Paper Stocks Prepped to Pop in This Recovery

You've read it here before, and you can see it in the stocks' recent performance: The economy is recovering. As a result, cyclical sectors, such as industrials, papers and chemicals, are where you want to be. The recession has severely punished these sectors, so they're poised to rebound nicely from here.

So far, this perspective has served us well. Last week I highlighted some of my industrial stock picks, which are up an average of 33%. Today I'll take another look at the paper sector.

Still Room to Move

Since I first wrote about this group in November, the Dow Jones Paper and Forest Products index is up almost 10%, compared to a scant 1% return for the S&P 500.

The stocks I highlighted -- International Paper (IP - commentary - Cramer's Take), Domtar (DTC - commentary - Cramer's Take) and Boise Cascade (BCC - commentary - Cramer's Take) -- are up an average 18%, handily beating the industry average. Domtar alone is up 24%. On Dec. 11, I also highlighted Abitibi-Consolidated (ABY - commentary - Cramer's Take), which is up 17% since the column ran.

To some extent, these stocks are already reflecting a lot of the good economic news to come. But I think there's still more upside in selected names. As I pointed out with my column on industrials, these aren't really big-cap stocks, so it doesn't take a lot of buying power to drive them higher. Consider these points:

The economy is in just the early stages of a recovery. The Institute for Supply Management's purchasing managers' index (formerly known as the NAPM) surged to 54.7 in January, the first reading above 50 since July 2000. A reading of more than 50 indicates that the economy is expanding. As the chart below shows, paper stocks perform best when the ISM's PMI is over 50 and rising.

Powered-Up Purchasing Managers Paper stocks should benefit from this index's solid jump

Source: Morgan Stanley

Pulp prices are hitting bottom. Pulp prices plunged 20% in 2001 from $685 to $551 per ton, and they're likely to post another 10% decline this year. But the first quarter is typically the seasonally weakest of the year, so prices may very well improve in subsequent quarters. Paper stocks perform best when pulp prices are rising, as the chart below shows. Once prices and shipments start to firm up, the stocks could move even higher.

Plummeting Pulp Prices Once again, the paper sector should benefit from this trend

Source: Morgan Stanley

All of the right ingredients are in place for prices to improve when demand picks up. Inventories are in great shape, particularly in the uncoated freesheet (mostly printer and copier paper) and newsprint categories. This is because paper companies haven't been overproducing and because of capacity reductions. According to Matt Berler, paper analyst at Morgan Stanley, North American producers shut down plants representing 11.9% of uncoated freesheet capacity and 4.9% of newsprint capacity since the beginning of 2000.

Capacity growth will be minimal, allowing for higher operating rates and improved profitability. According to the American Forest Products and Paper Association, U.S. capacity is expected to grow at just a 0.4% compound annual rate for all grades of paper from 2001 to 2004. Historically, this figure has grown at an annual rate of about 2.1% since 1975. As recently as the mid-1990s, it grew nearly 3% per year. Capacity growth is expected to be the tightest in newsprint, where the association expects a decline of 2% per year, and in uncoated freesheet, where capacity should drop 1.6% per year. As a result, some analysts like Berler expect operating rates to reach the profitable mid-90% range in the next year. The 2001 operating rates were 87.7% for uncoated free sheet and 91.2% for newsprint.

The stocks' valuations are still fairly reasonable. Clearly, the easy money has been made, particularly since September, when the paper group reached rock bottom. (Since the end of September, the Dow Jones Paper index is up 43.6%.)

Favorite Names

Nevertheless, some names still have room to go, particularly if you consider where the stocks have historically traded on a price-to-book-value ratio -- from 1.8 to 2.0 -- at the cycle's peak. It almost doesn't matter which stocks you pick because the whole group is moving together. These aren't really liquid names, so a little buying can move the stocks a long way.

In the S&P 500, the weight of the entire basic materials sector -- chemicals, metals and papers combined -- is less than 3%. That's less than the 4% weight of General Electric (GE - commentary - Cramer's Take). You may even want to consider buying an exchange-traded fund like the iShares for the Dow Jones U.S. Basic Materials index (IYM - commentary - Cramer's Take), although only 22% of that index is allocated to paper stocks.

My individual favorites include International Paper, the industry bellwether, which will likely continue to do well as it has the biggest market cap: more than $20 billion. But this stock is now trading at a price-to-2001-book-value ratio of 2.0, one of the highest in the group. Even so, peak price-to-book-value on International Paper has been as high as 2.4 in past cycle peaks, according to Berler, and the peak could still be several years away.

I continue to favor leaders in the best-positioned segments of the paper market: uncoated free sheet and newsprint. Domtar is my choice in the uncoated free sheet segment. It trades at a price-to-book-value ratio of just 1.6. Abitibi still probably offers the most longer-term upside for patient investors. It trades at a price-to-book-value ratio of 1.8 (on a very depressed 2001 book value), and it's one of the best ways to play a recovery in the newsprint segment, which is likely to lag behind the rebound in the rest of the paper market.

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Odette Galli writes regularly for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to Odette Galli.