Shares in homebuilder Hovnanian Enterprises (NYSE: HOV ) surged nearly 12% last Friday, on speculation that Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) was interested in taking a stake in the company. The price bump should come as no surprise, since that's what usually happens any time someone detects Warren Buffett lurking nearby. Over the years, this market reaction has become known as the "Buffett premium."
Whether Buffett really intends to buy shares in Hovnanian, the No. 6 homebuilder in the United States, is anyone's guess. It may very well be that Lou Simpson, Buffett's man at GEICO, is taking a closer look -- in which case, you should still be just as interested.
In any event, I try not to dwell on what Buffett is interested in. After all, the man has been investing since he was 10 years old, so he's probably always been interested in lots of businesses. But I do enjoy examining whether such a Buffett-infused rumor could indeed turn out to be a worthwhile piece of information.
In his early days, Buffett applied a high degree of intensity to the philosophies of Benjamin Graham, and look where that's gotten him over the past 50 years. Likewise, since I was 14, I have studied and tried to emulate Buffett's investing style very intensely -- some would say obsessively. It makes all the sense in the world to study and learn from the best, no matter what field of specialty you're talking about.
In my years of study, I have learned two important things about investing:
- You will rarely ever lose money by copying the world's best investors. When Buffett disclosed a large stake in PetroChina (NYSE: PTR ) several years ago, the stock had risen more than 8%. Since then, the stock is up nearly eightfold.
- It is very wise to pay close attention when you hear that Buffett might be interested in a particular stock.
I am not advocating merely buying any stock that Buffett's name is associated with. I am merely suggesting that it makes for a good mental exercise to take a closer look at any company that Buffett is thought to have an interest in.
The case for Hovnanian
The rumor that Berkshire might be interested in Hovnanian captures my attention because of the homebuilder's Buffett-like characteristics. The homebuilding industry is currently one of the worst-performing sectors out there, and that's where you'll always find Buffett, swooping in to buy what no one else wants, at big discounts. In other words, Mr. Market's famous mood swings might very well be causing him to once again offer some sound businesses at bargain-basement prices.
Indeed, before last week's surge, Hovnanian's shares were trading at nearly the same price they were five years ago, before the housing boom took off. Since that time, shareholder equity has nearly tripled, and book value and revenue have more than doubled. Yet Mr. Market is so emotional that he is currently selling you this business at 60% of book value and 20% of annual sales, in spite of the company's achievements over the past four years. During the good times, for example, Hovnanian was generating return on equity in excess of 25% and gobs of cash. So from a valuation standpoint, Hovnanian meets a lot of Buffett's characteristics.
Skin in the game
What about quality of management, you say? The chairman, Kevork S. Hovnanian, is the company's founder, and his son is the CEO. Insiders own more than 27% of the stock. Again, these very simple metrics satisfy an investor like Buffett. With a high percentage of insider ownership, management clearly has a lot riding on the company's continued success.
Hovnanian's price has fallen to a point where any serious value investor should be taking a closer look. In fact, the homebuilding industry as a whole has a lot of characteristics that deep value investors look for: low price-to-book ratios, healthy balance sheets, and historically low prices. And since humans will always need homes to live in, homebuilders will again have their inevitable day in the sun. Intelligent investors should be applying their time and practice to meticulously studying this industry and determining which one, two, or three offer the best investment opportunity over a satisfactory period of time. And there's no doubt that from a quality standpoint, Hovnanian is a well-run company. It just remains to be seen how well it can weather the current storm.
I'd be willing to bet that Buffett has read just about every single annual report on homebuilders over the past couple of years. His uncanny ability to eliminate all unnecessary noise from his analysis has made him the best. In the early 1970s, he purchased about 18% of Washington Post (NYSE: WPO ) , at a time when nobody cared about it, for about $11 million. That investment is worth $1.2 billion today. Investors like to call that a 100-bagger.
Nailing it down
The prospect that Buffett may buy Hovnanian is mere speculation, and I try not to waste any time speculating. Do keep in mind that Hovnanian's market cap is slightly more than $1 billion, and Berkshire's massive float requires much bigger prey to move the needle. However, I do know that Hovnanian and the rest of the homebuilding industry are experiencing just the type of storm that value investors like to see.
Homebuilding is a solid industry that will be around as long as there are people. Land, however, is a finite resource, so existing homebuilders have an edge over anyone wanting to join the industry. Some of these companies are coming close to selling below their liquidating value, although that might not happen now that Buffett's name has been invoked.
In any regard, investing is a process of continuous education, and if you want to bring something to the game, you have to apply a degree of intensity to your investing endeavors. The homebuilding industry provides just such an opportunity.
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Fool contributor Sham Gad is the managing partner of the newly launched Gad Partners Fund, a value-centric investment partnership similar to the 1950s Buffett Partnership. He owns a stake in Berkshire Hathaway, which is a recommendation of our Inside Value andStock Advisor newsletter services. You can reach him at email@example.com. The Fool has a solidly constructed disclosure policy.