back to worries that rates would stay higher for longer, as the normalisation of inflation rates decelerated. The U.S. economy stayed very strong despite widespread expectations for a slowdown and labour market weakness. Such strength is per se not a bad thing – the homebuilding sector is cyclical and an expanding economy is a positive fundamental driver. However, what the market has been most recently worried about is that if the Fed has to tighten further, this could ultimately have a negative impact on the U.S. economy and the housing market. The latest readings, however, continue to show resilient U.S. construction activity. While geopolitical risks abound and can lead to higher inflation, rates could rapidly fall again if inflation continues towards the 2% target set by Western central banks.
The situation in Europe has been different, with stagnating economies and particularly weak construction markets. As already discussed in previous reports, construction activity in countries such as Germany, Sweden and France has contracted and a reduction in interest rates would be needed to reinvigorate the sector. It is impossible to predict how interest rates will move, as this depends also on factors far beyond investors’ control, such as geopolitical and other exogenous dynamics in relation with energy markets and supply chains, as we have experienced in the 2020-2022 period. What we already see, however, are major demand/supply imbalances in several European housing markets, plagued by housing shortages [1] (in terms of quantity and/or quality), due to ineffective policies and immigration trends [2].
Figure 2: Building Permits in Germany (LHS) and the United States (thousands, RHS). Sources: DESTATIS Statistisches Bundesamt; U.S. Census Bureau and U.S. Department of Housing and Urban Development, retrieved from FRED, Federal Reserve Bank of St. Louis.
[1] https://commonslibrary.parliament.uk/research-briefings/cbp-7671/
[2] https://www.bdb-bfh.de/downloads.html?file=files/redaktion/bdb/froese/Studie%20zum%20Wohnungsbautag%202023_Final.pdf
2. Portfolio evolution since launch
While we cannot predict the future, what we can do as investors is to assess which companies have the best growth prospects within our investment universe and balance risks and opportunities relative to the price that the market is trading at. As described in this article, the companies in our investment universe have different business models and growth profiles, which we consider as part of the long-term investment strategy.
The strategy is based on the Timber Finance Carbon Capture and Storage Index, which tracks listed companies in Europe and North America with a strong focus on timber construction and durable wood products that store carbon over longer time horizons. The tracker invests in companies covering the whole timber construction value chain, ranging from large forest owners to real estate developers that are particularly strong in timber construction.
Figure 3: Timber construction value chain. Representation by Timber Finance.
The portfolio is rebalanced on a periodic as well as an ad-hoc basis, while maintaining broadly the exposures as in our proprietary index. At times we may deviate from the index with regards to certain positions, for reasons such as liquidity risk management, avoidance of excessive transaction costs, and active views on certain companies with respect to their long-term growth prospects. During the last 12 months, four new companies were added to the portfolio (as well as the index) :
- Boise Cascade, a U.S. buildings products wholesaler that is also vertically integrated through manufacturing of engineered wood products;
- BlueLinx, a U.S. buildings products wholesaler with a strong position in commodity and engineered wood products coming from a successful company turnaround;
- Husqvarna, a leading manufacturer of forestry, gardening and construction equipment, with a strong electrification strategy aimed at decarbonising the value chain at Scope 3 level;
- James Latham, a family-run U.K. distributor of building products with a focus on durable wood products, a robust track record of growth and a particularly solid financial position;
- Trex, a U.S. manufacturer of composite wood-plastic building products for exterior applications, with a very strong track record of growth and profitability and a very interesting sustainability profile supporting the circular economy.
Trex and Boise Cascade, added in September 2023, have been among the best performing stocks in the portfolio. Together with the other best performing stocks, mostly American, we were happy to take some profits at the 1Q24 index rebalancing date and add more European exposure – in particular with James Latham at what we consider an interesting valuation level for a company with a strong balance sheet and operating in two undersupplied residential markets such as Britain and Ireland.
Over the period, since launch, predominantly North American stocks – in particular engineered wood products manufacturers – contributed positively to performance, but European stocks were also a net positive contributor.
3. Looking forward
Despite the macroeconomic challenges described above, there are reasons for medium- and long-term optimism.
We have to recognise that the road ahead might be bumpy, in particular if inflation fails to recede and interest rates remain high (or go even higher) for longer – the European construction sector is already under stress and the U.S. resilience may fade in such a scenario. Investors need to be aware that they may have to go through volatile periods.
At the same time, there are important supportive drivers to consider:
- The strong slowdown in European construction exacerbates already existing housing shortages in countries such as Germany, Britain, Ireland, Sweden or even France, creating even larger opportunities for the companies that will survive this contraction phase.
- The U.S. housing stock has been ageing while high interest rates have inhibited both home buyers and home sellers (the latter who would have their mortgage rates reset when buying a new home) – a normalization in interest rates should reactivate existing home sales and repair & remodel activity.
- Forest owners have been working on multiple new ways to monetise their timberland asset base, including carbon credits and renewable power as well as carbon capture and storage leases.
- Mass-timber construction, while still a niche, especially within listed companies, creates new markets (high-rise commercial, multi-family) for wood products manufacturers.
- The decarbonisation of the building sector requires multiple solutions. Both European and American policies support low-carbon construction and renovation. Timber can be part of the solution, addressing embodied carbon at the construction/building material level and being explicitly included in certain countries decarbonisation strategy [3]. It can also mitigate operating emissions, for example through wood-fibre insulation and the insulating properties of mass timber (see article here).
[3] https://www.bafu.admin.ch/bafu/de/home/themen/wald/fachinformationen/funktionen_leistungen/wald–holz-und-co2/wirkung-der-holzverwendung.html; https://www.ecologie.gouv.fr/sites/default/files/20030_DP_RE2020_A4-1_pdf_accessible.pdf
4. Disclosures and Conflicts of Interest
Some or all the companies mentioned in this report may be included in the Timber Finance Forest-Based Construction Basket tracker and are part of the Timber Finance Carbon Capture & Storage Index. Timber Finance Management and/or the Timber Finance Initiative may have commercial relationships or be in discussions with some of the companies mentioned in this report. Specifically, Stora Enso is a member of the Timber Finance Initiative association.
Please note that this research is prepared for information purposes and targeted to institutional investors in Switzerland. It does not represent investment advice and does not take into consideration the individual requirements, risk tolerance and goals of an investor. Recipients who are not Swiss institutional investors should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents.
The information presented in this report is obtained from several different public sources that we consider to be reliable. Nevertheless, we cannot guarantee the accuracy of the presented information. The information used may change quickly and we are not committed or obliged to modify the reports base on new information. The opinions and views expressed in this report reflect those of the author at the point in time of its compilation and may vary at any time. Valuation methods like DCF and any other analysis or expert judgement do not provide any guarantee that the target price or fair value will be reached, for example because of unforeseen changes in financial or economic conditions.
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