No matter how investors view the current rewriting of global trade alliances and agreements, it appears Uncle Sam is willing to wait out his economic counterparts at the negotiating table. Considering he is in a good position, it wouldn't be surprising for the trade war with China to linger indefinitely -- even if it means that U.S. businesses suffer in the short term.
While there's no denying that some supply chains and trade routes will be squeezed, Wall Street has adjusted its outlook for some industries with the precision of a sledgehammer -- when a scalpel would have been more appropriate. Simply put, some stocks have been unfairly punished under the broad fear that the U.S.-China battle would damage their businesses. Solid operational performance through the first nine months of 2018 may prove otherwise for International Paper (NYSE:IP) and A.O. Smith (NYSE:AOS), two of the top stocks affected by the trade war that long-term investors can buy right now.
Wall Street analysts must have paper cuts from this one
As the trade war began heating up in early 2018, Wall Street analysts predicted that American pulp and paper businesses would suffer tremendously. The logic was simple: Prices of corrugated packaging (read: cardboard boxes) have soared to all-time highs in recent years thanks in large part to incredible demand from China, so tariffs on American products would crush that all-important growth driver. But that hasn't happened.
It's that's not surprising when you look at the dynamics of the pulp and paper industry. China has the newest fleet of paper machines in the world, but relies on imported pulp and recycled fibers for much of its raw material. After restricting recycled fiber imports in 2017, Chinese paper companies had to idle factories and import finished products such as cardboard -- mostly from the United States. Since China requires either American pulp and fiber or American finished products, Chinese tariffs on American imports lacked teeth from the start.
International Paper, the lowest-cost manufacturer of corrugated packaging, has taken full advantage. Through the first nine months of 2018, the business has delivered $1.4 billion in operating income, which is 115% higher than the year-ago period. All three operating segments have reported higher revenue and operating income in that time. And operating cash flow has increased 32% in that span (when excluding last year's pension contribution). Yet, shares have fallen 21% since the beginning of the year.
That drop in share price means the stock trades at just 8 times future earnings, and it has pushed the dividend yield to 4.3%. It will get better still: In October, management announced a $2 billion share repurchase program, equivalent to over 10% of the company's market cap. While the business faces increased friction from the trade war, International Paper doesn't appear to be suffering nearly as much as Wall Street predicted. That creates a solid opportunity for buy-and-hold investors.
A great business at a steep discount
A.O. Smith may be best known for its leading brand of water heaters, but investors shouldn't overlook the fact that it's been one of the best stocks on the entire market in the last 10 years. The stock has delivered a total return (share performance plus dividends) of 937% in the last decade, compared to "only" 249% for the S&P 500 -- and that includes a very unusual 21% drop in 2018.
Much of the stock's prolific performance is owed to incredible growth in the Chinese market, where many households have purchased their first water heater ever in recent years. That's provided considerable growth to pair with the company's more mature operations in North America, where most water heater purchases are replacements, which serve as the bedrock for the entire business. Additional product launches including home air purifiers, home water purification, and energy-efficient commercial boilers have tacked on additional growth.
Unlike International Paper, A.O. Smith has seen the trade war take a bite out of its business. Third-quarter 2018 revenue, operating income, and net income were below levels from the second quarter of this year as the company was forced to eat higher steel and distribution costs. Meanwhile, growth in China slowed as households began to feel the effects of the battle. Management cautioned that the fourth quarter is off to a poor start, and that it expects to face continued headwinds from slower purchases in both the U.S. and China. And it lowered full-year 2018 guidance as a result.
The situation could deteriorate from here, but the stock's 21% drop since the beginning of the year seems a little extreme. The business is comfortably profitable despite ongoing headwinds. In fact, the stock trades at just 17 times future earnings, which is the cheapest valuation in over five years. The company is growing revenue in India (another important growth market) by 40% per year. And the North American segment's 20%-plus operating margins are remarkably resistant to economic downturns. Long-term investors should view the recent collapse (and perhaps future slide) in A.O. Smith stock as a great opportunity to start or grow a position for the long haul.
Evaluate the trade war on a case-by-case basis
Is it possible that some industries and businesses will be significantly harmed by the U.S.-China trade war? Absolutely. But if the argument is broad and nonspecific (example: "China will stop importing American pulp and paper products, so sell International Paper"), then individual investors may want to look a little deeper into the details. Nuances are often important. And those nuances are what set up International Paper and A.O. Smith to be great trade-war stocks you can buy right now.