If you’re looking for beaten-up stocks, this is a sector to watch

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Beaten-up forestry stocks led us into this bout of market mayhem. Will they lead us out?

West Fraser Timber Co. Ltd. epitomizes the forestry sector’s dismal state. The stock price tumbled 28 per cent since mid-August amid falling lumber prices and concerns that higher borrowing costs are depressing homebuilding activity.

There are many factors weighing on the broader stock market right now. But the factors driving the forestry sector – from trade tariffs to declining Chinese economic growth to some disappointing corporate financial results – could be key to the overall volatility.

The Federal Reserve and the Bank of Canada are raising interest rates, which is affecting the ability of consumers to finance home purchases.

The Canadian central bank raised its key rate by a quarter percentage point on Wednesday and suggested it could become more aggressive with its rate-hiking campaign. Canada’s big banks responded by raising their prime lending rates to 3.95 per cent.

Much like the broader market, forestry stocks have enjoyed a good run during the past nine years of economic expansion. West Fraser, the biggest Canadian company in this sector, saw its share price rise more than 850 per cent from mid-2009 to its peak midway through 2018.

Now, though, the fundamentals are less supportive. Lumber prices are down more than 50 per cent over the past four months. And U.S. housing starts – the number of homes where construction has begun – appear to be levelling off at about 1.2 million units a month, which is below the long-term average and well off levels seen a decade ago, before the financial crisis.

Some forestry analysts are cautious in this environment, noting lumber prices could slide further if U.S. housing starts continue to miss economists' expectations (as they did in September). Even if fundamentals improve, forestry stock valuations may stay low.

“Even when lumber prices eventually rebound, we suspect multiples may be constrained given the multiple compression we have observed across homebuilders, big box stores and building products distributors in recent weeks as U.S. consumers have pulled back from the housing market,” Hamir Patel, an analyst at CIBC World Markets, said in a note.

He reiterated forestry is not a sector that anyone has to own. If investors are wary, they can stay away.

Nonetheless, investors who aren’t put off by volatility should keep an eye on the sector. While the market is nervous about the effect of rising interest rates, there’s little indication we are on the verge of a nasty economic downturn, given robust corporate profits and low unemployment levels.

Daryl Swetlishoff, an analyst at Raymond James, pointed out West Fraser’s share price has declined to where it was in mid-2017. The drop comes even though the company has increased its manufacturing capacity, raised its dividend twice and repurchased $600-million of its shares, or about 9 per cent of the total number of outstanding shares.

“Less shares, more capacity, higher payout … share price unchanged,” Mr. Swetlishoff said in a note.

The company’s third-quarter profit, reported Monday, surged past analysts' expectations. Net earnings rose to $238-million, up about 98 per cent from last year. The company’s third quarter EBITDA (or earnings before interest, taxes, depreciation and amortization), adjusted for U.S. export duties, rose to $388-million, up 63 per cent from last year.

The takeaways here? First, West Fraser is a company that’s making piles of money, even with lumber prices down. Second, it’s impossible to know when this stock will hit bottom. And third, if you’re looking for beaten-up stocks, this one should be on your list.