University of Chicago Investment Office: Investing in Timber

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What is the intersection between the investment philosophy of the UCIO and the current allocation to timber?

The University of Chicago Investment Office is a department within the University of Chicago which is mainly responsible for handling the endowment fund of the university. The main aim of this division is to find reasonable investment opportunities for the university without taking too high risk. By June 2004, the value of the endowment fund stood at 3.5 billion dollars. Mainly, the current portfolio of the university involved investments which were not very risky such as real estate, stocks, natural resources, bonds and private equities. The university has specifically defined different asset classes to ensure optimal levels of return for a given investment made in different asset classes.

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The investment philosophy of UCIO follows that investments will be made according to the level of returns generated by that investment. For instance, UCIO will give more management focus to opportunities which will provide a high level of returns and vice versa. The timber industry in United States has shown very strong investment perspectives which are aligned with the investment policy of UCIO. For instance, over the past fourteen years, timber has shown more or less average normal returns. This means that investment in timber is less volatile as compared to other investment opportunities available to the firm such as bonds, stocks, real estate and so on. Moreover, high growth potential in timber can be observed through the financial performance of timber business in the industry. During the years, 2002 to 2004, Plum Creek Timber has earned maximum revenues through the sale of timber. Currently, UCIO is only investing 8% of its total portfolio in the real asset class. This analysis shows that, UCIO is not making justice between its investment philosophy and the current allocation of resources.
 

Did historical returns justify a larger allocation?

When justifying higher allocation in a certain industry; factors such as asset liability surplus and sufficient asset return in contrast to the risk involved must be taken into account. The risk for a greater investment increases with the increase in the number of variables associated with a particular investment; in case of timber factors such as environment, land prices, government regulations add to the risk. According to the historical data it can be analyzed that the timber industry has been stable compared to other industries as it has resulted in a negative yield only three times in the past couple of years. The yield in the recent years has also increased as compared to other sectors, and with 31.76% return Plum Creek Timber has given the highest yield in 2004. In addition, the revenue Plum Creek Timber received by timber sales is roughly half of the total revenue which reveals that the company is not entirely dependent on one asset but rather there 3 other vital areas such as real state, manufacturing via which Plum Creek Timber manages its revenue. In addition, despite a decreased return yield in the year 2002. Plum Creek Timber still managed to give a dividend of $1.49 which shows that the return is roughly constant. On the other hand; however, there is a potential risk involved when one analyses the historical data of prices for Saw timber, which reveal wide fluctuation over the period of time. Hence, there is a possibility of a higher risk with a higher return because if the price of timber falls in the coming years it might be that investments will be exposed to potential risk, but Plum Creek Timber yield is considerably higher that the inflation in the past years which is evident from exhibit 6. Currently, UCIO’s share is around 8% in this sector. But keeping into consideration the risk involved and the high return that Plum Creek Timber is giving at the moment; it shall be a just decision to allocate a larger portion in the portfolio.
 

How much could we rely on the historical data?

Timber industry cannot be categorized in totality with other industries such as equities, bonds etc because the factors that determine the change in yield vary considerably for other industries. Timber’s main factors are price of land, environment, and price of timber, government regulations, and then the timber price. The historical data is an example of how well timber industry was doing over the past years, but the reason why timber has gone up or gone down form each year. Furthermore, through keeping into perspective that some variables such as environment are uncontrollable; thus, the historical data cannot form a precedent for future trends. For example, the prices for property might fall, or there could be a drought causing trouble for the industry. In contrast to this, Plum Creek Timber has a diversified portfolio as it’s not relying on only timber sales and thus the potential risk is minimized, and in that case the historical data can be considered consistent. Lastly, whatever the case is, the company has been consistent in delivering dividends which shows that the yield is realized by the investor, and the company keeps the stockholder’s trust. This might conclude that even though there can be some hard years, the profiting years are so much profiting that they keep the company running and giving a good return on investment and in that case the historical data can be relied upon. The data related to the prices of timber has fluctuations in it, and this proves the fact that factors that affect the price of timber are strong and are not stable. This can be related to the change in revenues associated the timber. Therefore, the data for price cannot be heavily relied upon. Thus even though, there are many factors that affect the yield for a company such as Plum Creek Timber, no co-relation can be derived from changes in prices of timber and inflation or the country’s economy. The data pertaining to the yield of the Plum Creek Timber can be relied upon as timber production and sales are just a part of it and it balances its income by real estate and manufacturing.
 

Were there other assets that might provide similar benefits?

The benefits vary from sector to sector as some have a high yield with a higher risk while others have a lower yield with lower risk factor involved. So, in order to analyze the investment, there is need to decide what type of investments UCIO tends to make. UCIO’s Market value has risen considerably over the period of sixteen years, reaching its highest value of $3769 in 2000 and then dropping down to $3159 in 2003 after which it rose to $3550 in 2004. Evaluating the company’s preferences in terms of investments it can be seen that the company’s portfolio consists of 15% of investments in absolute returns where there is minimum risk, 13% in fixed income which has no fluctuations in relation to the change in returns for other investments, 20% in private equity which again has high liquidity and can be disposed of in terms of emergency and so on. All these investments reveal that UCIO is a company which tends to be safe and is willing to receive a lower return, but for a lower risk and wishes to invest in the long run rather than on short term capital gains. It only has 8% investment in the real assets sector which is at a higher potential risk and return. If we look at this scenario AAA corporate bonds can be termed as a safe option for long term investments as it has lower fluctuations compared to Plum Creek Timber and has lower return. Furthermore, the default risk on AAA bonds is zero; therefore, the company will get the actual price for the bond on the date when it becomes mature. Again the 10 years US governments bonds can also act as a safe way out for the company as they also have no default risk and can provide fixed return over a period of 10 years. This will act as a safety measure and will act to increase the company’s market value. By keeping into perspective that the company already has a good proportion of its portfolio in the minimized risk sector, the company can also tend to diversify it by investing in a high risk and high return sector. REIT can be considered as a potential investment in this regard. Over the couple of years, it has shown fluctuations in terms of its yield, but in the recent years, it managed to give a yield of 40.81% in 2003 and 29.55% in 2004, even though it is a high risk investment, but it can be an alternative to Plum Creek as it is a bit more stable and offers lower returns from Plum Creek Timber but higher that the comparative bonds or fixed investments.
 

 How would we adjust for the inherent liquidity risk exposure?

UCIO is faced with two types of liquidity risks in this situation. First type is called cash flow risk and the second type of risk is called market liquidity risk. Like every other organisation, UCIO is also faced with the cash flow liquidity risk. This means that the company does not have sufficient liquid reserves to invest in any new investing opportunity if there is any. On the other hand, market liquidity risk refers to the illiquid state of an asset. This is related to the quickness of converting an asset in to cash. Timber is considered as an illiquid asset which is why UCIO has not allocated high portion of investment to the timber asset class. In case of UCIO, risk of liquidity is inherited with the timber investment. The reason for the inherited market risk is that the price for timber is fluctuating and at one point, or the other, there is a possibility that timber will experience a lower demand at a higher price, and this can be a problem when it comes to liquidity as it will be difficult for UCIO to sell its investment. Furthermore, the risk is based on another factor such as the time horizon. Now, it is evident from the above data that UCIO is making long term investments and not concerned about making short term capital gains. In this case the flow risk is automatically minimized as the company have no intention to sell its assets. The risk can be reduced by a diverse portfolio which consists of liquid assets that UCIO already has. If still a problem exists then UFIO can look towards contingent financing by managing a supply of finances to be used in extreme situations this can be done via short term loans. The other way is through negotiation; UFIO can negotiate with the parties that are liable to pay in order to extend the deadline or settle them for stock rather than cash or settle in terms of bond or note payables.

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