Gannon On Investing

Bill of Absolutely No DooDahs began his May 31st post entitled “My Homeys” by writing the following:

“Rarely has there been a single segment or industry as universally loathed as the one I’m writing about today. Almost every stock I’ve screened from this industry has double-digit negative 52-week returns and short ratios over a week to cover. This industry’s P/E is below 5.5 on average, and its PEG and Price/Sales are 0.4 and 0.5 respectively. This industry’s Price/Book ratio is hovering close to 1.3, a rarity for a set of businesses with double-digit Return on Assets. I’m talking about, of course, the homebuilders.”

Bill has written three excellent posts about homebuilders. I highly recommend reading them, especially because you will find I’ve sprinkled quotes from those three posts throughout the post you’re reading now. There’s no need to re-invent the wheel. If Bill said it better first, why shouldn’t I quote him instead of struggling to find a different way to say the same thing?

Here are Bill’s three posts (in chronological order):

My Homeys

I Value My Homeys

DHI – One of My Homeys

A Contentious Topic

Although nearly three months have passed since Bill wrote that paragraph, it remains an appropriate introduction to a contentious topic. I’ll try to take the discussion in a slightly different direction by presenting some questions (and hopefully a few answers) that seem most likely to help investors form actionable judgments about the homebuilders.

Naturally, the first question is why housing in general and homebuilding stocks in particular are such a contentious topic. Two culprits immediately spring to mind: self-interest (enlightened or otherwise) and the financial media (almost certainly otherwise). These two forces have a hand in the forming and fomenting of a great many controversies. So, it’s hardly surprising to find them at work here.

The self-interest is genuine. Many Americans own a house. Some Americans own more than one house. This second group is probably somewhat more likely to watch CNBC, read The Wall Street Journal, etc. So, the financial media takes that kernel of genuine self-interest and blows it ups.

The manner in which it does this is particularly interesting, because it affects the way Americans in general and investors in particular think about the subject.

Discussions of the housing market often involve talking heads and statistics. The talking heads naturally present opposing views. The statistics are, of course, meaningless without a point of reference.

Obviously, a series of historical data could provide such a point of reference; however, a series of historical data is complex, backward-looking, and above all else not a good way to keep an audience’s attention. In contrast, estimates are simple, forward-looking, and a bit more exciting. So, estimates win out. Not just in the reporting on the housing market, but in financial reporting as a whole. Estimates pervade the financial media.

While they can be very useful, estimates do carry the unfortunate side effect of turning shades of gray into either black or white, simply because every number has to end up on one side or the other of a precise estimate. This provides a kind of win or lose moment that usually leads to both more excitement and less perspective.

Perspective

Much of the reporting and commentary regarding the homebuilders centers around expectations for near-term operating results. Where are earnings headed? How far will they fall? How weak will the U.S. housing market become?

These are important questions for investors to ask. However, they aren’t the only important questions. A successful investment is made by exploiting the difference between the price and the value of some asset. The health of the U.S. housing market in general and the future earnings of specific homebuilders only address the value side of the price/value inequality investors seek to exploit.

The price side of the inequality is of equal importance. At some price, the future for homebuilders may be quite poor and yet their shares may be an excellent investment. Have we reached that price yet?

That’s the way investors need to think about the problem. We need a little perspective. How far will the homebuilders’ earnings have to fall during the next few years before the value of their shares falls below the current market prices? Simply knowing whether (and how far) earnings will fall is not enough. We need to consider future earnings relative to the current price.

Bill took up this problem in his post entitled “I Value My Homeys”. In that post, he discusses discount rates and valuation methods. The discussion is clear and worth reading even if you have no interest in valuing the homebuilders, because the same valuation methods can be applied in countless other situations.

At one point in the post, Bill illustrates how to find an appropriate P/E ratio for a stock with an expected near-term earnings decline followed by some renewed earnings growth (obviously, this is an entirely different matter from valuing a stock with earnings that will continue to decline for many years to come). After going through this hypothetical illustration, Bill writes:

“Does this mean they’re cheap? Yes, it means they’re dirt cheap, at least, by this methodology they’re trading at a 33% discount. However, a lot can go wrong with those analysts’s assumptions, the earnings might fall more, or for longer, than expected, and a whole holy host of other things could go SNAFU on us. And don’t forget that dirt cheap stocks…usually keep getting cheaper for a while.”

Let me take the last point first. Such stocks may continue to decline for a time. I differ from Bill in that he utilizes technical analysis while I do not (see "On Technical Analysis").

I only mention this because some people will say that while the homebuilders may be truly cheap, you shouldn’t buy them if the stock prices will keep falling. I can’t argue with the logic of buying a stock as cheaply as possible. But, as I don’t know the day on which the lowest quoted price will appear, I’m willing to take Mr. Market’s offer when I think there’s a good deal in it for me – without worrying about whether he’ll be making an even better offer tomorrow.

Some people think such an attitude is foolish. Certainly, it may prevent achieving the optimal result in some investment operation. However, it shouldn’t prevent achieving an adequate result. After all, if you aren’t going to sell your shares when the stock price falls (and the gap between price and value widens) you will still reap the rewards of your original investment when that gap is closed.

So, if you have the stomach to ride out whatever price swings may occur and you believe the gap between price and value will eventually be closed, you simply need to find a sufficiently wide gap between price and value to ensure an adequate result.

Value

Now, I can get to Bill’s other excellent point: while the homebuilders look dirt cheap based on the assumptions outlined in his hypothetical illustration, those assumptions may prove to be wrong. That’s always a risk for investors.

An unjustified assumption can justify any stock price. If you’re willing to project a blistering earnings growth rate into the distant future, you can justify almost any P/E ratio. Likewise, if you ignore an inevitable near-term earnings decline, you will see bargains where none exist.

To give you some idea of what it would take to justify these absurdly low P/E ratios, I looked at Comstock Homebuilding (CHCI). This isn’t in any way a suggestion that you buy Comstock – or that it looks particularly attractive.

There are real issues with the company: debt, the markets it operates in, its most recent financial results, etc. It’s also a very small cap stock – it has a market cap under $100 million, although the low P/E ratio makes the business appear smaller than it really is by more than halving the kind of market cap you’d expect a similar business would have. If you really were looking at Comstock as an investment, there would be a lot of company specific issues to consider and weigh in your final analysis.

This post isn’t about Comstock. It’s about the homebuilders in general. I’m just using one name as an example, because it clearly illustrates the difference a very low P/E ratio makes. In 2005, Comstock reported net income of $27.6 million. The company has a market cap of $63 million; so, the stock is trading for less than 2.5 times 2005 earnings.

Obviously, the company is quite capable of reporting a net loss sometime during the next few years. But, for the sake of simplicity, let’s assume Comstock’s 2005 earnings will decline by 20% a year for each of the next five years and then increase by 3% a year thereafter.

In other words, let’s assume the company will earn $22.1 million in 2006, $17.7 million in 2007, $14.1 million in 2008, $11.3 million in 2009, and $9.0 million in 2010. These numbers are for the purposes of illustration only.

It seems reasonable to expect the company will actually earn much less than $22.1 million in 2006 and $17.7 million in 2007 and much more than $9.0 million in 2010. I’m just using these hypothetical numbers to better illustrate what modeling a 20% annual decline in earnings for the next five years really looks like.

We assume that in 2011 earnings will increase by 3% to reach $9.27 million and will continue to increase at an annual rate of 3% thereafter. To put this in perspective, the assumption is that the “peak” earnings of 2005 will have turned out to be a veritable Everest – it will take the company 40 years to complete the second ascent.

That’s obviously a ridiculous assumption. I have little doubt 2005 was a peak that will remain the high water mark for several years to come. However, I sincerely doubt it will take four decades to recover from the bursting of the housing bubble.

Anyway, what if it did? What if this absurd model was an accurate representation of reality? Would Comstock be a good investment?

Yes. Despite the earnings decline and the four decades of anemic growth, an investment in Comstock would work out well at today’s price. At a price-to-earnings ratio of well under 3, the company doesn’t have to do much for the stock to take off. If the scenario really did play out as outlined above, today’s buyer of Comstock shares would have no problem beating the market. In fact, a 15% annual return would be a near certainty.

So, what would justify a P/E ratio of less than 3? Bankruptcy. Seriously, that’s about it. Obviously, the company could simply fail to earn anything ever again. Some businesses can go years and years without earning a dime or declaring bankruptcy. So, I suppose I should say a failure to report any earnings whatsoever would justify a P/E ratio of less than 3 (in fact, it would justify a P/E ratio of zero).

Although it’s obvious, I should mention that a P/E ratio of 3 translates into an earnings yield of 33.33% - which is a very high yield. This is an important point, because most homebuilders actually have an earnings yield considerably lower than Comstock’s (i.e., their P/E ratios are higher). For instance, a P/E ratio of 5 translates into an earnings yield of 20%, which is a full thirteen points below the earnings yield on a stock with a P/E of 3.

A 20% yield is still good. But, many investors don’t realize just how large the differences in various single digit P/E ratios really are. The closer you get to the low single-digits the more absurd the worst case scenario has to become to justify the market price.

At some point, it seems everything can go wrong and the stock can still turn out to be a great investment. Of course, if the “e” half of the P/E ratio disappears entirely (and never reappears) you stand to lose your entire investment regardless of how low the P/E ratio was when you bought the stock.

Worst Case Scenario

In no other industry is the imagining of a worst case scenario more important than in the homebuilding industry. Why? Because the homebuilders are currently priced in a way that would make them bargains under any circumstances that existed during the last decade and a half. But, isn’t it conceivable the housing market will, for quite some time, be far, far worse than anything we’ve seen in a decade and a half?

It’s possible. If you removed the “for quite some time” part, I’d say it’s highly probable. The next few years will be very bad years in the U.S. housing market. But, the homebuilders aren’t going the way of the dodo.

That’s an important point to keep in mind, because some otherwise decent businesses that trade at low price-to-book ratios do so precisely because they are expected to wither away. Here I’m thinking of companies like USA Mobility (USMO) and Handleman (HDL).

Whatever you might think of these businesses and their stocks, you have to admit they operate in industries that are threatened by the sort of pervasive and pernicious changes that can never threaten the homebuilders. This simple fact may not offer much comfort now, when the near-term outlook for the housing industry is so poor; but, the fact that the long-term viability of the industry is not in question is actually a very important matter when a high ROA business trades at or near book value.

If the future is going to be anything like the past, a high ROA business shouldn’t trade at or near book value. A handful of homebuilders currently trade below book, and quite a few trade for less than 1.5 times book.

Considering their record of strong profitability, it is hard to imagine the homebuilders should, in the aggregate, sell for much less than about 1.33 times book value. If you had to pick a necessarily arbitrary price-to-book ratio at which homebuilders should prominently appear on you value radar, 1.33 would probably be my choice.

It’s certainly not an overly optimistic assessment considering the strong returns on assets posted by the group during the past decade and a half. It allows for a period of much lower returns on assets, without assuming some sort of long-term industry wide problem – a scenario which seems highly unlikely to me.

Of course, that’s a question you’ll have to answer for yourself. Personally, I find it difficult to imagine the profitability of the homebuilders will look historically low six years or more from today. In other words, I don’t see much chance of a lingering problem, if lingering is defined as lasting more than five years. Why?

Once again, I’ll quote from Bill: “Interest rates are rising and easy money is long gone? Sorry, I’m too cynical to think the powers that be can ‘allow’ easy money to go away for very long. It’ll be back, and sooner than you think.”

I agree with Bill’s assessment. Despite all the time we spend talking about interest rates, the Fed, and the macro environment, we rarely step back and consider the larger (post war) picture.

Inflation is a governmental phenomenon. Whatever the intentions of individual policymakers, where you have both a strong central government and an aversion to deflation, it is difficult to imagine anything other than “easy money” being the norm. There will be aberrations; but, inflation will only be dormant – never dead.

That’s bad news for investors. However, it's good news for homebuilders and other capital intensive businesses that disproportionately benefit from such easy money policies.

This time won’t be different. Interest rates will rise and fall. But, the trends we see today will look a lot more cyclical and a lot more "normal" when viewed from a couple decades down the road. Reversions are rarely evident to the participants.

There is always a lot of extreme sentiment that seems silly in retrospect, though perfectly logical at the time. The near-term housing picture is grim, but the long-term will probably look a lot more familiar than the market seems to believe. The prices at which the homebuilders currently sell will look very foolish a decade from now.

You can’t wait a decade? I don’t think you’ll have to. Considering the P/E ratios at which the homebuilders trade, operating results would have to be consistently and extraordinarily poor to allow these stocks to remain at such low levels for more than a few years.

I never make predictions about stock price movements over a period of less than a few years – which is probably a good thing considering what Bill Miller wrote about the homebuilders in his latest letter to shareholders:

“While the statistics in the space have come in roughly as expected, the stocks have moved down significantly more than we expected. We have witnessed p/e multiples contract from roughly 6-7x a year ago, to, in some extreme cases, 3-5x earnings. Although estimates came down as we expected, multiples contracted on the lower estimates, which we did not expect.”

A week ago, a breakingviews column appearing in The Wall Street Journal passed judgment on Miller’s investments in homebuilders as follows:

“As the housing market slows further, there will be more bad news. New home sales are still running at 50% above their level of four years ago…Even after their recent decline, the share prices of homebuilders have doubled. During the housing bust of the early 1990s, housing stocks sold for half book value. It’s conceivable that could happen again.”

It could happen again. Of course, homebuilders were a bargain at half of book then and they would be a bargain at half of book now.

Decent businesses shouldn’t sell for half of book value. I don’t know what stock prices will do this month, this quarter, or this year. But, I do know that if you can buy a decent business at half of book value you don’t need to know what the market will do, because you’ll be doing quite a bit better.

I hope we do see the homebuilders sell for half of book value once again. It would certainly make stock picking a lot easier – just point to a homebuilder.

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