Selling My Louisiana-Pacific

Although I think this is a great investment at the right price, the shares have gotten a bit frothy in my view. I\'m taking my 29% gain and leaving.

The last time the company hit a soft patch, the shares languished. I\'d rather leave the party before that happens.

In spite of getting out of the shares, I think there\'s still opportunity with short puts that I outline below.

Since writing my bullish piece on Louisiana-Pacific Corp. (LPX), the shares are up about 23% against a gain of 15.5% for the S&P 500. While gratifying, this means that I need to revisit the company to see if there's still value here, because a stock that's trading at $24 has much less risk than one that is trading at $29. I'll update my view of the financial profile here, and I'll look at the stock as a thing distinct from the underlying. For those who can't wait to get to the end, I'll state it at the outset. I'm selling my shares and I recommend other investors follow suit. Just because I'm selling, though, doesn't mean that I can't also sell a put or five.

I think the following slide best exemplifies the situation the company faces at the moment. The North American OSB market has taken a bad turn, as evidenced by the OSB volume and price declines.

Source

A quick review of the financial history here indicates that this is a long-term growth, short-term cyclical company. Although revenue and net income have grown at a CAGR of 5.2% and 14.8% respectively over the past six years, the ride has hardly been smooth. For instance, revenue was 9.5% lower in 2015 relative to 2013, and net income absolutely collapsed during that time. Given that the share price sank in these years indicates that we should be on the lookout for any slowdown in demand.

I think comparing the first six months of 2019 to the same period in 2018 offers some clues about a slowdown here. Revenue and net income were down in the first six months of 2019 by 22% and 83% respectively. As the company itself suggested per the slide above, this is a challenging OSB market. I've not been able to find any evidence of improvement.

Source: Company filings

The fact is that investing is about much more than buying a company that's growing its cash flows well. It's about not paying too much for those future cash flows. In my view, the more you pay for something, the lower will be your subsequent returns. For that reason, we need to spend some time looking at the stock as a thing distinct from the business. When I look at the stock, I basically want to understand whether the shares are optimistically priced or not. If they are optimistically priced (i.e. if the market has great expectations for the business), that indicates much higher risk in my view.

The reason for that relates to the fact that even the best business will hit a soft spot. If the market assumes perfection, and those expectations are dashed, the shares will suffer. For that reason, I like to buy companies that the crowd has largely dismissed. That's where the idea that a struggling business (like this one) can be a great investment comes from. If the market reacts to something, it usually overreacts, and it's those overreactions that are the foundation of our successes.

There are a few ways that I judge the optimism or pessimism of a given stock. I'll initially compare price to some ratio of value like earnings or free cash flow. On that score, the shares of Louisiana Pacific have undergone a dramatic transformation. When I first wrote about this company, the shares were trading for ~8 times free cash flow. At the moment, the valuation on a PE basis looks like this:

Valuation on a price to free cash flow basis looks like this:

It could be said, then, that the market is paying more for a dollar of future earnings or free cash than it has for years, which is a demonstration of high levels of optimism.

I also judge the market's mood about a given company by working out what the market must be assuming about future growth. The way I do this is by employing the methodology outlined by Professor Stephen Penman in his excellent book "Accounting for Value." In this book, Penman walks investors through how they can use a fairly standard finance formula (and some high school algebra) to isolate the "g" (growth) variable that the market must be assuming given the current price. Employing this approach here reveals that the market is assuming a perpetual growth rate of 6.85%, which I consider excessively optimistic, especially in light of the history here.

Because I think the shares are overpriced at this point, I will be selling them. That said, I would like to have the opportunity to buy them at $24, which is very near the price they traded at when I last wrote about the company. I can sit and wait for the shares to inevitably drop in price, or I can sell put options on the name. I'm not known for my patience, and the idea of sitting and waiting sounds monstrous to me. Thankfully, the alternative allows me to generate some premiums now, and, more importantly "do something."

My favorite Louisiana Pacific puts at the moment are the May 2020s with a strike of $24. These are currently bid-asked at $.80-$.95. If the investor simply takes the bid on these and the shares flatline or rise, they will pocket the premium, which is not the worst fate to befall an investor. If the shares decline, they may be obliged to buy, but will do so at a net price ~30% below the current one. At that price, the dividend yield would be ~2.3%, and, more importantly, that price has a much better chance of offering great long-term returns here.

The evidence that this is a cyclical business is pretty compelling in my view. Additionally, I think the last time the company went into one of its inevitable soft patches, the shares swooned for years. In addition, the market seems to have done a mood shift on this name since I last wrote about it ~275 days ago. The market's pessimism at the beginning of the year is mirrored by extraordinary optimism today. Optimism is not the investor's friend in my view, and so I must recommend avoiding buying shares at the current price. Just because I recommend avoiding the name at $29 doesn't mean there's nothing to do. I think short put options represent an excellent "win-win" trade where the investor either pockets some premium or buys at a much more attractive price than anyone who simply buys today. Louisiana Pacific has been a great ride, but I think I must let it go until there's good relative value here.

I am/we are long LPX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure:

Although I'm currently long, I'll be selling the shares today. In addition, I'll be writing 5 of the puts I mention in this article.