In Texas hold 'em poker, an out is a card that will "make your hand" -- or make you a winner. For example, if you've got in your hand the king and the queen of spades, and a 10 and a jack of spades are on the board, then you've got a lot of outs to make a flush, a straight, or a big pair. In other words, although you haven't "made your hand" yet, you have a high probability of getting lucky.

I believe manufactured housing (MH) is an industry with a lot of outs. I'm bullish precisely because there are so many reasons to be bearish. So many bad things have happened in the industry -- extending a downward cycle -- that not only has most of this bad news been priced in, leading to some tantalizing valuations, but also not much more can go wrong.

A hangover
In 1998, the industry shipped about 370,000 manufactured housing units. For 2006, the industry will ship around 123,000 units, a decline of more than 60%. The last time the industry shipped this few units it was 1962, JFK was in the White House, and I would not be born for another 20 years. So how did things get so bad?

A vicious cycle
Why were 370,000 units shipped in 1998? It wasn't "natural" demand, but lax lending, just as we see traditional housing borrowers today buying houses way beyond their means thanks to option-only, no-documentation, and negative amortization loans, which artificially boost demand. Unlike traditional housing, the manufactured housing market is much smaller and more illiquid, which caused the market to spiral downward.

Here's what happened: MH lenders and dealers got greedy, artificial profits were booked, and times were good. Lenders financed MH mortgages that borrowers didn't have a prayer of making good on. Then borrowers started defaulting, and times got bad -- real bad. Some MH lenders went bankrupt; others who survived withdrew from the market. A substantial chunk of financing evaporated. In 1999, Green Tree Financial accounted for 41% of all MH financing. In 2002, the company went bankrupt. Imagine the ramifications for the housing industry if Wells Fargo or Bank of America defaulted.

When borrowers default, the house gets repossessed and goes back on the market. Here's the vicious cycle -- soaring defaults led to a glut of repossessions, which caused resale values to plummet. That discourages lenders, who have to deal with lower recovery rates on repossessions. And that leads to financing being unavailable, which leads to fewer customers, and so on.

The aftermath
The MH rebound was supposed to happen a long time ago. It hasn't. Adjusting for non-recurring emergency homes bought for Hurricane Katrina victims, industry shipments fell to 40-year lows in the past three years. Why? The continued lack of financing is the major issue -- lenders once bitten are twice shy. MH financing is much stricter than that of traditional housing, and because of the perceived risk, MH mortgages cost several hundred basis points more and require higher down payments. This is a tough sell for the traditional low-end MH buyer.

The list of problems goes on and on: a tarnished image, NIMBY (not in my backyard) protests against the housing, aggressive sales tactics at MH dealerships, and poor service for installations. Furthermore, low interest rates and lax credit standards for traditional housing make it much easier for low-end buyers to trade up.

Positive catalysts
Any number of things could help the manufactured housing industry regain some momentum. One important overhang that has been removed is that the repossession glut has painfully been whittled down. Also, if interest rates increase, and easy credit for traditional housing contracts, then low-end buyers may be forced to switch to cheaper manufactured housing. Furthermore, long-term demographics are favorable: Many retirees will opt to "downsize" to cheaper MH in places such as California and Florida. Most importantly, the industry is fighting to get Fannie Mae and Freddie Mac to essentially give it parity with traditional housing standards. If this bill is passed in 2007, then the manufactured housing industry would become much more attractive to lenders, which should help ease the paucity of financing.

I recently spoke with Richard Ernst, president of MH consulting firm Financial Marketing Associates, who has worked for 35 years in virtually every aspect of the industry. He believes that the industry is improving, but is still not where it needs to be. He noted that Fannie Mae's and Freddie Mac's help is critical in improving the availability of financing. And he said that one of the bright spots in the industry is modular housing, which is built to local standards and should provide some upside for some manufacturers.

David Rand, chairman of the Manufactured Housing Institute's Financial Services Division, said that the industry has taken some steps in the right direction through installation training standards and certification, lenders' best practices -- to align borrower and lender interests and avoid a repeat of the latest lending debacle -- and more standardized pricing. All of these should help the industry provide better value for customers.

How to play it
Among the players in the industry, I'm actively looking at manufacturers such as Fleetwood (NYSE:FLE), Champion (NYSE:CHB), Palm Harbor Homes (NASDAQ:PHHM), and Nobility Homes (NASDAQ:NOBH). Of the manufacturers, I'm most partial to Skyline (NYSE:SKY), which has about 40% of its market cap in net cash and has never lost money in more than 50 years -- amazing given the downturn. After speaking with Skyline Chief Financial Officer James Weigand, I feel the company is a class act. Although I haven't taken a position in Skyline yet, I'm not at all surprised that Third Avenue, a stellar value investing mutual fund, has added to its Skyline shares in its small-cap fund. Also, Motley Fool Hidden Gems pick Drew Industries (NYSE:DW) is a well-run MH component supplier that offers exposure to the industry to investors not comfortable with picking individual winners.

I can't predict when the industry will emerge from its doldrums, or if the financing situation will improve. However, I do think patient investors will be rewarded eventually. So far I've taken a position in only one company and am actively watching another, which I'll write about later. But if I put my money in well-run manufactured housing companies, given the multiple outs, I'll eventually make my hand.

For more on the industry:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned, and The Motley Fool has a disclosure policy. Emil appreciates any comments, concerns, and complaints.