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Trading the Homebuilders Profitably

July 18, 2007 | About:
10qk

Joe Citarrella

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Fair warning: I’m still working on the research here, but I’ve come up with an idea on profiting from the homebuilders’ continued weakness and overselling.

It’s fairly simple: buy the builders trading below book value (Beazer, CHCI, etc, etc) and short an appropriate amount (i.e. buy puts on) of the Case-Shiller housing price index.

The thesis is as follows: several of the builders are trading at mere fractions of book, largely due to the fact that investors anticipate plenty more writeoffs of inventory, consisting of unsold homes and land, going forward. This inventory comprises the vast majority of these companies’ tangible asset values, so it naturally makes sense that discounts to book are largely due to fear that the asset values are overstated. Normally I’d simply buy and hold such cheaply priced companies, but the truth is that I haven’t a clue where housing prices are headed going forward or how much in charges to inventory the builders will take.

What I do know is that a company like Beazer Homes (BZH), for instance, has a geographically diversified portfolio of decidedly normal homes which I believe, on average, to be well-representative of the typical American house. The average unit price is listed on the company’s books at around $220,000, and, interestingly, the average composite home price can be shorted via Case-Shiller at around the same price.

This means a savvy investor can effectively profit from the spread/discrepancy between book value and price of Beazer’s stock by hedging out the writedown risk via a short position in the Case-Shiller composite. While I’m not positive, I’m fairly confident that an inefficiency in the smaller homebuilders’ pricing exists since most investors are not considering how they can come close to eliminating the risk of writedowns. Of course, this is assuming that investors are also willing to stomach the risk of heavy debt, poor management, etc., but for some it may be worth these risks.

Note: I do not currently have a position in Case-Shiller futures or any homebuilding stocks.

About the author:

Joe Citarrella
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Comments

marco.guerreiro
Marco.guerreiro - 7 years ago
Interesting point, the only problem would be if the house price remains stable at those levels eliminating the value of the options and keeping losses at the builders if they still have to hold on the houses for longer.. Timing is the bigest problem I see in the strategy, it might be a while before sentiment recovers for the housing sector (builders, morgagers, etc etc) or it might ocurr in the next months, who knows.
JJINVEST
JJINVEST premium member - 7 years ago
Personally, all the options and shorting simly aren't worth the money. If you are positive about certain homebuilders, you would buy it, go long and just add more position as it goes down more. The best hedge in the world is simply cash. Nowadays, you can collect 5% "dividend" on cash (with one of the online banking savings account that give you 5% interest per year). Put options and shorts are inheriently, fundamentally bad trades because over time the market is on the way up (5 years out, 10 years out). So using those tools, you are going against a general handicap right away ("going against the tide" so to speak) and just like long, short-thesis takes time to play out and before then, the pain might be too great and you might cash out early.

Anyway, I have digressed. I was looking at homebuilders mid-2006 when it had a temporary bottom and was kicking myself when in late 2006, homebuilders had a 30-50% rally! I was skeptical that the housing had indeed bottomed, however, and felt that the risk is greater than the reward after such mini-rally. Boy, was I glad not to have bought it because in the last 3-6 months, the home builders are plunging almost in the a linear line.

Recently, I am starting to look into homebuilders again. The view on this sector is decidedly mixed among the guru's. Some bought it (and way too early as I might add) while some simply don't like the sectors because homebuilders are 1) essentially a commodity business because each home competes on the basis of price (the only advantage a homebuilder has is how it procured that land because in real estate, it is all about location, location, location) and 2) homebuilders have too much debts and when the tide turns, as all leverage is meant to do, the effect is massively magnified.

The good thing for us, the individual investors, is that we have had some time for the scenario to play out. I have not seen any of the guru's who had bought homebuilders to be seeling out (instead some even bought more). Secondly, I don't agree with the guru's who simply wouldn't touch the homebuilders. Like Munger said, "all intelligent investing is value investing." I bet half of the guru's who are now buying oil/gas companies would have said that oil/gas companies were commodity businesses and they would not touch it, when oil as $20 per barrel. There are bargains in any sector and it is all about timing. There are homebuilders having the better capital structure and better management teams as the rest of the gang who unscrupulously just kept on piling on land when the time was good.

Anyway, unfortunately, even the best guru's get timing wrong. Nobody can get timing correct; if one could, there would be many many more Buffett's in this world. I would say, don't trade. Select a couple good ones, go long and slowly average down your costs as homebuilders continue their descents. Hey, who knows, maybe tomorrow, they will also spike up in terms of price? I remember somewhere that stocks turn around about 6 months prior to the bottome of the economic depression (i.e. the bottom of the bottom in recession). Similarly, homebuilder stock prices also turn around 6 months prior to the bottom of the housing cycle. You can't predict these things. Just go long and be reassured that many guru's are investing alongside with you.
allenwhite
Allenwhite - 7 years ago
This would make some sense if there wasn't so much debt on the companies you mentioned. CHCI is close to bankruptcy as is and BZH would be as well if the housing market takes another leg down. I.e. your long could easily go to 0 while your short may make you 10% or so.

You have to look at the builders form the standpoint of what you would be left with if you liquidated the assets and paid off all of the debt. I am pretty sure you would be left with nothing with CHCI and would probably have trouble getting enough to pay off the debt. All you have to do is look at the bear stearns subprime funds to understand this.

The only builders that don't have the liquidity issues are ones like MDC and they are trading right around book value.

Hope that helps.
roke6362
Roke6362 - 7 years ago
10% of my portfolio is in BZH. Although my experience in investing is limited, I respectfully disagree with allenwhite. I believe you should value the assets based on reproduction costs if the industry is viable in the forseeable future. One thing is guaranteed: The population will get larger and those people will want to own homes. Therefore, I don't think one should significantly discount inventory if they are a long-term value investor. I do agree BZH is too leveraged. I think they would be purchased before they went bankrupt. Also, check the SEC filings of the past 6 months. There have been at least 8 #13 filings in the last 6 months. I don't think they are taking a short position on a company that is at less than 50% book value. My problem is that I bought too early and my cost basis is too high. I should continue to buy down, but I am going to wait until the end of the year. Maybe I'm a chicken, but I want to insure against my inexperience in case I end up being dead wrong.
allenwhite
Allenwhite - 7 years ago
Then how are you thinking about replacement cost then? Do you know what the market is like now for the type of land these guys own? The builders can't economically buy land for prices anything higher than 50% of where they were a year ago in most of these markets.

Do the math. The builders are all saying that house prices are down 20% plus in these formerly hot markets on an apples to apples basis (net of incentives, etc). Land is usually about 1/3 of the house price. So if a builder is trying to buy land that he can build on and still market the normal 20% gross margin, then he can only afford to pay 50% as much for the land as a year ago. And that would assume that prices don't fall any further, and they clearly are.

I am not sure where the margin of safety is. If you are buying an asset at 50% of book that can be sold for 100% of book, thats great. But if the asset is now only worth 50% of book, where is the value?

BZH also has a unique problem. Their reputation is being destroyed by all of these mortgage fraud allegations. Considering the fact that the general counsil and CFO have both left the company, it is not looking good. I am not sure why you would own the company whose reputation is being tarnished in a price taker industry.
roke6362
Roke6362 - 7 years ago
That's the beauty of the market. One of us is right and one of us is wrong. It is a zero-sum game. Time will tell. I always look at reproduction costs as a barrier to entry on the same level as the company I am considering. Then I compare it to their normalized earnings over at least a 5-year period. If the EPV is higher than the asset value, I look further. I am not saying that BZH is the best homebuilder. However, I do believe their problems are industry driven as much as anyone else in that sector. 3 guru's have piurchased or added to their positions in the past 3 months. 50% of the company is owned by a much smaller group of investors than in the past. Change may be easier to affect in the near future.

I think we may be looking at this from different perspectives. It sounds like you do this for a living. I don't know. I do it as a hobby. I may think the same way you do if I were investing OPM rather than my own. I can afford to hold onto positions longer without reprisal from bosses or clients. I only answer to my wife. I believe BZH is a $25 liq stock, a $40 BV, and $53 as a going concern. I may have to wait 3-5 years for it to reach $53, but I'm willing to wait.

We'll see. Good luck.
allenwhite
Allenwhite - 7 years ago
I am not short BZH, so it doesn't matter much to me what happens to it. I was just intially responding to the trading idea of long the builders and short shiller index. And then I thought I would give you another point of view on BZH since it is such a significant stake for you.

I mentioned it before, but why not buy MDC instead? There is less immediate upside if housing stabilizes quickly, but there is dramatically less downside if it doesnt. You are referring to several gurus as owning it. These are not guys that just bought in at depressed levels. Some of them started buying in Q4 '05 when the group first traded down some. Obviously that doesnt mean much in regards to what will happen from these levels, but I would pay more attention to those that have a better track record with investing in this industry. I.E, Greenlight, Third Avenue, and others. I personally think there are much better risk/reward investments in the space like MDC, PHM, KBH.

Good luck.
KRajan
KRajan - 7 years ago
AHM is an excellent candidate now. Buy @11.70, Sell Sept $12.50 call for $2.05. If the stock moves up, the gain is $2.85 in 2 months - an easy 23%. If the stock trades around $11, the call expires and one can pocket 17%.

AHM is trading at 40% discount to the Net Asset Value. So, in the worst case, you got the stock at $9.65... What a value!!!
buffetteer17
Buffetteer17 premium member - 7 years ago
I went for MTH (Meritage Homes). I did a quick scan of many of the homebuilders and noticed

selling for 0.7x book

land is held mainly through options

I didn't study all the homebuilders, but I took a closer look at MTH. Decided to put a small stake into it. After I bought it declined further so I increased my stake to 6%. If it doesn't go bankrupt, it'll double or more. The big question is how long? I'm willing to wait a few years, but I actually expect some improvement within 2 years. That's because the prices of homebuilders lead the their operating results, due to the market anticipating.

Wonder if AHM will continue their dividend? It would be around 20%!!
billytickets
Billytickets - 7 years ago
I expect this sector to pick up in 2009 but this is a classic value play. I have noticed a lot of impatience by posters here and just want to add that the true "value investor" has a 5 year or more time frame.Personally i will buy ANY stock that I feel has little downside that Will double in 5 years.It took me 8 years to get "fair value" for Altria but that"wait" made me more than 60% of my net worth.peace
tmcmill81
Tmcmill81 - 7 years ago
MTH is a good move. I've been thinking about that lately. They are trading low relative to their book. But, I think I will be patient and wait for it to drop some more. Who knows if that will happen, but I'm also looking hard at HOV. If HOV drops to its 52 week low of 15.23 I'm in.

I Love the homebuilders right now, I'm excited about the possibilities. I"m thinking 3 years. How long do you guys think until it improves?
JJINVEST
JJINVEST premium member - 7 years ago
the sector will improve once that people feel the pain and the prices of home drop substantially. In some markets, the price is holding up alright. It is always at the deepest despair that the market bottoms. One important rule is "If it is on the cover of New York Times, it has bottomed" (that I borrowed from Jim Cramer but there is some truth to it").

Another possibility is that a few home builders go belly up. When that happens, you know the bottom has come.
ttrader
Ttrader - 7 years ago
... now is the right time to start investing in homebuilders (just have a look on the Short Ratio nvr 18.3, hov 8, dhi 6.1) and also financtials (e. g. BSC) were now interesting
buffetteer17
Buffetteer17 premium member - 7 years ago
I used to think so, but vooch convinced me that it is too early. Two reasons.

First, some of the homebuilders are going to suffer serious damage, either bankruptcy or forced sale of some assets at a loss. We don't know which ones.

Second, the market uncertainty will keep the prices depressed for quite some time, maybe another year. Real recovery, i.e., increasing home sales and home price recovery is possibly three years out, although the homebuilders' share prices will recover before that as the market anticipates.

Having said that, I suspect a small roll-your-own index fund of the major homebuilders will do fine over the next five years. But I'd rather be more focussed.

Before vooch's level-headed and clear logic caused the scales to drop from my eyes, I took up a moderate stake in Meritage Homes, starting buying and 25 and averaging down. My average basis is 22.62. The price now is 20.15, so I'm underwater by 11%. For reasons unknown, the price went up to about 22.45 last Wednesday, giving me a chance to bail for a negligible loss. Being stubborn and unwilling to lose money, I put in a limit sell order for 23.00 and didn't sell any.

John Krantz
John Krantz - 7 years ago
I bought one homebuilder (BHS) too early, after I saw a big insider purchase and decent financials. In retrospect I should have waited. I am waiting to add homebuilders till next year, by when most of the ARMs have reset already. Then I will probably buy TOL. TOL has a good amount of cash and is planning on expanding into India and China.

I flinched when I read that someone has 10% of his portfolio in BZH...of all the large homebuilders it is my opinion they are the most unethical and have the worst balance sheet (most likely to go under). If you really wanted to take a big risk I would replace BZH with HOV. HOV's financials aren't much better but this is a family owned company who has been in business over 45 years I think. A gut feeling tells me they have a better chance of getting out of bad finances more than BZH, who by many reports is a sleazy company.

I own BHS, do not own or option any of the other companies mentioned.
marco.guerreiro
Marco.guerreiro - 7 years ago
HRPT is not a homebuilder, but it is a good choice for a secure investment. Especially recommended for income investors.

With a 8% dividend, likely to keep going or rising.

There is a very interesting article on the stock that describes briefly the opportunity..

Just remember to substract the 800M in preferred shares when calculating NAV. :)

http://www.fool.com/investing/dividends-income/2007/08/02/a-high-dividend-reit-with-a-kicker.aspx

John Krantz
John Krantz - 7 years ago
ahhh, yes, HRPT is on my watchlist too.^^^ Good REITs will be/are a great opportunity in these times because you can get a high dividend and good potential for a lot of capital appreciation. I have my eyes on SFI as well.
vooch
Vooch - 7 years ago
Which homebuilders have gone bankrupt so far? Any?

Which home lenders have gone bankrupt so far? NEWCQ.PK? Others?

- Vooch

marco.guerreiro
Marco.guerreiro - 7 years ago
AHM, HMBN.PK

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