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Pulp Fiction: A Paper-Stock Story

Odette Galli

Finding deep value is tough these days. Many cyclical sectors of the market, even those that were hardest hit after Sept. 11, such as airlines and lodging stocks, have snapped back.

That said, the cyclical group still has some opportunities left. In particular, paper stocks look attractive. The paper index is still down 20% from its short-lived 1999 peak. International Paper (IP Quote - Cramer on IP - Stock Picks), for one, is 30% off its highs and is about flat for the year.

The earnings of paper companies (and, in turn, the fates of their stocks) are tied to the price of wood pulp, the basic material from which paper is made. One indicator of industrial activity, the Commodity Research Bureau index (CRB), suggests that prices for commodities such as pulp may be bottoming. While the CRB doesn't track pulp prices, it does measure prices for 13 different industrial commodities such as copper and steel. (You can access the CRB weekly for free on www.yardeni.com..)

The chart below shows the performance of the CRB through last week.

CRB Raw Industrial Spot Price Index Price of commodities such as pulp may be bottoming

Source: Yardeni.com

A bottoming in the CRB could bode well for pulp prices because, according to Edward Yardeni, the chief investment strategist for Deutsche Banc Alex. Brown, "when these commodities turn, they turn together." And the prospect of strengthening pulp prices means the stocks of paper companies could outperform.

Market Pulp Prices vs. S&P Paper Stock Relative Performance

Source: AF&PA, Morgan Stanley Research

Here's why pulp prices are likely to rise in coming months:

• There isn't a lot of excess supply in the marketplace to cause prices to plunge. Inventories are at five-year lows at the producer level, and possibly at eight-year lows at the customer level. This rarely occurs at this stage of a downturn.

• Capacity is coming out of the system. The industry is consolidating and plants are being closed. Matt Berler, Morgan Stanley Dean Witter's paper analyst, estimates that more than 11% of North American uncoated free sheet capacity will have been shut down between 2000 and early 2002. Worldwide, capacity has been growing below trend line, he says.

• Returns on capital can improve once demand picks up. The paper companies have demonstrated more discipline about spending this cycle. Berler estimates that capital expenditures as a percentage of sales are 5% at most paper companies; that's an all-time low.

• Pickup in demand will improve operating rates and set the stage for firmer pricing. Berler estimates that pulp demand will be down 6% this year, but could swing up to between 6% and 8% next year. That could cause industry operating rates to jump to 92% to 94% from their current level of 87%. Berler notes that, historically, the higher level has given pricing power to producers. In fact, Berler says that pulp and paper shipments already have begun to turn positive on a year-over-year basis.

While paper stocks have moved, they are still very attractively valued, particularly when you look at price-to-book value, the most reliable measure for valuing the sector. Berler says that, on average, the group is trading at about 1.3 times book value -- roughly in the middle of its historical valuation range of 0.8 at the cyclical trough and 2.5 at the peak. So, one could argue that the stocks are about halfway through their potential move. In the last recession, paper stocks more than doubled from their lows. So far this cycle, the index is up just 31.7% from its September 2000 low.

In general, the paper stocks are not highly liquid names. The basic materials group as a whole accounts for only 3% of the S&P 500 index. So when money managers decide they want cyclical exposure by owning papers, you can get a nice liquidity squeeze in these stocks. It almost doesn't matter which stock you pick.

Having said that, I'd probably choose International Paper, as it is the industry bellwether. As one of the largest companies in the sector, with a market cap of $19 billion, IP is likely to be the "go-to" stock for portfolio managers seeking exposure to the group. Berler estimates that IP is trading at a price-to-book value ratio of 1.8, compared with its historical high of 2.4. (Berler rates IP outperform, and in the past three years, Morgan Stanley Dean Witter was involved in an IP investment banking deal.)

Another interesting choice is Boise Cascade(BCC Quote - Cramer on BCC - Stock Picks), which Berler says has the most exposure to the best segment of the market: uncoated free sheet. According to Berler, every $50 per-ton increase in uncoated free sheet prices boosts earnings per share for Boise by $0.78. The analyst says he can easily see a $100 per ton recovery in free sheet prices next year. Boise is trading at a price-to-book value ratio of just 1.2, compared with its high of 1.7. (Berler rates the stock outperform.)

Berler's favorite stock is Montreal-based Domtar(DTC Quote - Cramer on DTC - Stock Picks), which he thinks is the best-managed company in North America. Domtar also has large uncoated free sheet exposure, made even bigger recently with its purchase of four plants from Georgia Pacific. Domtar trades at a price-to-book ratio of 1.4, compared with a high of 1.9. (Berler rates Domtar strong buy.)