FOOL ON THE HILL: An Investment Opinion
After a pummeling in 1999, homebuilder stocks are on a tear. It's not a mystery. The market regularly misprices cyclical companies, out-of-favor industries, and sectors less sexy than optical networking, CRM software, and biotechnology.
Consider that returns for homebuilders in the S&P sank 33.2% in 1999. Among consumer cyclicals, only companies in the jewelry, novelties, and gifts segment performed worse.
In fact, in January I wrote a story about Pulte, one of the country's largest homebuilders -- which, despite 77% earnings growth in 1999, traded at a 20% discount to its book value. (Book value is a pretty good proxy for liquidation value of homebuilders, since they don't have much in the way of intangible assets on their balance sheets.) Talk about getting trampled underfoot. Why would the market make a fundamentally solid company available at firesale prices?
It happens all the time.
A big part of the answer is that homebuilders are cyclical, moving with interest rates and other indicators of the nation's economic health such as inflation, new housing starts, and commodities prices like lumber and gypsum. The Federal Reserve had been steadily raising interest rates, yet there was no sign its efforts were cooling off the economy. This added to the uncertainty that made it hard for homebuilders to flourish.
Still, it was hard to see how Pulte and its kin could, in some cases, be priced below book value, even by a market in love with technology and Internet stocks.
Fast-forward 10 months, and the homebuilders have returned 26.7% this year, and 40.9% in the last 13 weeks. These kinds of companies represent opportunities for investors willing to dig and understand the market's cyclical nature. Pulte is up 69%, Centex is up 49%, Kaufman & Broad is up 24%, and Toll Brothers is up 93%. Not bad for a few months' work.
I got thinking about homebuilding companies again last week after reading John Neff on Investing, the autobiography of the man who ran Vanguard's Windsor Fund for more than 30 years. Over that period, Windsor returned an annual average that beat the market by more than three percentage points. Put another way, $10,000 invested in the Windsor Fund from 1964 to 1995 grew to $564,637, while a $10,000 investment in the S&P 500 would have grown to $232,974. That makes Edwin Moses' amazing 10-year unbeaten record in the 400-meter hurdles look like a mere hot streak.
Neff loved quality, low-P/E stocks. He loved cyclical companies, too, and was keenly aware of the market's willingness to misprice them. During his tenure at Windsor, he owned oil and gas company Atlantic Richfield seven times.
At the end of the book, published in 1999, Neff shakes his head at investors' eagerness to pay too high a price for earnings, momentum, and sizzle. Then he mentions a few out-of-favor sectors worth a closer look: real estate investment trusts, banks, savings and loans companies, airlines, nonferrous metals, petroleum refiners, and, yes, homebuilders.
How are these sectors doing in 2000, a year when the S&P 500 is down 2.2% so far?
Sector Returns Returns
REITs* 13.0% 10.0%
Regional Banks 13.1% (16.3%)
Savings and loans 46.7% (24.2%)
Airlines 15.8% (0.9%)
Oil and gas 12.9% (26.4%)
Homebuilders 26.7% (33.2%)
*REIT results were culled from Bloomberg's real estate investment trust index.
** I couldn't find a category to match here, but it looks like these companies are way down for the year.
Want to bet Neff would have found some winners? He used a little P/E formula to get a sense for what he was paying relative to a company's expected return. Basically, he took the company's expected earnings growth, added its dividend yield, and then compared the total returns to the P/E ratio. He used to hunt for companies expected to generate a total return twice as high as their P/E.
This formula is really the old price-to-earnings-to-growth (PEG) formula with the dividend added, and investors have to be careful trolling for companies with low PEGs. After all, most of them sell at a discount to expected growth rates for a pretty good reason, and the market has already priced this into the stock. Also, we've talked ad nauseam about relying too much on earnings and the income statement when analyzing companies. Investors have to be sure earnings are a fair proxy for actual profitability by checking the balance sheet and cash flow statements.
Neff, however, didn't just hunt for low P/Es. He wanted quality companies with a story, a story he saw developing before the market caught on. (He also, by the way, took his role as a fund manager seriously, regarding himself as a steward of investors' money, not a locomotive driver on the fast train to success. This point of view not only drove performance through the roof, but kept churn in his portfolio low.)
Finding a story before it broke is what Neff called "hitting ahead of the ball," and what Brian Graney meant in Tuesday's Fool on the Hill column when he talked about variant perception. If you can match low P/Es and quality companies waiting for the wind to turn, you'll have a better chance of finding winners.
So, how does the homebuilding sector look? Let's run Neff's formula.
Earnings Total Return/
Company Growth Yield Return P/E P/E
Pulte 11.2% 0.4 11.6% 7.0 1.6
Centex 12.0% 0.4 12.4% 8.2 1.5
Kaufman 16.1% 1.0 17.1% 7.2 2.3
Toll 14.6% 0 14.6% 9.7 1.4
I should stress that I'm not recommending buying any of these companies. Remember, these companies are cyclical, have already had a nice run, and the market generally caps the P/E on cyclical companies. I have no idea whether they'll continue to climb. This kind of formula is just a starting point for further review. One question, for example, is Kaufman & Broad. Why is it available at this kind of discount if the expected growth rate is so high? What kind of risks are priced into the stock, and are they reasonable? Is the growth rate realistic? These aren't easy questions to answer, but it's a critical part of the investor's job.
Still, the formula offers an interesting place to start, and this year's performance in the homebuilding sector makes me smile. There's plenty of value outside the high-growth technology market. Learn to hunt for it.
Have a great day.