Homebuilders... Plus Buffett's Comment on Them...

(UPDATE: One point unrelated to this post was when Warren Buffett was asked what his best investment of all time was. He remarked it was probably GEICO, the insurance company with the likable green lizard mascot. Based on my little understanding of Buffett and his history, I would have put that near the top of his best investments list as well. Interestingly, Benjamin Graham also made more money on GEICO in an earlier era than with anything else.)

Wild week in the markets but anyway, some notes on homebuilders.

Warren Buffett Comments on Homebuilders

The new business television network in the US, Fox Business, snatched an exclusive interview with Warren Buffett. Thanks to Reflections on Value Investing for the heads up and providing some useful links. You can find excerpts of the interview here (search for Buffett near the bottom). There is some partial transcription at Wall$treetFighter, which mentions some stuff not in the video.

I thought it was interesting to hear Warren Buffett's comments on homebuilders:

I didn’t buy a share. I look at them. I look at their debt, their equities. I look at everything. I’m waiting until they’re under priced. That’s what I look for with any security. And, I don’t think they’re undervalued. Starting 30 minutes, ending 18 months ago – that year – we probably had more home builders offer to Berkshire where the managements wanted to see the business that I’ve ever seen in any industry. A significant percentage of the publicly-owned home builders, when their stock was flying high and their management was talking bullishly, were trying to sell their companies. Apparently they knew what was going on or likely to go on. Though, I don’t think they saw it coming as extensively as it did.

(source: Wall$treetFighter; original television interview by Fox Business)

As I bolded above, Buffett thinks that homebuilders are not cheap yet. I share a similar opinion. The homebuilders are sitting on a lot of inventory and until I see that starting to decline materially, it isn't time yet IMO. If one wants to make decent money, they need to act long before Buffett does. Usually, but not always, when news of Buffett initiating a position in something becomes public, the whole sector runs up quickly.

Quick Notes on the Housing Situation

Business had a good article on housing that you can find here (as I pointed out last week in a lengthy post, it's front page stuff so maybe it's a good contrarian indicator). Housing is making the news everywhere so most of the article may be repetitious but one should read it if they want to get a feeling for the situation. Here are some things I found interesting:

Even though the five-largest publicly held residential builders have cut the value of their land and unsold homes from $49.7 billion in 2006 to $41.9 billion today, that inventory as a percentage of sales has soared 33% during the past year, according to Banc of America Securities.

I'm quoting this to point out that, even after paring it down, outstanding inventory is massive. In my newbie opinion, this is the #1 danger to investors in this sector. The numbers being bandied about are just staggering compared to past housing cycles. It is going to be difficult to unload all this inventory without marking it down or getting rid of it somehow. Someone (can't remember where) actually remarked that when homebuilders bulldoze their homes, we know housing has hit a bottom (supposedly it happen in Texas during the housing collapse in the late 80's). All this inventory has to be written off and book value is going to get destroyed big time. Pepople probably shouldn't just barge into the sector based on the low price-to-bookvalue of the homebuilders.

A year ago builders' debt payments were roughly the same as their cash flow. Now debt is 2.5 times cash flow.

This is something I don't understand (if you do, please leave a comment below and explain it). How can you have debt payments way above cash flow? Even one year ago, if cash flow was equal to debt payment, doesn't that mean that there would be no money leftover for shareholders? But how come these companies posted earnings an year ago? Something looks weird with the quote.

With a slew of risky, adjustable-rate mortgages still to reset next year, foreclosure rates could climb even higher. That's a big reason why the stocks of the nation's 20 largest homebuilders have fallen an average 65% since the start of 2007.

The ARM resets next year are the next big question mark. Long bond yields actually declined sharply this week, as the stock market sold off, so who knows how things will be early next year. Interest rates need to be accomodative by early next year or else things are going to be far worse.

But there a few weak rays of light at the end of the tunnel. Builders are taking the painful step of cutting production. Permits are down 49% from the market's September, 2005, peak. That's half the time it took to reach this point in the last decline. "Builders definitely responded more quickly this time, and that's a good thing," says Banc of America Securities analyst Daniel Oppenheim. "But the inventory overhang is so great, it's going to take a long time to work through this. They still have a ways to go before there's a recovery."

I think the market interprets declining permits as being bearish for homebuilder stocks (since that lowers potential profits) but it is healthy for the sector. Given the huge inventory, builders have to ramp back down to levels they were operating at before the big boom. Some of the homebuilders will also likely go bankrupt in the process. The risk of bankruptcy, along with potentially several years of losses or weak profits, is what makes me look at the homebuilder bond (PHA in my case).

(source: stockcharts.com)

PHA is right now trading around 25% below its par value and has a yield of around 9.5%. For it to have a yield of around 13%, price needs to drop to around $14. I would only consider it attractive around that price.