Time to Buy the Homebuilders?

We here at Running of the Bulls are value investors.  In the short-term, we'd trade anything - if we traded, that is.  But for investment purposes, we fall soundly in the value camp.

One of our favourite strategies is to by a basket of stocks in an industry that has been completely blown out of the water and left for dead.  Buying small pieces in a raft of crappy Internet companies that were trading below net cash in 2002 produced returns of 200%, 300% or even 400% over the next 12-24 months, depending on what you bought and when you did so, even though many of the Talking Sock Puppet Companies eventually went under.  I used to undertake such a strategy with semiconductor equipment, which now have become absolutely @%^%$#&$@#!@?! boring stocks, akin to watching paint dry.

I expect a similar fate to befall the homebuilders, and I was wondering if we were at that point yet.  Steve Kim over at Salomon Smith Barney Citigroup, amongst others, has been making the case that these stocks bottom at 1x book value, and they are either there or getting close.  If the group is trading at a cyclical low book value, then I am interested. 

I look at book value for this group because earnings estimates are meaningless as the imploding housing market - or at least imploding in the five states where, according to Credit Suisse's top-notch homebuilders analyst Ivy Zelman, estimates her group generated 75% of its profits this decade - is putting severe pressure on profitability.  The group, after all, was trading at something like 4-5x estimates a year ago, and is now something like 20x today so PE to me doesn't tell me much. Also, we truly have no idea what normalized earnings through the cycle will be as the prior top may represent the biggest housing bubble of all time.

I used 13 companies as my industry.  The following is the closing price today and the current PB.

Beazer (BZH)  $32.32, 0.77x BV
Centex (CTX)  $43.17, 1.05x BV
DR Horton (DHI) $22.79, 1.10x BV
Hovnanian (HOV)  $27.34, 0.97x BV
KB Home (KBH)  $45.99, 1.21x BV
Lennar (LEN)  $44.54, 1.24x BV
MDC Holdings (MDC)  $50.25, 1.05x BV
Meritage (MTH)  $33.50, 0.87x BV
NVR (NVR)  $712.66, 3.41x BV
Pulte (PHM)  $27.25, 1.06x BV
Ryland (RYL)  $45.60, 1.29x BV
Standard-Pacific (SPF)  $22.34, 0.82x BV
Toll Brothers (TOL) $28.85, 1.28x BV
Average 1.24x BV

Several of those valuations look enticing, if you assume that buying the stocks at 1x book value is a good strategy.  The group isn't far from that at 1.24x, which is skewed by NVR.  If you exclude NVR, the group is 1.06x.

Back up the truck, right?

Whoa, not so fast.

First, let's look at how the group traded in 1999/2000, when everything but TMT (tech, media and telecom), the Talking Sock Puppet companies (companies that had little revenues, negative profits, and nothing but a web site and marketing plan), and big cap growth stocks (which, apparently, weren't in a bubble, or so I'm told).  In 1999 or 2000, the stocks bottomed at the following valuations.

Beazer 0.60x BV
Centex 0.76x BV
DR Horton 0.79x BV
Hovnanian 0.49x BV
KB Home 1.20x BV
Lennar 1.00x BV
MDC Holdings 0.70x BV
Meritage 0.51x BV
NVR 1.08x BV
Pulte 0.60x BV
Ryland 0.57x BV
Standard-Pacific 0.64x BV
Toll Brothers 0.94x BV
Average 0.76x BV

So, in fact, if you bought the stocks at 1x book value in 1999 or 2000, you lost 25% of your investment.  So if the stocks were to revisit their lows of the turn of the decade, and if you were to buy them now, how much would you lose?

Beazer -22%

Centex -28%   

DR Horton -28%

Hovnanian -49%

KB Home -1%

Lennar -19%

MDC Holdings -33%

Meritage -41%

NVR -68%

Pulte -43%

Ryland -56%

Standard-Pacific -22%

Toll Brothers -26%

Average -33%

But this assumes that book value won't change.  Ivy Zelman estimates that there is another $6.5 billion or so in charges and write-offs coming.  If those charges occurred today, then you would wipe out another 15% of book value.  What would book value per share of the homebuilders be, and what would be the downside to the 1999/2000 lows after the charges if the charge-offs were equally distributed across the board (an unrealistic assumption, for sure, but for simplicities sake)?

Beazer 0.90x BV  -34%

Centex 1.24x BV  -39%

DR Horton 1.29x BV  -39%

Hovnanian 1.14x BV  -57%

KB Home 1.42x BV  -16%

Lennar 1.46x BV  -31%

MDC Holdings 1.24x BV  -43%

Meritage 1.02x BV  -50%

NVR 4.02x BV  -73%

Pulte 1.25x BV  -52%

Ryland 1.51x BV  -62%

Standard-Pacific 0.96x BV  -33%

Toll Brothers 1.50x BV -37%

Average 1.46x BV -44%

But why look at the lows from 7-8 years ago?  The housing market today resembles 1990 far more closely than 2000, and my guess it will be far worse.  So what were the homebuilders trading at when they bottomed during the housing market wreck back then?

I have nine homebuilders that were trading publicly IN 1990.  This is what they bottomed at in 1991 or 1992, and the losses from current levels if stocks were trade that low after Ms. Zelman's charges.

Centex 0.53x BV,  -57%
Hovnanian 0.29x BV,  -75%

KB Home 0.80x BV,  -44%

Lennar 0.14x BV,  -91%

MDC Holdings 0.22x BV,  -82%
Pulte 0.50x BV,  -60%

Ryland 0.57x BV,  -62%

Standard-Pacific 0.48x BV,  -50%

Toll Brothers 0.71x BV, -53%

Average 0.47x BV,  -64%

Now, one can make a very cogent argument that the group will never get to 0.50x book value - there is an ocean of liquidity in the world, the homebuilders are more rational, they are better financed, they control more market share, interest rates aren't as high, etc.  And I certainly am willing to concede all that.  However, one should not count out the real possibility that the group certainly could still be cut in half, at least.  The one thing that never ceases to amaze me in financial markets is that markets can go a lot farther for a lot longer - on both the upside and the downside - than I could ever have imagined.

So no, I do not believe the time has come to buy the homebuilders.  I think there is still significant downside to come.  But that's just my opinion. 

My guess is that the group will bottom higher than 0.47x book value in 1991/1992 but lower than 0.76x.  Maybe they bottom at 60%-70% of book value.  Then, you close your eyes and buy.  And when they double, you sell them because I imagine the group will move sideways for years thereafter.


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