The log yard at the West Fraser Timber sawmill in Quesnel, B.C., Dec. 16, 2010.JOHN LEHMANN/The Globe and Mail
Canadian lumber stocks survived an infestation of mountain pine beetles, two particularly destructive years for forest fires and heavy U.S. duties on Canadian softwood exports.
But the recent dip in U.S. homebuilding activity has proved to be a stumbling block for the sector since June. West Fraser Timber Co. Ltd. has fallen 23 per cent over this three-month period, Canfor Corp. has fallen 25 per cent and Interfor Corp. has fallen 30 per cent.
Are declining stock prices setting up a buying opportunity ahead?
The recent market turbulence comes as the U.S. housing market – traditionally a massive consumer of Canadian softwood, and key to softwood pricing – is wobbling amid rising input costs, a tight labour market and higher interest rates. On Wednesday, the Federal Reserve raised its key rate by a quarter of a percentage point, for its third rate hike this year.
Even before this latest hike, U.S. homebuilding activity had been flashing warning signs of weaker demand for lumber. In the second quarter, housing starts fell 4.8 per cent from the previous quarter, and they have fallen another 2.5 per cent so far in the third quarter, according to RBC Dominion Securities.
Equally worrisome, weaker demand for lumber comes at a time when supply is humming. Lumber inventories are flowing, thanks to resolved rail transportation issues this year.
It’s not a pretty picture. Prices for Western SPF (spruce, pine and fir) – Canadian softwood lumber that is key to homebuilding – fell 13 per cent last week, according to Raymond James. Prices are down 36 per cent since the second quarter, underscoring how volatile this commodity can be.
Nimble investors who had been eyeing the exits saw their opportunity and fled. Now, with lumber stocks well off their highs and sentiment in the dumps, new investors should be contemplating a move in the opposite direction.
“With depressed valuations, strong returns on invested capital, high free cash flow, and financial flexibility churning out returns of capital to investors, we urge investors to add to positions,” Daryl Swetlishoff, an analyst at Raymond James, said in a recent note.
RBC Dominion Securities analyst Paul Quinn is also enthusiastic. “Lumber market fundamentals remain strong, from both a supply and demand perspective going forward,” he said.
The bullish case for lumber stocks rests on a couple of assumptions, but neither of them looks particularly stretched.
First, lumber production must rise only modestly, which seems to be a reasonable bet given that we’re dealing with slow-growing trees and new sawmills that can take more than a year to become fully operational.
Mr. Swetlishoff noted that while U.S. lumber production has risen this year, Canadian production has fallen, leading to an overall situation where supply continues to trail rising demand.
Second, the U.S. housing market must stabilize, which also seems reasonable given the strong economy and low unemployment. According to Capital Economics, the healthy inventory of new homes and the relatively quick time it takes to sell a home should offset rising mortgage rates, leading to slowly rising sales over the next year.
Although Mr. Quinn has trimmed his expectations for U.S. housing starts in 2019 and 2020, he believes that demand for lumber needed for repairing and remodelling homes – which accounts for more than 50 per cent of current lumber consumption – will rise 6 per cent, up from an earlier forecast of 5 per cent growth.
What’s more, he noted that home-ownership rates among young consumers is at last beginning to pick up: 36 per cent of Americans below the age of 35 own homes, up from a low of 34 per cent in 2016 but still well below the high of 43 per cent before the financial crisis – suggesting rising demand for new homes among millennials.
Analysts note that fall traditionally has offered a strong seasonal buying opportunity for investors, as a dip in share prices offers a good setup to the spring building season. The current backdrop of gloomy housing stats and rising interest rates only adds to the allure.