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david berman

Globe and Mail columnist David Berman.The Globe and Mail

After the United States announced hefty duties on Canadian softwood lumber exports, investors responded with defiance: They jumped into Canadian lumber stocks.

West Fraser Timber Co. Ltd. rose 8.8 per cent and Canfor Corp. rose 7.9 per cent, making these two stocks the top movers on the S&P/TSX composite index on Tuesday.

Far from a nationalistic response, the rally recognizes some good news: The duties could have been worse and the U.S. still needs Canadian lumber to feed its recovering housing market.

The U.S.-imposed duties, which are based on the argument that Canadian lumber producers benefit from unfair government subsidies, average about 20 per cent across the Canadian sector.

Explainer: NAFTA, dairy and softwood: What's going on with Trump? A guide to the trade file

But investors had been bracing themselves for something far more punitive. Earlier this year, at least one industry observer had floated the possibility of an initial tariff as high as 40 per cent, or about double what the U.S. has started with.

These concerns had been weighing on Canadian forestry stocks.

West Fraser shares slumped 8 per cent last year and Canfor tumbled 24 per cent, next to gains of nearly 14 per the S&P Global Timber & Forestry Index over the same period.

Canadian stocks are also conspicuously cheap next to their international peers. West Fraser shares trade at just 12.4 times trailing profit, which is well below the timber index's price-to-earnings ratio of nearly 21.

Now that investors know what duties lumber producers face, they are relieved – sending share prices and valuations upward.

Daryl Swetlishoff, an analyst at Raymond James, turned up his bullish enthusiasm by a notch, raising his recommendation on Canfor to "strong buy" from "outperform" previously.

He also crunched some numbers for the entire sector, illustrating why the tariffs won't hurt.

Assuming a 30 per cent cumulative duty (which takes into account further measures by the U.S.), he estimates that operating profits will continue to rise with lumber prices in 2017 and 2018.

For example, West Fraser's earnings before interest, taxes, depreciation and amortization (or EBITDA) should rise by 17 per cent in 2017. Norbord Inc.'s EBITDA should rise by nearly 40 per cent.

"We note that there remains significant upside to current trading levels, and with the uncertainty of the preliminary countervailing duty removed we expect that a layer of risk is removed from share prices," Mr. Swetlishoff said in a note.

How much upside? He believes Canfor, Interfor Corp., West Fraser, Conifex Timber Inc., Western Forest Products Inc. and Norbord should see rallies averaging 40 per cent within 12 months.

But the bullish response to Canadian lumber stocks can also be explained by upbeat conditions for the U.S. housing market, which uses a lot of imported lumber for its frames.

New home sales rose 5.8 per cent in March, over the previous month, which pushed down the supply of new homes to a five-month low, according to Capital Economics.

Reflecting the strong conditions, PulteGroup Inc., a U.S. homebuilding company, announced on Tuesday that its first-quarter profit rose 17 per cent over last year. Revenue rose 14 per cent.

When the lumber tariff came up during the company's conference call with analysts, executives didn't like what they saw.

"I'm not sure what will happen," said Bob O'Shaughnessy, PulteGroup's chief financial officer. "Obviously, how it plays out over time can have an influence on our cost structure."

In other words, U.S. tariffs may end up hitting the wrong target: U.S. consumers and businesses.

"U.S. homeowners will pay a price," Derek Holt, an economist at Bank of Nova Scotia, said in a note.

"Higher lumber prices and a half percentage point rise in the 30 year U.S. fixed mortgage rate since last September is an odd recipe for a continued housing recovery in the U.S.," Mr. Holt added.

The United States needs access to Canadian lumber. Now, the country is going to pay more for it – and investors don't mind one bit.