Timber! Look Who’s Loading up on Lumber

We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds).” – Prem Watsa, 2004 Letter to Shareholders.

By now it all seems so obvious. All the warning signs were there. The “Bad Credit, No Problem” slogan at car dealerships, banks’ no-standard lending practices, etc. We all knew the good times had to come to an end; it was only a matter of when.

That “when” is now and the good times have come to a fairly quick end. A sustained bear market has set in, banks are afraid to even lend to each other, and a harsh recession that I don’t believe the “recessionless” generation is prepared for is on the horizon.

Regretfully, a lot of investors weren’t prepared. One man was not only prepared, he made a killing in this downturn. Now, he’s taking his winnings from a big bet on risky loans going bad and pouring the cash into timber land at rock bottom prices.

I know what you’re thinking…“Trees…now!?!

That’s right. I’ll explain in a second, but first I’d like to introduce you to Prem Watsa.

Never heard of him?

That’s understandable. Watsa isn’t as recognizable a name as the likes of Buffett, Rogers, and Pickens. But just because he’s not on CNBC every week doesn’t mean he doesn’t know what’s going on. He does.

Watsa has actually prospered from the current meltdown. Like most of us, Watsa saw the debt problems growing in the world. More importantly and unlike the rest of the pundits in the world, he took action. As CEO of Fairfax Financial Holdings (FFH), Watsa took out an insurance policy on the collapse of the debt securities that are causing all the huge write-downs at the banks.

Remember, somebody makes money on the winning side of all the bets (the credit crisis has been largely fear over whether those bets will be paid). Fairfax was one of the companies on the good side of things. Fairfax purchased $197 million worth of insurance against the collapse and is now reaping the benefits. Fairfax’s turned that $197 million into $1.85 billion.

That was just one of Watsa’s brilliant moves. Since its founding in 1985, Fairfax’s book value per share has compounded at a 26% annual rate. Its share price has tracked right along with book value over the past 22 years too. Fairfax shares have delivered an annualized return of 23% per year to shareholders.

With returns like that, it’s no wonder why Businessweek has called Watsa the “Buffett of the North.”

That’s why Watsa is someone worth keeping an eye on. When he makes a move, he expects big gains to follow. Right now he’s betting big on timberland.

I know there’s no sensible reason to invest in timberland right now, but that’s exactly why it’s worth a look.

The herd is saying:

“We’re in the midst of a housing crisis. The number of new homes under construction has plummeted. The ratio of vacant homes to occupied ones is at the highest point since 1956. It’s going to take a couple of years to sort through the extra capacity in the housing market. Lumber sales have already plummeted and aren’t going to get turned around until the housing market does. “

That’s all true. But it’s also a good case to buy trees and timberland now.

Nobody wants them and trees and timberland are as cheap as they’ve been in years. That’s what is getting Watsa excited.

It’s not just the beaten down price of timberland and timberland shares though. Timberland is one of the best investments you can make in a recession. In fact, timberland has been one of the best performing assets in history. It always survives the ups and downs. Trees are not assets that waste away if they’re not used. They grow. And they continue to grow until the market comes back. As a result, timberland values appreciate very consistently.

And right now, after an across the board sell-off in stocks, Watsa is taking this opportunity to buy shares in companies that own a lot of timberland.

When the market was panicking last week, Fairfax shelled out about $7 million dollars to buy more than 2.2 million shares of International Forest Products (IFP-A) last Tuesday. As panic continued on Thursday as stocks fell drastically lower, Fairfax added another 2.3 million shares of IFP to its holdings. Fairfax now owns just over nine million shares of IFP. That’s more than 19% of the company.

Clearly, Watsa sees something positive despite IFP’s 60% decline in share price since peaking in May 2007. And we should too for a long-term opportunity.

Watsa foresees pretty much what we see ahead for the global economy. He recently said:

“We think there is a significant recession coming, long and deep. It’s going to spread all across [the world] … It’s very difficult to not be caught by it.”

I couldn’t agree more. However, buying shares in a company that owns timberland is not like buying shares of a manufacturing company like 3M or Honeywell. While a manufacturing company needs to lay off workers, shut down plants, and reduce prices just to scrape by during hard times, a company like IFP can slow down knowing that its assets are continuing to grow.

I’ve got to warn you, if you’re going to buy timberland now, you’ve got to do it with a long-term perspective. Watsa may have scored a 756% gain on his bet on risky loans going bad, but he waited five years for the payoff.

The way the economy looks now, it could be just as long until the huge rewards are reaped for buying timberland stocks now. But eventually the benefits will come.

The bubbles have burst. It’s just a waiting game until we hit bottom. Some of us have stuck our toes in the water…others have stayed on the sidelines. But with an investment in timberland, your investment grows in value each year which the stock market will eventually recognize.

If you’ve got your living expenses already set aside in cash and have two year outlook or longer, timberland is one of the best places to start stepping into right now. Some potential timber stocks that have sold off recently along with IFP are Plum Creek Timber (PCL), Rayonier (RYN), Deltic Timber (DEL) and Timberwest Forest Units (TWF.UN).

If you’ve got the stock buying itch, scratch it with timberland stocks.

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