Is Now the Time to Buy Paper/Forestry or Building Materials?

As part of David Merkel’s rules on industry selection, he lists the following:

• Buy strong companies in weak industries when the industry pricing outlook seems hopeless.
• Buy moderate to strong companies in strong industries where the earnings power and duration are underestimated.
• Underweight/ Ignore/ Short industries where pricing power is likely to be negative for several more years, and especially industries that are in terminal decline.
• Avoid fad industries. There are P/E levels that no industry can grow into.

My best example of #1 is the P&C insurance industry in early 2000. Total gloom. I bought a lot of The St. Paul (STA) then. Another example: Steel in 2001-2002. I bought Nucor (NUE).

In his industry rankings, updated about two weeks ago, he suggests that paper/forestry as well as building products are worth looking into on the value side. I’ve said several times that I think there is much better risk/reward in the housing arena by sticking with the building products companies, because they have much better liquidity.

A few months back, I did a two-part analysis and valuation of Weyerhaeuser (WY), where I said that the valuation seems more compelling if the stock came down into the mid-$50s. Well, four months later, we’re there – and Weyerhaeuser has shed the CBPR unit I disliked for a pretty good price.

So, is it time to buy Weyerhaeuser, or any other company in paper/forestry or building products? The last few days, I’ve seen two articles suggesting just that – one arguing that Weyerhaeuser is a buy and another stating that paper maker Domtar (UFS) has unrecognized earnings power. On a recent episode of Mad Money, Jim Cramer recommended combination play Temple-Inland (TIN), which he said looks very cheap at $12. In other words, with all of these companies trading within a fraction of their 52-week lows, people are starting to come out of the woodwork and get positive on them.

The sell-side sentiment is mostly negative on the larger companies, like Weyerhaeuser and International Paper (IP), although not as negative as I’d like it to be on the others. It does seem clear from the stock prices, however, that investors aren’t waiting out any cyclical turndown in earnings; though with one notable exception – the timber REITs. Plum Creek (PCL) and Rayonier (RYN) are both within sniffing distance of 52-week highs, and their divergence from a will-they-won’t-they REIT candidate Weyerhaeuser soared of late when Weyerhaeuser came out in the “they won’t” camp.

For visual effect, here is a pairs trading chart of the two timber REITs. Notice the tight range they trade in.

This chart shows the average stock price of the two timber REITs, divided by WY’s closing price.

PCL and RYN are modestly priced as dividend plays, with the former’s yield equal to that of a 5-year T-bond, and the latter’s equal to the yield on the 10-year. All else being equal, I think that the yield divergence is reaching the top end of its range (just using price as a proxy, as in the first chart), so RYN looks like a better bet right now.

But getting back to the original point – is paper, forestry, or building products a good area to be picking over now? I think there are certainly widespread concerns about the lack of pricing power, as poor demand from housing has crushed forestry margins and obviously hurt the buildings products companies as well. But as for a bottom, I think more pain needs to be felt.

IP is trading at 6x EV/EBITDA; Domtar is marginally above that – certainly not expensive, but not capitulation-cheap. The trailing valuations get pricier as you get away from paper and move into pure forestry because of the much lower tax rates, and buildings products comps are out of whack because we’re on the bad side of earnings deleveraging. I will say that Sherwin-Williams (SHW), after round-tripping back to nowhere from four months back, is still a good company at a reasonable price. Todd Sullivan is correct to say that it’s inexpensive, but it’s dangerous to expect the market will let Sherwin shake the housing stigma soon, especially after the company just cut its outlook.

So other than long Rayonier against Plum Creek, the other tradable bounce – or potentially more? – is long Weyerhaeuser, which has been sold off very hard. It still has great timberland assets, but hasn’t exactly thrilled many shareholders with its restructuring plan and has had huge macro headwinds. At this point, I’d imagine the remaining shareholders are extremely patient people, and are willing to buy more as the stock comes in. If I didn’t already have building materials exposure, I’d like to add a little WY in the mid-$50s.

Disclosure: None

Comments

[d_teller]

Recently an article quoted J. Grantham as saying..."Timber has had an avg 6.5%/yr/100yrs" growth as an investment. But many of the recommended companies looked to their land valuations for development/sales, and their dividends were lower during the housing "bubble", because their P/E's included land sales.

Last Fall, the P/E's, and ebita's started falling. However, after the recent drops in T-rates, the dividends appear: a-large, and the investment prospects appear: b - great. This is appearance and has driven pricing up, for PCL, as an example from 36 to 46.

The question for an investor is: how do the current prices appear relative to the last time that interest rates were first cut and home-builders and land sales had not yet exploded? If the prices look good, go buy. But I think these and other real-asset REITs have moved up in price due to the decrease in treasury yields. They appear to be slightly above a "fairly-valued&qu... point now.

Let's propose a possible scenario: slightly increasing inflation pursuades the Fed to begin raising rates, very slowly, but over a couple of years

+ high commodity prices for construction (lumber, steel, cement, bitumen, wallboard, piping, wiring, insulation, paint, etc.) put a floor under "housing affordability"

+ the necessity of bank lenders to keep mortgages at a higher than (normal to the fed funds ) rate because of a necessity to rebuild damaged reserves,

+ an increasing tax-burden and debt load across all segments of the Developed Nations' economies, preventing central bank economic easing from continuing (they'll still print money, but at a slower rate).

Looking forward, I believe that these factors indicate a slightly more expensive valuation on the "Timber" group, than recent writers here at SA have assumed.