This “Hated” Sector Could be Buffett’s New Favorite

Warren Buffett’s annual letter to shareholders is one of the most highly anticipated reports in the financial community. (You can find a copy of his latest letter here)

Every year, investors around the world anxiously wait to hear what the world’s most prolific investor has to say about what lies ahead… this year was no exception.

As always, this year’s report sheds some light on the inner workings of Buffett’s mind and identifies specific areas of opportunity… and his latest prediction might surprise you.

Believe it or not, Buffett, in his 47th annual letter, has given a ringing endorsement to what is arguably the most spurned of all investments: housing.

In fact, he boldly claimed that it would be smart for affluent investors to purchase not just a second or third home, but “load up” on “hundreds of thousands” of single-family homes.

I couldn’t agree more.

After the most devastating crash on record, home prices are dirt cheap in many markets. In fact, it is now cheaper to buy than rent in 98 of top 100 metropolitan areas. And let’s not forget that mortgage rates are at historic lows.

Of course, we’ve been waiting for the housing recovery to kick off for some time now. But the past few months have brought real, tangible signs of progress.

Housing starts hit a three-year high in January by rising to an annual pace of 705,000 units. That’s almost 100,000 more than the total from 2011.

— The Commerce Department reports that new home construction permits reached an annual rate of 717,000 in February and then 747,000 in March, the strongest pace since 2008.

–Builders have just begun work on new condo and apartment developments at a pace of 241,000 units annually, a 21% increase from multi-family construction projects this time  last year.

— Median new home prices have bounced 8% over the past 12 months to reach $233,700.

— Homebuilder sentiment has risen in six of the past seven months, touching a fresh five-year high in March.

The surge in permits is a reliable leading indicator of future groundbreaking. And housing is expected to add to GDP (rather than subtract) this year for the first time since 2005. In fact, ratings agency Fitch is forecasting a healthy 10% increase in new home construction in 2012, versus a 9% drop last year.

Now, most of us lack the idle cash to buy up entire neighborhoods or invest in new developments like Buffett does. But fortunately for us, there is another way to can take advantage of the housing turnaround… lumber.

After all, how can you build houses without more wood? You can’t. And that’s exactly why I think timber owners are primed for a strong rally in the coming year.

One such company is Weyerhaeuser (NYSE: WY), one of the world’s largest integrated forest products companies. Weyerhaeuser owns vast tracts of shady land in Arkansas, Louisiana, North Carolina and several other states, some six million acres in all.

The company is fortunate in that it owns two million prime acres (33% of the firm’s total) in Oregon and Washington — the industry sweet spot. As a result, each of Weyerhaeuser’s acres generates $80 in annual EBITDA on average. That’s far superior to two of its biggest rivals, Rayonier (NYSE: RYN) and Plum Creek Timber (NYSE: PCL).

And timberland only accounts for one-quarter of the company’s revenue.

The largest segment, with $2.3 billion in annual sales (38%), is wood products, which includes boards, plywood and other finished goods used to build homes and businesses.

This unit is currently operating at a loss, which isn’t terribly surprising given the operating environment. But to give you an idea of what it can do under better conditions, the company was shipping nearly $10 billion worth of wood products per year before the crash — four times what it sells today.

But even under dismal conditions, Weyerhaeuser still managed to generate $330 million ($0.62 per share) in net profits last year across all the company’s business divisions. And it wasn’t even jogging, let alone running at full speed. That’s why I’m looking ahead to tomorrow.

Management calculates that the wood products unit needs 665,000 housing starts per year to turn a profit. Builders are currently breaking ground at an annualized pace of 750,000 — and even that’s just half of the 1.5 million new homes built on average each year since 1971.

Keep in mind, as a real estate investment trust (REIT), the company aims to distribute at least 75% of its pre-debt cash flow. Shareholders can currently look forward to $0.60 per share in annual dividends, for a yield of 3%.

I expect those payments to climb significantly in the coming years as housing wakes from its slumber and construction picks up. In the meantime, demand from overseas remains brisk — the company exported $370 million in logs last year to Japan, China and South Korea.

Risks to Consider: Of course, with investing nothing is 100% certain. The housing market is still fragile and nowhere near full strength. So initially at least, I think we’ll see an uneven recovery where hits are occasionally punctuated by misses.

Action to Take —-> But, that said, the fact remains that the U.S. isn’t building nearly enough new homes to keep pace with the number of new households being created. Eventually, the two will come back into balance. And when they do, timber owners could be a clear beneficiary.