Sometimes the most beautiful ideas can come from the ugliest places. At least, one can only hope that's the case when it comes to the newsprint sector.

Few cyclical groups have performed as badly as newspaper stocks. Even though the Dow Jones Forest Products and Paper sector in general is neck-and-neck with the 2% return on the

S&P 500

so far this year, shares of North America's largest newsprint producers --





( BOW) -- have been a bust. Since the beginning of this year, Abitibi's shares are down 17%, while Bowater's shares have lost almost 11% of their value.

Lagging Recovery

With the economic recovery having been clearly in place for several quarters in a row now, the market appears to have lost patience waiting for demand to pick up in the newsprint sector. But based on past cycles, recoveries in newsprint typically lag not only growth in gross domestic product, but also a turn in other paper markets, according to a recent report by Raymond James Canada-based paper analyst Daryl Swetlishoff.

As a result, even though Abitibi and Bowater haven't earned an operating profit in almost three years, they may be on the cusp of doing so soon -- if trends in newspaper demand follow their historical pattern. Assuming that's the case, both stocks still look like pretty good buys. Using estimates from Deutsche Bank analyst Mark Wilde, Abitibi and Bowater are trading at price-to-book value ratios of 1.4 and 1.5, respectively, compared with the industry average of 1.8, or price-to-peak earnings ratios of 3.4 and 3.8, respectively, compared with 6.4 for the paper sector overall.

Rising Prices

Unfortunately, the latest data on newsprint demand has yet to confirm that a turn is imminent. Total U.S. consumption is still negative, falling a disappointing 1.3% year over year in May, the 12th consecutive month of declines and slightly more than the year-to-date decline of 1%. If there's any good news to be had, it's in inventories, which fell 14,000 tons year over year, thanks in large part to the discipline on the part of producers in idling capacity. Between 2003 and 2004, roughly 9% of North American newsprint capacity will have been idled or shut down.

As a result of the tight inventory control, as well as the strength in the Canadian dollar, prices already have begun to move higher. Although most newsprint sold is denominated in the U.S. dollar, 60% of North American capacity is based in Canada and therefore has a Canadian dollar cost base.

Newsprint producers attempted to raise prices by $50 per ton earlier this year, but just $30 of that has stuck so far. Even so, current prices are back to $560 per ton, up from an average of $503 for all of 2003. According to a recent report by CIBC analysts Don Roberts and Herve Carreau, U.S. consumption would have to increase 4% to absorb the 535,000 tons of idled capacity and restore industry operating rates to a 98% level from May's 90%, which typically supports higher prices.

Demand Could Increase

Strong advertising trends in the newspaper industry indicate that an increase in newsprint consumption finally could be close at hand, although it has remained elusive so far. Total newspaper advertising revenue grew 3.2% in 2003 and is expected to be up in the 6% to 7% range now for 2004, although the increase in May decelerated to just 4% year over year. Help-wanted advertising finally has turned the corner thanks to the improvement in the labor market. In May, help-wanted classified revenue rose 17.4% on average for the newspaper industry. That's the fastest rate of growth in a long time and the fifth consecutive monthly increase since the growth rate turned positive in January of this year.

Thanks to years of consolidation in the industry, Abitibi and Bowater combined control 50% of the North American newsprint market. Therefore, they have the most to gain (or lose, which has been the case recently) from an upturn in the newsprint market. For now, investors may have to endure a few more ugly, nail-biting quarters, as both companies have fairly stretched balance sheets with net debt-to-capital ratios in the 60% range.

On the other hand, the stocks are cheap -- the cheapest in the paper universe, trading at less than half the price-to-earnings ratio of 8 that they typically are valued at during the peak of a cycle, according to Wilde. So assuming that newsprint demand follows its historical pattern of being a later-cycle play, patient investors could be well rewarded.

Odette Galli is a freelance columnist for She has been a writer at SmartMoney Magazine and a senior manager at Ark Asset Management, where she co-managed $3 billion in institutional assets. In addition, Galli was a senior vice president at J & W Seligman. At the time of publication, she had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. She welcomes your feedback and invites you to send your comments to