2 Ways to Protect Your Assets

Who would have thought that Harvard University -- smart money -- was, at one time, the largest owner of timberland in the world? It’s not absurd: Timber can be a solid-as-oak investment, particularly during periods of great uncertainty.

According to data from the Hancock Timber Resource Group, the world’s largest institutional timberland manager, the average annualized return for U.S. timber over the period 1960-2002 was 12.6% (against 10.1% for the S&P 500). Looking forward, well-respected investment firm GMO is forecasting a 6% real (i.e., after inflation) annualized return for managed timber over the next seven years. Although that’s marginally below the long-term average annual return for U.S. equities (6.5%), timber holds other advantages for patient investors.

Trees keep growing even as stocks get chopped down
Where do the returns on timberland come from? Biological tree growth is the largest contributing component. Tree growth adds value in two ways: First, timber volume increases; second, as the trees grow larger, the value per board foot of timber also increases, because it can serve in the manufacture of higher-value-added items.

Timber is also one of the few commodities that can be “warehoused” indefinitely (on the timescale of an individual investor). If timber landowners consider that prevailing timber prices don’t provide them with an adequate return, they can simply opt to put off harvesting the timber until such time as prices are more attractive. There’s no hurry: the trees will keep growing at a steady rate, even when stock and bond prices are getting chopped down.

A great inflation hedge
And if you’re concerned about inflation, timber serves as a great long-term hedge -- in fact, it is one of the assets that is most highly correlated with inflation over the period 1987 to 2007, ahead of stocks, bonds, or real estate (if you’re not concerned about inflation over the next decade, you should be, in light of the government’s massive programs to reflate the economy.)

Unfortunately, individual investors have fewer options than Harvard when it comes to investing in timber. However, one accessible and relatively cheap vehicle is real estate investment trusts (REITs), most prominent among which is Plum Creek Timber (NYSE:PCL), the largest private landowner in the U.S.

Beyond timber: timber-strength businesses
Thankfully, there are other ways of protecting your assets against inflation. The common stock of high-grade companies should do the trick as well. Companies that have built a defensible franchise can outrun inflation better than their lower-quality peers -- a strong franchise is often synonymous with market power, an economist’s expression to describe companies’ ability to raise prices on their customers without chasing them away.

Getting back to GMO’s predictions, they think “High Quality” stocks will beat the S&P 500 over the next seven years, with an estimated annualized return of 12.7% (more than double their estimate for timber)! Keep in mind that we are still referring to real returns here (i.e., after inflation) -- so that would be a great return.

The High-Quality company screen
What are these “High Quality” stocks? GMO doesn’t disclose how it categorized those stocks, but we can make some of our own assumptions in trying to find companies that deserve that designation. I created a screen based on the following three criteria:

1. Return on capital exceeds 12% in each of the last five years.
2. Free cash flow margin exceeds 10% in each of the last five years.
3. Total debt-to-equity ratio is less than 50%.

Of the 5,619 companies with a primary stock listing on a major U.S. exchange, only 19 -- approximately one-third of one percent -- met these three criteria. The following table contains six of them:

Sources: Standard & Poor’s Capital IQ.

So what’s the rub -- why not go out and buy these stocks immediately? The answer largely comes down to valuation. By design, the screen results suggest these companies are indeed high quality; nonetheless, overpaying for them is the best way to achieve returns that are decidedly low quality. Using the forward price-to-earnings ratio, the range of valuations for the 14 companies is pretty wide on the face of it, from a low value of 6.4 to a high value of 26.4. On top of that, a forward P/E ratio doesn’t tell the whole story. So in theory, all these stocks could be buys ... or none of them.

An ideal time to focus on high-grade companies
At a time when stock prices have declined substantially and the economy is in tatters, it makes sense to concentrate on the highest-quality segment of the market in your search for attractive investments. The stocks in the table are a good place to start, but it would require further due diligence to confirm whether any of them are truly a buy.

That’s exactly the down-in-the-trenches work the team of analysts at Motley Fool Inside Value are busy doing, day in and day out. Hewing to Warren Buffett’s principle that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” they are focused on ferreting out the best businesses and figuring out what they are worth in terms of the cashflows they generate for their owners. If you’d like to find out their five best ideas for new money right now, sign up for a 30-day free trial today.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value pick. The Motley Fool has a disclosure policy.