As both a contrarian move and a pure commodity play, I like lumber as an investment right now. Prices have fallen sharply from their peak in 2004, and the commodity is very undervalued. I also like it because the market does not have a big speculative following on lumber the way it does for some of the other commodity markets, such as gold and oil. Lumber futures are pointing to an uptrend in prices through 2007, and there is a seasonal bias to support this. In short, if you are a contrarian and want to be bullish on a commodity, here is a market with many of the elements a contrarian would love.
So, how do you "play" lumber? You can buy lumber futures that are traded on the Chicago Mercantile Exchange, or you can use an equity proxy. If you prefer to go the latter route, you have several stocks to choose from: International Paper (NYSE: IP ) , Weyerhauser (NYSE: WY ) , Louisiana-Pacific (NYSE: LPX ) , Universal Forest Products (Nasdaq: UFPI ) , and Potlatch (NYSE: PCH ) . All of these companies are in the forest-products, wood-production, and lumber business. Before I discuss them further, let me address a few more of the fundamental factors influencing the lumber market.The fundamentals
Without a doubt, housing construction is a major contributor to lumber demand. Increases in home construction tend to push lumber prices up. When housing starts were strong and rising, as was the case from 2001 to 2005, lumber was on the increase. Since then, the price of lumber has been falling.
Some might wonder why I would be bullish on lumber now, when housing starts have contracted sharply since the beginning of this year. It's because I took a look at the monthly housing-starts number on a year-over-year percentage-change basis rather than simply basing my forecast on what is happening with the monthly headline number. Year-over-year analysis often yields greater insight into whether momentum is fading or strengthening.
When viewed this way, we see housing-starts data suggesting that the contraction in starts reached its peak in August. In addition, new-home sales have rebounded in the past two months. Both developments may cause builders to scale back their planned cutbacks in new units. In other words, the worst may have passed.
There is another reason to believe the worst may be over: The cutbacks have been severe. You have to go back to the recession of 1990-1991 to see a construction pullback of this magnitude, even though the current economy is nowhere near as bad as it was 16 years ago. The early '90s saw the nation's unemployment rate hovering just below 8%, and the yield on a fixed-rate 30-year mortgage was almost 11%. Today, unemployment is at 4.6%. Moreover, the economy is not in recession, and interest rates are about half what they were 16 years ago, despite record-high oil prices and two years of steady rate hikes from the Fed. The cuts the builders made may not only prove to be sufficient, but they also may have gone too far. That is exactly what the homebuilder stocks appear to be signaling. Their current rally suggests that they are discounting a better operating environment.
OK, so you may have guessed by now that I am pretty sure housing has seen the worst. (Please refer to my Sept. 19 and Aug. 29 columns on housing and homebuilders.) That's where my lumber and building-materials play comes in. Now we'll look at the securities that I mentioned, starting with International Paper.The lineup
International Paper is the largest of the forest-products companies, with revenues of about $25 billion and a $17 billion market capitalization. The stock is trading at 16 times its forward earnings, and the price is about 10% beneath its 52-week high. This company is not as attractively valued as some of the others, but it is widely held by institutions and will participate on the upside if lumber prices rise.
Weyerhauser is the No. 2 forest-products company in the U.S., with revenues of about $23 billion and a $16 billion market cap. Like IP, it currently has an operating loss for the year; however, earnings are expected to turn positive going through 2007. The stock is about 15% beneath both its one- and two-year highs.
The next company is Louisiana-Pacific, which, at $2 billion in revenues and $1.6 billion in market cap, is far smaller than IP and Weyerhauser. The stock is 33% below its one- and two-year highs, but it still trades at a hefty multiple. Normally, I would not go anywhere near a stock like this, because I like value. But such an extreme multiple says to me that analysts and investors have not factored in the likelihood of a rebound in lumber prices. Remember, I am playing this as a commodity speculation rather than as a value-stock investment.
Universal Forest Products is a lumber play that is also a value play. The company has a good management team that generates high returns on equity in excess of 16%. In addition, it sports an earnings yield of almost 10%. All this, yet its stock is about 50% below its two-year high. This could be a big winner.
Potlatch is not a forest-products company but rather a real estate investment trust that owns and manages timberlands. The vehicle pays a 3% dividend, has an effective management team that generates about a 14% return on equity, and sports an earnings yield of around 7%.
There are some of the choices you have if you want to take a shot on the lumber market -- a commodity that is currently overlooked, underowned, and undervalued.
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Fool contributorMike Normanis the founder and publisher of theEconomic Contrarian Updateand is aFox News business contributor. He is also a radio show host atBizRadio Network. He does not own shares in any of the companies mentioned. The Motley Fool has adisclosure policy.