Does the market overreact in its valuation of the Swedish forest?

Does the market overreact in its valuation of the Swedish forest?

31 May 2019 from Mikael Syding

Does the market overreact in its valuation of the Swedish forest?
Rottnerros’ share price surged 75% during the period January to April this year. After that, the
share has fallen back about 15% in May, to SEK 12.20 / share.

In the last twelve months, the entire sector has fallen sharply. Metsä, for example, is at the
bottom after having collapsed by almost 60%, while the giants Stora and SCA lost 25% each.

How can this be reasonable for something as massive and permanent as the Nordic forest and
its products? Does the market overreact? Does it miss the forest for the trees? That was the
subject of my thesis at the SSE.

When I conducted my study, I was able to measure the stock price at a date, for example in
1960, at the same time as I knew how the cash flows would be in the next 25 years, in this case
1961-1985. Thus, I could calculate an almost exact DCF value and compare it to the actual
share prices.

 

I did not arrive at any definitive answers then, a quarter of a century ago, but in general my
conclusions are:

The companies' results vary more than what the stock prices do, which could indicate that the
market is less nervous than we normally give it credit for. However, the fact that the share prices
do not fall below zero when companies show a loss a few years is a very low threshold for
assessing the degree of overreaction.

No, what is more important in this context is that share prices historically varied much more than
what the sum of future cash flows in the sector later turned out to be. That was what I showed in
my essay.

So the answer is "yes," the market overreacts regarding the pulp, paper and wood industry. Or
rather, it has overreacted earlier. There is reason to believe that this is still so.

Of course, we do not have the same omniscient perspective that I had in my essay. We do not
know exactly how the profit development will look like in the next 25 years. But, our best guess
is still that it will be reminiscent of how it looked historically:

Thus, given that there are no direct reasons to assume that one should extrapolate a few years
of up or down as an eternal trend, we can expect that the forest over time has a given share of
our total economy. My guess is that the share slowly falls, but in a relatively predictable way,
which thus hardly leaves a room in a cash flow valuation for warranted large share price
movements.

Thus, given that there are no direct reasons to suppose that one should extrapolate a few years' up or down as a perpetual trend, we can expect that the forest over time has a given share of our total economy. My guess is that the share slowly falls, but in a relatively predictable way, which thus hardly leaves a motivated space in a cash flow valuation for price doubles and halves in a short time.

Large movements in the sector are thus probably too large.

The sector has as I said earlier fallen sharply in the last twelve months, but this year it has gone
up. Rottnerros is up 48% only this year. Holmen has risen by 23% and Stora by 16%. The
figures are excluding dividends, which adds another 2-7 percentage points per company. SCA
stands for the lowest figure and Metsä Board for the highest.

Despite the year’s upturn, several of the companies in the sector look cheap on traditional key
metrics, such as profit and sales multiples, or dividend yield. I would still prefer to play the
companies on the downside, for example as funding sources for other long positions.

For example, SCA lost relative to the OMX index during the period September to December
2018, but did not regain the gap when the stock market rose. As a result, SCA seems to work
best as a short-selling candidate which falls more than the stock market during the fall, and rises
less when the market appreciates. It is probably a symptom of both that we are late in a cycle
and that SCA is the most expensive forest share in the Nordic region.
 
Without claiming to be a forest analyst, the Swedish construction market, export to the UK and,
to a growing extent, China are three important areas for Nordic forest products. All three are
today surrounded by uncertainty factors, which in addition to the construction market also
include Brexit, trade war and weaker growth in China. In addition, there is reason to expect a
weaker economy globally, after ten years of expansion (although Invesco's positive macro
analyst describes it as we’re only mid-cycle, not late cycle).
 
All of these negative factors can of course be turned round, and if anything we have learned that
the forest stocks are happy to oblige and overreact. Thus, there are often new momentum trade
opportunities, if one manages to identify them early. Alternatively, you could wait for the
overreaction to lose momentum, and then you get ready to follow in the other direction.
 
In the sector, Stora and SCA are clearly the largest, if one does not count the hygiene article
company Essity. Holmen, Munksjö and Metsä come on shared third place and far below them
we find Rottnerros.
 
Rottnerros is not only the smallest but also the cheapest in the sector and fluctuates the most.
Knowledgable and alert private investors are often better at managing the rapid fluctuations in
Rottnerros than professional analysts and financial journalists. One example of that was last
autumn, when one of the most well-known business magazines completely botched their sell
recommendation. That happens a lot, when you have to deal with a sector where the market is
prone to overreaction.
 
Do you want to be part of the overreactions, or are you ready to go against them? There is
something for everyone in the forest sector. And then we have not even touched upon the
issues concerning the the forest as a secure real asset in a world of money printing, or its role in
issues of climate change and environmentally friendly, sustainable alternatives.

 

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12/12/2019 15:35:43

 

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