Hot Commodity

First, step back to economics class. You probably studied the hog cycle. Farmers overproduce when pork prices are high and underproduce when prices are low — which makes commodity markets volatile and raising hogs a risky business. Similar forces affect paper companies. When pulp prices are high (as they were in 1990 and 1995), everyone builds new plants. In a couple of years, all that extra capacity is available. So prices fall and profits slump.

The problem in both situations is too many producers. There are about 25 publicly traded paper companies in the U.S. and another dozen in Canada, fewer than the number of hog farmers, to be sure, but more competition than in other slow-growing, capital-intensive industries such as mining and steel. That's one reason paper companies haven't been popular long-term investments, but it's also why I'm excited by the current mergers.

During two weeks in February, when paper stocks were slumping and investors were chasing the tech darlings, there were five major takeovers with a total value of over $15 billion. The two largest were landmark deals in which Finnish paper companies bought U.S. firms (Champion International (CHA) and Consolidated Papers (CDP). Add in more than $8 billion in 1999 acquisitions by International Paper (IP) and Weyerhaeuser (WY) and roughly one-third of the North American paper industry has changed hands in the past 12 months.

That's massive consolidation. It won't eliminate price cycles, but it will make for less overspending. Bigger companies do a better job of adjusting to customer needs. Eventually, this will bring smoother earnings and fatter margins. Paper stocks will command higher multiples. And instead of worrying about volatility, investors will discover that many of these companies have irreplaceable land holdings with renewable assets that are an ideal inflation hedge.

Now cyclical thinking still prevails. And this is the sweet spot in the cycle. New paper mills opened regularly in the late '90s, as stock prices slumped. There was a brief rebound last year, but many paper shares still sell for less today than they did in 1995. That was the year pulp prices peaked, at just below $1,000 per ton. Since then, they've bobbed between $400 and $600; they are now at the upper end of that range and rising. No new mills will start producing for the next two years. The industry is operating at 97% of capacity, the highest figure in the past decade. Result: Paper company earnings should grow by roughly 50% both this year and next.

So how do you know this is the right time to buy? An old rule of thumb can help: You should invest in cyclical companies when price/earnings ratios are high, and sell when they're low. This sounds upside-down, but more often than not, it works. And it's yet another reason that paper companies are appealing now.

To understand why, look at my table. I've included price/earnings ratios for three different periods. First, there are P/Es based on current earnings, the most recent 12 months. By this measure, my forest products companies look expensive. Three are losing money, and who wants a sluggish IP at 31 times earnings when the median S&P 500 company trades at 18? Current P/Es are high because we're in the trough of the paper cycle and earnings are depressed. Look now at the forward P/Es, based on earnings estimates. The median S&P 500 stock trades at 14 times next year's earnings, while my paper companies (except for Plum Creek (PCL), a special situation) sell on average for half as much.

Suddenly, they look attractive. But you can't wait two years to buy. Then we should be near the peak of the cycle, which means fat reported earnings and low current P/Es. That's when paper company shares tend to be near their highs and short-term investors bail out.

These numbers won't go unnoticed for long. And unless the economy slows dramatically, anyone who buys at today's prices could enjoy significant short-term gains — 30% by December wouldn't surprise me. In the accompanying table, however, I've tried to highlight investments that will be profitable both long and short term. Ideally, I wanted well-managed companies with maximum exposure in the industry's fastest-growing and most profitable segments.

Smurfit-Stone (SSCC) is a good example. Management has concentrated on container board (raw material for corrugated boxes), and the company has become the world's largest producer. There is relatively little domestic competition and none from imports. Most Web purchases get shipped, which is great for the box business. A recent acquisition presents opportunities to cut costs, and expanding cash flow will make it possible to reduce debt.

Abitibi-Consolidated (ABY) and Bowater (BOW) are leaders in the North American newsprint market. Combined, they have a 50% share, and prices are firming after Abitibi's recent decision to close some big plants. Even with a boost from dot-com advertising, domestic demand is growing only 2% annually. But as older, inefficient mills shut down, margins at both companies should improve. They're also major exporters, with double-digit growth so far this year.

Boise-Cascade's (BCC) niche is uncoated free sheet, paper for copiers and computer printers. This is another of the industry's stronger markets, proof that the paperless office is a myth. Demand from in-home printers, for example, is expanding by 25% annually. Mead (MEA), meanwhile, sells container board and coated paper, mostly to magazine publishers. Again, dot-com ads are great for business. And as an integrated producer, Mead is more profitable than many competitors.

Georgia-Pacific (GP) and IP are big and diversified in an industry where size is an advantage. GP also has a major share repurchase program, which could cut its float by 20% over the next two years. Its timber assets are in a tracking stock (Timber Group (TGP)), but IP has 7.5 million acres — more than anyone else. It is also still reaping benefits from last year's acquisition of Union Camp.

I've saved the most unusual for last. Aracruz (ARA) is a Brazilian company that is the world's most efficient pulp producer. It can build plants cheaply and uses eucalyptus trees, which reach maturity in eight years. And the company just announced plans for a major expansion. Finally, Plum Creek isn't a paper company but a real estate investment trust that owns lumber mills and timber — 3.2 million acres in Louisiana, Maine and the Rockies. Steadily growing earnings and a yield of more than 9% make this a wonderful addition to anyone's IRA.

Anyone who buys at today's prices could enjoy significant short-term gains — 30% by December wouldn't be surprising.