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.