Teak Investments – An Intransparent Market
Teak is a prime tropical hardwood and requires 20 to 25 years to grow in a commercial forestry plantation. The plant origins from Asia but today teak plantations can be found in various tropical climates such as Central and South America, Asia and Africa. Teak investments in a plantation are said to be one of the most attractive investment opportunities in the long term, avoiding deforestation of natural prime forest and producing investor returns in excess of 10% and thus are claimed to beat the stockmarket.
When looking at concrete available teak investment opportunities, the individual investor is faced with a jungle of different providers and ‘Best Buy’ options. Doing a proper comparative analysis is difficult, requires too much time and also there is a lack of data making it very hard to actually understand and evaluate the available options. For the non-expert it is nearly impossible to compare the various teak investment offerings and shortly the investor is lost and faced with the only option to trust in whatever he was told.
IRR
Most teak investments highlight the return potential of such investments and use the Internal Rate of Return (IRR) as best proxy (or sometimes also referred as the Return on Investment ROI). The IRR is a subjective forward-looking estimate, derived from expected cash flows. Showing a stream of cash in and out flows does not necessarily mean the financials are put in stone, in contrast those estimations are heavily dependent on the underlying assumptions. For teak, only a few assumptions already define most of the cash flows:
- Price inflation estimate
- Base selling price assumption per m3 of teakwood
- Commercial timber volume of a tree (in m3)
- Thinning schedule
Inflation is difficult to estimate going forward and in some cases historic data is being used for justification purposes. Just to mention, supply and demand dynamics in the future might be very different from the past while a base selling price should correspond to a realistic achievable price currently observed in the target market.
To estimate expected timber volume, the tree diameter is of especial relevance when buying into an existing plantation. However, even if the diameter appears superb, the trees should be straight and should have enough space to grow to maximize the commercial value.
The thinning schedule defines when commercial thinnings are made to take out the bad trees and leave more space for the good ones to grow further (natural selection). In order to have a commercial value, the wood needs to have a certain age. For estimation purposes, setting the thinning schedule earlier on, positively impacts IRR, since the investment horizon is shorter.
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Changing one or two key assumptions in such a model results in significantly different cash flows and IRRs. Thus, more important than looking solely at the outcome (IRR) it is crucial to review the underlying assumptions and potential risks of the investment proposal.
Since all those assumptions are subjective, they can be used to ‘push’ IRR up, showing a more optimistic picture to attract investors than in reality. Thus its important to check that the assumptions are consistent with observations in reality. Without having a proper comparative basis, it will be very difficult for the single investor to challenge and put those assumptions into a context. Teak investments are long term in nature thus require strict discipline in cash management. Compounding effects of incorrect assumptions could have a devastating effect for investors: the company runs short of cash, requires more funding and existing investors could get diluted. Thus from an investor point of view, it is more important to be comfortable with the assumptions rather than the IRR.
Risks
Teak investments have various risks starting with improper site and location analysis, fires can especially damage younger trees while older trees are more resistant to such. Those risks are especially relevant for Greenfield projects after the first years since planting the trees. Passing the first years leads to bigger trees, thus the need for maintenance work reduces and the results are clearly more visible. Thus entering a plantation at a more mature stage should actually show a lower risk when the first years have already passed.
From an investor point of view, as relevant as the technical risks, are the risks of the investment itself:
- Quality of the plantation manager
- Asset being illiquid
- Overpaying at time of acquisition
- Underfunding of the investment
- Legal risks
It is important to obtain confidence that the plantation manager has the capability to undertake the maintenance properly in order to maximize the commercial value of the trees. What helps best here is to look at reference projects and actually check that the underwood has been cut and the branches are pruned.
Private teak investments are illiquid in nature and thus the investor needs to be prepared to be invested during the whole time of the project. One way to mitigate this risk is to be invested at a project involved in plantations of various maturities, thus expecting ongoing cash flows rather than be exposed to one final harvest year. The other option is to sell the investment before harvest, e.g. in year 10, which in theory is attractive to a new investor (shorter investment horizon) but in practice is difficult since the market is intransparent and it is difficult to find a buyer. However, contacting an independent broker such as might be advisable.
Price Per Hectare
Price Per Hectare bases on effective costs to be paid for an investment, thus is less affected through a subjective bias than IRR. Teak plantations have similar activities – growing trees – and the cost structure is pretty similar. Thus, Price Per Hectare is an ideal quick ratio to compare investment options across the industry. From an economic point of view, Price Per Hectare should be low when entering an investment. However, Price Per Hectare should always be considered in the context of a risk analysis. There might be valid reasons why it is worthwhile to pay a higher Price Per Hectare if it helps to reduce risk:
- Sustainability certifications such as FSC should allow to sell the timber to more buyers than non-certified timber, thus reducing risk
- Value additions such as a mill can allow to capture more value along the value chain
- Quality of the plantation manager since it affects the risk of improperly maintaining the plantations
Factors like these influence the risk / return equation, thus providing arguments to pay higher price per hectare than a similar opportunity which shows less premium arguments, thus has higher risk.
Conclusion
Some folks in the industry might tell you that financial forecasts are just numbers which all base on estimations and have not much to do with the reality which is growing a tree. From an investor point of view they are wrong. Visiting a plantation and seeing it in good condition is not enough to complete a Due Diligence. You should only invest if the expected return outweighs your risk. Thus this requires an in-depth look at the financial forecast, the entry price, the risks and how the investment relates to other investment proposals.
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