Foolish Forum: Homebuilder Havoc

The housing situation in the U.S. seems to be unraveling. Homebuilders have reported nothing but cancellations and asset writedowns, and even the staunch bulls aren't seeing a bottom. Here to discuss the housing situation is homebuilder analyst David Lee Smith.

JK: Dave, thanks for joining us. You've got some first-hand experience in the homebuilding industry. Tell us a little about it.

DS: Thank you, Joey. I suppose there's not another sector that today is as fraught with frustration, consternation, and second-guessing as homebuilding. My own background in the industry actually results from a couple of different perspectives.

First, I spent a period of time as a vice president of Centex Corporation (NYSE:CTX), which then was the nation's largest homebuilder, along with being a major general contractor on such structures as Cinderella's Castle at Walt Disney World and Boston's city hall. In addition, the company operated four cement plants, which ultimately were packaged with Centex's gypsum wallboard operation to form what is now Eagle Materials (NYSE:EXP).

Later, after I'd become a securities analyst, I specialized for a time in homebuilding, and was fortunate enough to be named to The Wall Street Journal's All-Star Research Team for my coverage of homebuilding, manufactured housing, and building materials.

JK: People are looking for someone to blame for the housing and lending woes -- greedy lenders, ignorant borrowers, dishonest appraisers, the Fed, the media, the regulators. Who can we point the finger at and say "You're responsible"?

DS: I'm of two minds on that question. On the one hand, we're perpetually absorbed with the blame game in the U.S. today. If an industry falls on hard cyclical times, it must be someone's fault and we probably should find the guilty party and prescribe some punishment. If a hurricane does damage to an area, someone should be held accountable for that freak of nature.

Having said that, we know now that the homebuilders -- and homebuilding is a very unscientific function, with each market having its own individual dynamics -- got ahead of themselves vis-a-vis their land positions and their speculative building. But that's an easy thing to do when you consider that, with really only one significant downturn, the most recent building cycle had been essentially positive for nearly 20 years. In a climate like that, it's easy to forget the tough times and crawl too far out on a limb that comes crashing down when a set of soft conditions does arrive.

Beyond that, many of the mortgage industry's lending practices clearly had become absurd. Imagine furnishing the funds for someone to buy something as expensive as a house and not even requiring proof of employment or income! In a very real sense, the builders' cavalier approach to land and inventories, coupled with that sort of mortgage-lending foolishness, has resulted in a perfect storm that's now battering the housing industry.

JK: These homebuilders seem trapped in a boom-and-bust cycle. Is there anything they can do to prevent these huge swings in the future?

DS: As an analyst, I left coverage of the homebuilders and picked up the media companies toward the end of the technology bubble. I certainly didn't know that technology was about to cascade off a cliff. I simply happened to be with a firm whose core interest was decidedly in technology.

I bring this up because a year later the technology companies began dropping like flies and the homebuilders started an ascent that increased many of their share prices fourfold in less than two years. The key is that many, many industries are characterized by pronounced cycles. Indeed, we could factor energy into this equation as perhaps the consummate cyclical industry. I sincerely hope, however, that both the lenders and the builders have been severely sobered and that they'll keep their reins tight and short going forward. I trust that for a while at least they will.

JK: We tend to lump all the homebuilders together, but obviously they have unique characteristics and strategies. For example, you've often mentioned that Toll Brothers (NYSE:TOL) differentiates itself in the high-end market. Are there any other homebuilders that stand out from the pack, in your opinion?

DS: You're right. I like Toll because of its special position in the industry. In many places, Toll homes cost double the average price for the area. But the company builds beautiful homes, and I think it will be able to fly somewhat higher than the muck and mire that has been created by the subprime and Alt-A difficulties.

I tend to be a management freak, and therefore I like Centex (not at all because I was once an officer of the company). The company has a tradition of incredibly sound management. I reported to two co-CEOs who couldn't have been more different from one another, but they did an excellent job of shepherding the company. The company's capable management -- which has been passed along -- coupled with its general contracting business and its geographic diversity, should be a real source of strength for Centex itself and its investors once the current homebuilding smoke clears.

JK: I noticed that some of the highest-paid executives last year came from the homebuilding industry. What do you think about this compensation, looking back?

DS: Perhaps surprisingly, given my background, I think that even the Tolls, who have started and built a wonderful company, are perhaps being paid too much. Tim Eller had oversight for Centex's Minneapolis area when I was with the company. I'm pleased he's done well. But I'd just say generally that it's difficult to defend compensation of the levels indicated, especially when the pay scales of average workers have been flattish when adjusted for inflation over the past several years.

JK: Any final thoughts? How are you keeping a level head as an investor in all this chaos?

DS: I'm simply trying to stick with the best companies in the industry and maintaining a long-term perspective. Anyone who is looking for 30% in a year would be well advised to invest in other industries. During about an 18-months time frame, however, I think the industry not only will regain its health, but will also benefit shareholders substantially.

That's a wrap. Join us next week in the Foolish Forum for more witty banter on hot investing topics.

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Fool Financial Services editor Joey Khattab does not own any of the shares mentioned. Tell him what you think about the Foolish Forum. David Lee Smith owns shares of Centex, but not any of the other companies mentioned. The Fool has a disclosure policy.