Saturday, October 6, 2007 0 comments ++[ CLICK TO COMMENT ]++

A Look at Homebuilders (and Related Sectors)

I haven't posted much lately (haven't much useful to talk about) but I hope I make it up with this very long post on housing. Hope some of you find it interesting and feel free to leave comments...

One of the areas that contrarians and value investors often look at are cyclical industries that are beaten down. Benjamin Graham remarked:

If he [enterprising investor] followed our philosophy in this field he would more likely be the buyer of important cyclical enterprises--such as steel shares perhaps--when the current situation is unfavourable, the near-term prospects are poor, and the low price fully reflects the current pessimissm.

(source: Benjamin Graham, The Intelligent Investor, Revised Edition, 2003. Page 383 (top))

Anything related to residental real estate fits this mold, although it's nt clear that prices fully reflect the pessimissm (they may not yet). Certainly mortgage lenders have sufferred greatly, with more than 50 bankruptcies already, and leading homebuilder stocks are down more than 40% this year.

Negative News Galore

There is a lot of negativity surrounding housing. As they say, a good indicator for contrarians is when something makes the front cover of a leading magazine (or website these days I guess). Well, housing just made the front cover of the October 15th edition of Businessweek:

(source: Businessweek, October 15 2007 edition. URL here.)

There is a somewhat decent article talking about investors looking at housing-related stocks. A lot of people are clearly interested in the beaten-down stocks but most are uncertain of the timing.

I think you can find a million charts to show that housing is headed downhill. I'll pull up some of the key ones, including one I created.

(source: Businessweek, October 15 2007 edition. URL here.)

The charts above are pretty straightforward. The chart below is one I created of NAHB housing starts. The housing start number is one of the key metrics used by Owens Corning (OC) executives and is a good indicator of how much OC may sell off (it has already sold off a lot).

Finally, for those that haven't followed the homebuilding sector...


The chart above plots the homebuilder index (^HGX) against Pulte Homes (PHM), a leading homebuilder and a security I'm analyzing. We have had quite a rise and a fall. PHM is back at the levels in 2003 when the big move in housing took place. I am not sure if any of the homebuilders are cheap yet. I'll be looking deeply at PHM soon and will post my thoughts.

Are homebuilders value traps?

Leading the superbear case is Robert Shiller, who predicts that prices have further to fall. Check out this blog entry by Nick Nejad of Rational Angle if you are interested in some of Shiller's comments. I think house prices can fall further but the question is whether the market has priced them in.

Some prominent value investors like Bill Miller have been burnt by housing so far. So the question is whether these are value traps? My feeling is that they are not (on an unrelated note, what may be value traps are forestry stocks, which is an area I'm also tracking). Although the suffering may continue for the time being, I think the situation will improve once inventory has been cleared and mortgagees are comfortable with mortgage resets. We just don't know when.

Let me quote some of Bill Miller's thoughts from his 2nd quarter commentary:

Owning housing stocks in the midst of the worst housing market in at least 15 years, and one where the problems may linger until 2009, may prompt a reaction similar to that one client had when we bought a company in the midst of a scandal: don’t you read the papers? At LMCM we actually try to buy low and sell high, and you don’t buy low when everything is great and the headlines reflect it. Usually, but not always, when you read about some industry or company having the worst time since some period of years, or even decades ago, you will find that buying that industry or company when it was going through those difficulties proved quite profitable if your time horizon wasn’t measured in days or months...

We were clearly too early in buying these stocks in late 2005 and 2006—and if you are early enough, that is indistinguishable from being wrong—thinking that the US housing experience would be similar to that in the UK and Australia, a correction from inflated levels that would be over in less than two years, that is, just about now. The very poor housing fundamentals, now exacerbated by a subprime loan collapse and the continuing upward repricing of adjustable-rate mortgages made in the past few years, show no signs of improvement. But the market looks forward, and by the time those signs are tangible and evident, the stocks will likely be a lot higher.

(source: Bill Miller, Legg Mason Value Trust Investment Commentary,
Manager Insight/Q207, Legg Mason Funds. URL here)

It's always hard to pick the bottom but if something is cheap enough, it's worth taking the risk IMO. A lot of the homebuilders have book value way below 1, but one needs to do some homework and figure out how much of the inventory and land assets will have to be written down.

Even with my cautious optimism, one of the big question marks in my eyes is the degree that housing has benefitted from the secular decline in interest rates throughout the 80's and 90's. Although some mistakenly think the lowering of the rates to 1% by the Federal Reserve started the big move in housing, if you trace the performance of homebuilder stocks and other related entities (including homebuiling suppliers), you will find that the ascent started back in the early 90's. You are not going to get the same impetus from interest rates that you did in the last two decades. Although I don't expect rates to go up much, any decline won't have the same effect. So what one should think about is whether all these companies in the housing area are going to face big headwinds over the next 20 years. The companies themselves will point to a bunch of bullish scenarios like increasing population but interest rates are more important.

Potential Investments

There are many ways to invest in the housing arena. I am looking at the following:

  • Homebuilders: I'm looking at Pulte Homes exchange-traded bond (PHA) but if you are not interested in an exchange-traded bond, or simply want equity, then Pulte may not necessarily be the best bet (this is the only one that trades on NYSE so that's why I'm looking at it). The reason I am looking at the bond rather than the stock is because if housing goes nowhere for years, at least you will earn the 9% yield on the bond whereas the stock won't pay anything meaningful (this is assuming the company doesn't default or go bankrupt ;) ). I'll be looking at Pulte Homes in the future from a credit point of view (i.e. default risk) rather than a potential turnaround in the stock price.

  • Mortgage lenders: I took a small position in Delta Financial (DFC). I have to admit that I don't understand this company (or financial companies in general). This is a highly speculative turnaround play.

  • Building material suppliers: I like Owens Corning (OC; PK: OCWAZ) and am doing research on it. A lot of value investors are taking positions in USG but I like OC better (there are not really direct competitors). The only thing with OC so far is that its ROE (return on equity) looks very low. But given its bankruptcy-related issues, I am trying to track down older information.

My feeling is that there is more downside to housing (huge refinancing resets early next year, as well as potentially greater than expected economic slowdown) so I'm researching them while I wait. Unless the bottom falls out on some of these by Christmas (it may due to tax-loss selling), I'll wait until 1st quarter of next year before I make a move.

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