Is it Time to Build Up Your Portfolio With Discounted Residential Construction Stocks?

The sexy side of investing for a living is trading. Everybody loves to trade. People that trade are smart and cool. At least according to those nauseating brokerage commercials you see on TV and in print.

But the reality to investing for a living is a lot less glamorous. You make money in a successful trade by sitting around waiting while time yields capital appreciation in a well chosen trade. And it’s just as important to have a feel for which sectors will not move during market uptrends, thus not wasting the opportunity for gain by investing in other areas.

Trying to discern sectors to avoid I listened last week to the conference call of the nation’s second largest home builder, D. H. Horton’s (DHI), because I’ve been hearing a lot of buzz amongst traders that builders are “good buys.” The thinking, of course, is that they’ve sold off precipitously from their highs and have now put in what appear to be constructive sideways price movements that could support price advances. Some are already advancing out of these consolidation areas.

What I most took away from the call was that the company couldn’t indicate with any confidence when the market for new homes will begin to stabilize, thus allowing them to produce a predictable earnings stream.

And therein lays the cautionary tale. Investors love YESTERDAY’s story. They became comfortable looking to a particular group that’s yielded gains over the past several years and yearn to buy these stocks on any price decline, convinced of the inevitable reward of higher stock prices. If there’s one characteristic of human behavior we can be sure of it’s that people will always come back to what’s worked in the past, convinced that past is preamble to the future. The smart money knows a lot better.

Now these stocks could well continue moving higher over the short term. Indeed I could be wrong and they could come roaring back. But consider this, and we’ll use DHI as an example. At its all time high earlier this year the stock was selling for only about 8x's forward estimates. Since that time home building stocks have imploded because of the kind of poor management from these companies that we've seen in the past. Estimates have been ratcheted lower. And while DHI’s stock in particular has been given as much as a 53% haircut, the stock now sells at more than 10x's forward estimates, and those estimates might have to be lowered even further. So at a time when these stocks are more expensive relative to earnings than they were when their stock prices were at record highs, people want to consider their investment potential, even as the companies themselves cannot give reliable indications as to their earnings power.

Thank you but no, I think I’ll pass.

What about esteemed professional investors, like Ron Muhlenkamp, who insist that they will buy these companies in good markets or bad because of their single digit PE’s? They argue that sooner or later the market will reward the earnings power of these companies with expanded multiples into at least the mid to high teens, thus insinuating a minimum of 50% upside from current trading levels.

My response is that I’m not wiser than the market, which has always awarded relatively low PE’s to cyclical companies. This is because their fortunes are rarely tied to an internal growth driver, but rather they will move according to economic conditions. Outsized multiples are awarded to companies with unique products and services, not to one of a zillion companies that mines ore or builds houses.

The market also rewards companies with high quality earnings, i.e., those that are derived from the company’s core competency. Builders have a history of obfuscating earnings quality when times become difficult with one off land sales, off balance sheet partnerships and other accounting machinations. This makes it more difficult to discern true earnings.

Consider also that all through the more than 5 year bull market in these stocks the market never awarded a major builder a forward PE much higher than about 11x’s. If it didn’t happen during all the exuberance it’s not going to happen now. Meantime during the last builder bear market these stocks bottomed at about 4x’s forward estimates. Frighteningly for these stocks and their investors we are a long way from those valuations. I'm not inviting you to short the group but rather cautioning that precedent warns us to be wary.

One final point to discuss is that these are home building stocks. They are not plays on real estate or whether the price of existing homes will or will not decline. There is always a market for new homes and a well run builder should always be in position to deliver those homes at a price that yields a good profit. The secret to builders making money is buying land at attractive prices and maneuvering the legal minefield that exists in many areas of the country to prepare property for development. But time and again builders have been as enthused by bull markets in the sector as investors. In an effort to sustain earnings momentum they commit to overpay for land out of fear of having insufficient buildable inventory to meet a demand that will seemingly pay almost any price. This is a fool’s errand, but one builder’s have shown a propensity to run time and again judging by history repeating itself in successive building cycles.

A Lesson in Speculation

In spite of the market selloff Thursday and Friday we appear to be in a nascent uptrend. Money is returning to smaller capitalization stocks, meaning that market participants are feeling more confident and are therefore willing to assume greater risk.

And so I arrive at the conclusion that it’s time to take a look at the biotech sector. As you can imagine the sector is out of favor, as it always is during cautious market environments. After all, apart from some profitable large cap companies for the most part the sector is littered with concept companies that have no earnings or sales, but are long on intellectual capital that they hope to turn into profits.

I found what I felt was an interesting company that just came public last year, Accentia Biopharma (ABPI). It trades for less than $3 despite their having a treatment for chronic sinusitis, SinuNase, in Phase III trials.

But the real attraction to ABPI is that they own almost 80% of a Bulletin Board traded stock, Biovest International (BVTI). This company has a follicular non-Hodgkin’s lymphoma drug, BiovaxID, in Phase III trials. And it has been granted Fast Track status by the FDA.

ABPI, which came public at $8, now has a market cap of about $89MM. BVTI, trading at $1, has a cap of about $80MM. This means that if you buy ABPI at the current price, it’s like buying 8/10 of a share of BVTI and getting ABPI for under $1, quite a discount to Friday’s closing price. It seems like an intelligent, well thought out plan that could pay off nicely with a little bit of patience.

What’s wrong with this thinking? Plenty. Bear with me while we review another great opportunity from last year that has now completely played out.

A well respected subscription service submitted a speculative biotech, Corcept Therapeutics (CORT), for consideration on 04 February 2005. At the time it was trading at around $5 a share. The company had come public just the prior April at $12 a share, well below its $15 - 17 target range. Their rationale was thus:

“This week CYBX benefited from a surprise decision by the FDA to issue an approvable letter for a treatment resistant depression indication for vagus nerve stimulation and they expect that other stocks might benefit from what appears to be the FDA's seemingly new and positive stance on alternative depression treatments. CORT is a tiny co engaged in the development of drugs for the treatment of severe psychiatric and neurological diseases. CORT's main drug candidate CORLUX is currently in Phase III trials in psychotic major depression (PMD). With the main treatment option currently being electroconvulsive therapy (ECT or shock therapy), its not hard to see the potential of CORT's offering. Peak sales estimates range from $200 to $500 mln. It is also worth noting that CORLUX is the first psychiatric treatment to receive fast track from the FDA. With a 65% insider ownership and no plans for further dilution, the co has been flying below most analysts’ radars. Mkt cap is $108 mln, which is way below its peers that have candidates in late-stage development.”

On their surface the arguments for ABPI and CORT are cogent. But when being seduced by the anticipated upside what you forget most is the downside potential.

On 25 August of this year Corcept announced that patients in their Phase III study did not respond much better to Corlux than to a placebo. Shares in the company, which had already dipped below $4 a share plunged below $1 during that day’s trading.

This company may not be finished. They may well have other drug candidates. But clearly the reason for the speculation has been invalidated. Your loss on this would have been considerably over 50%, perhaps over 80%, and you would have lost the chance to invest the money elsewhere for almost 20 months, so the return is even worse when you factor in the time value of money.

This is not intended as an affront to the subscription service, for which I have the greatest respect and to which I contribute pieces from time to time. They clearly stated this was a speculation. I am writing this piece because every once in a while we are all attracted to a speculative story like ABPI, and CORT is the poster child for why they should be avoided.

I am a trader and investor. People look at me cross eyed when I tell them how I make a living. They feel what I do is akin to gambling. But it is NOT gambling. I am buying companies with real value. If I have a losing trade there is downside risk, to be certain. But the cost of losing a gamble is 100% of your money, and the odds are never in your favor. The odds of losing more than 10% percent due to adverse news in a well chosen trade in a profitable or at least cash flow positive stock are small.

And so on Monday I will NOT be buying ABPI. The stock may quadruple on good news if it ever comes. But I’ll look elsewhere for my living, in places where the downside cost of investment is a lot less than 100%.

Implications of the Commodities Bust

Last week I posted that commodities have unmistakably climaxed and cited as evidence the destructive technical action in the Commodities Research Bureau Futures (CRY0). It logically follows that we should assess the implications for this nascent reversal.

First, the obvious: if the US economy can grow above the long term 3.1% trend for the last several years in the face of higher input prices, imagine what it will be able to do with the relief that’s on the way.

Second, it’s time to sell short Hugo Chavez and the Mullahs in Iran. They’ve caused plenty of mischief the last several years, stoking anti-American fires all over the world. Significantly lower prices for their oil will slow these activities. In fact, the outlook for these rogues is probably far worse than most imagine. Government run commodity sectors have a long history of poor long term performance. In most cases the proceeds are not reinvested. The money is often wasted through corruption, redistribution to restive citizens in an attempt to quiet discontent, and the advancement of their revolutionary cause abroad. Meantime their easily accessible oil is being exhausted. The longer you pump a field the more difficult it becomes to extract what remains. In order to halt this production decline the sophisticated equipment and services that can only be provided by private Western companies are badly needed. But they will not be available as these companies have seen their holdings in these countries expropriated and contracts broken and having suffered such reversals will be unlikely to return under the current governments. It will be a bitter time for these regimes, and of course they will add this to their list of real and imagined grievances against us. But the increased sense of worldwide security that will ensue will benefit our markets, which have in part been held back by the seemingly unstable international situation of late.

Finally, I note an interesting divergence in a key index that I think is important. The NYSE International 100 about doubled off the bear market bottom to its top the middle of this year. But lately, with many important indices making higher highs, this index is taking out recent lows and looks technically weak. The reason isn’t hard to fathom. Like most indices this one is subject to the fashions of the day, and nothing’s been more fashionable than commodities, steel and energy. And 30% of this index is related to these sectors. Predictably, of the 11 new entrants to the index over the last two calendar years every one of them hails from these sectors. This, of course, speaks to the lack of sophistication of many overseas economies and the reason why foreigners rush to reinvest their money here, financing our mortgages at what are even now historically low rates. But more importantly it means that many overseas funds are likely to start underperforming. And investors everywhere, from John Q. IRA Rebalancer to those with deep pockets, are going to start to notice this divergence the next time they review the mutual fund quarterly performance charts. And they are going to yank money from these funds they couldn’t get enough of the last couple of years. This money is more likely than not going to be reinvested in funds that focus domestically. There is likely to be a steady and significant inflow over the next year and that means only one thing. Domestic fund managers will have increasing wads of cash to put to work in our markets.

The conclusion is clear. More now than at any time since March ’03 it’s time to buy American stocks. They’re cheap, and they’re getting ready for liftoff.

CRB - The Air is Set to Come out of the Commodities Balloon

The Commodity Research Bureau has published indices for as many as 70 years. They are some of the most watched indicators of global commodities markets. I review their spot and futures indices as part of my discipline at least once a week. Of late an interesting divergence has emerged in that the spot chart has been basing near its highs but the futures have experienced a sharp selloff.

The futures chart shows that commodities bottomed well before the general market, in October '01. Since that time this comprehensive index has paused occasionally to put in a constructive base, but it's always been followed by another leg up. Now, after nearly 5 years, we have clear signs of exhaustion.

Forget all the trite bullish sound bites you've heard (China, M&A activity in the sector, etc) in the mainstream media about why this time it's different (isn't it always different?). The chart is telling us it's over. The index is breaking down below its 200 SMA daily/40 MA weekly. It's pierced these MA's before but it's always snapped back quickly. The sole exception was during a basing period in 2003, and at that time the move below did not take out a prior pivot low. This time it has.

Just as tellingly, the long term uptrend line on a weekly log chart has been broken. I wanted to mention this when the trendline was first broken over 3 weeks ago, but when dealing with an uptrend of this gravity you want confirmation. And instead of bouncing back, over the last two weeks the index has plunged lower. In fact, the index might actually be oversold to the point where we are due for a bounce, so this is not an actionable trading call. It’s a warning of a change in trend. For the first time since the 2001 bottom we have a downtrend establishing itself on this chart.

Simply put, the law of supply and demand is making itself felt. All the years of low commodity prices led to underinvestment in the sector and resulted in little excess capacity. Once demand picked up insufficient production led to sustained record high prices. Now these five years of powerful pricing and seemingly endless demand have led to increased investment in the sector. The market is telling us that either demand will quell, supply is getting ready to swell, or a combination of the two. Either way, this sector is likely to be poor for your portfolio.

If you'd like to view a symptom of the disease in real time check out a daily chart of U S Global Investors (GROW), the mutual fund manager whose bread and butter is resource funds. Their stock vaulted as much as 43% the last five trading days because the outperformance of resource funds in general is leading a lot of "dumb" money into the sector, just as the curtain is ready to come down. You can't ask for any more classic sign of a top.

History is repeating itself. Tulip bulb, anyone?

Big Caps finally have the upper hand

We have the most significant evidence yet of a lag in small and madcap stocks vis-à-vis their big cap brethren. The big cap S&P 500 and the Dow are near their highs for the year. Even the Nasdaq Comp and 100, whose charts are laggards in comparison, showed impressive buying when the market made a smart advance two weeks back, taking out their August highs. But the S&P 400 and 600 did not take out their August highs and are miles from their all time highs in May, a marked change in character from the way these indices acted off the bear market bottom in 2002. It clearly seems time to move into larger capitalization names.