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Homebuilder Industry Analysis

5 July 2006 2,422 views 11 Comments

Last week the Federal Reserve raised interest rates for the 17th time in a row. This is dire news for the Homebuilder Industry because with every interest rate hike, it gets that much tougher for new home buyers to afford to buy a home. It also introduces an additional negative factor into the equation, in that existing homeowners become worried as to whether they are losing equity in their homes. This may induce them to panic and to put their homes up for sale. These same homeowners, many of whom took out ARMs (Adjustable Rate Mortgages) or “Interest Only” mortgages a few years back, will soon see reality knocking at the door.

Reality will come in the form of higher mortgage payments adjusted to current interest rates. Fortunately, many homeowners have seen their homes appreciate in value significantly over the past 3 years and this signifies higher equity in their homes. As a consequence, some were able to get fixed mortgages, but nevertheless may be concerned about falling house prices in their area, which may induce them to sell as well. With each existing home that goes on the market, it makes it that much harder for the Homebuilder Industry, as existing home sales constitute strong competition.

As an analyst, I like to take theories such as the one presented above and go out and see for myself what is happening on Main Street. Over the past few years I have been driving around the various neighborhoods in the metro Seattle area and have been on the lookout for “For Sale” signs. About three years ago, we were in a “sellers” market and “For Sale” signs were non-existent. This was due to the fact that whenever a home went up for sale, there were a dozen buyers waiting in line to make a bid for it, making the need for a sign superfluous. Exactly the opposite scenario is in place currently. Within a three-mile drive on West Mercer Way on Mercer Island, Washington, the other day, I was able to spot 23 “For Sale” signs. Mercer Island exemplifies a nouveau riche residential area that is located just a few miles from the central Seattle business district. Its residents are good examples for our analysis because they are the type of consumer that the Homebuilder Industry targets when marketing their homes. Perhaps one can argue that this was an isolated event and that it has no bearing on the rest of the country. However, I should mention that I received further verification of this scenario the other day when listening to CNBC commentator Ron Insana. Mr. Insana took a similar drive in Nyack, New York, a suburb of New York City. He reported very similar findings to those that I saw on Mercer Island. Nyack, like Mercer Island, is a key market for the Homebuilder Industry.

The scenario I have just outlined is part of what a qualitative analyst does. A qualitative analyst masters his trade, in part, by studying the works of Philip Fisher (the father of Qualitative Analysis) whose masterpiece, Common Stocks and Uncommon Profits, is a must-read for anyone who is serious about investing. It is a road map of things to look for on “Main Street” which signify just how good a company, its management or the Industry as a whole, is performing. Fisher analysis also works well with macro-economic analysis when trying to predict how the economy will affect a particular industry.

By contrast, quantitative analysis is not instructive in analyzing the Homebuilders at the present time. Quantitative analysis was brought to the forefront in 1934 by Benjamin Graham in his masterpiece Security Analysis which he wrote with David Dodd. Prior to Graham’s work, those who analyzed companies in a quantitative fashion were statisticians and later, were called Security Analysts. A quantitative analyst “crunches the numbers” or analyzes companies in a bottom-up approach by analyzing its financials. Value is then assigned by analyzing each company in an industry, comparing companies with each other within an industry, and then forming a conclusion on the Industry as a whole. This value analysis is micro-economic in nature, and is the basis of Value Investing.

Now it is important to explain why quantitative analysis is not useful in analyzing the Homebuilders. Listed below are the eleven major players in the Homebuilder Industry that are worth noting.

COMPANY TICKER SP DEPS PE ROE
Beazer Homes USA BZH $45.20 $10.46 4.32 23%
Centex Corp. CTX $47.48 $9.67 4.91 23%
Horton D.R. DHI $23.40 $5.03 4.65 23%
Hovnanian Enterpr. ‘A’ HOV $28.65 $7.09 4.04 19%
KB Home KBH $44.09 $10.54 4.18 24%
Lennar Corp. LEN $43.13 $8.60 5.02 21%
M.D.C. Holdings MDC $51.48 $11.24 4.58 21%
Pulte Homes PHM $27.23 $5.65 4.82 19%
Ryland Group RYL $43.04 $9.67 4.45 27%
Standard Pacific Corp. SPF $25.01 $6.51 3.84 20%
Toll Brothers TOL $26.05 $5.15 5.06 22%

SP = Stock Market Price
PE = Price to Earnings Ratio = SP/DEPS
DEPS = Diluted Earnings Per share
ROE = Return on Equity = DEPS/Shareholders Equity

If we were to view the foregoing table solely from a quantitative point of view, these results would be considered excellent. Indeed, as a group, the Homebuilder Industry’s results are superior to any other industry out of the 440 main industries that the federal government tracks for its Standard Industrial Classification (SIC 440) tables. In 2004, I wrote an article and concluded by saying that the Homebuilders as a group should be considered a superior investment and I actually picked it as my “Industry of the Year.” I was justified in saying so because the companies in the foregoing list skyrocketed in value and made some amazing gains.

However, despite the fact that the quantitative figures (“quants”) are excellent, the qualitative analysis is quite dire. Companies in the Homebuilder Industry are required to deal with increased commodity prices (raw materials), increased competition (existing home sellers), and a customer base that is rapidly getting priced out of the market (over-leveraged consumers). On top of this, the Federal Reserve is still uncertain as to whether it will raise interest rates again, and this produces way too much uncertainty to have any confidence in the Homebuilders as a safe investment. Moreover, if the real estate market gets flooded with existing homes, then envision the opposite scenario of what occurred in 2003-2004, and instead of a seller’s market, we will enter a buyer’s market. If this turns out to be the case, then home values will drop sharply and the equity that was accumulated will slowly erode. If the Federal Reserve continues to raise rates, then this process will be accelerated.

As if I have not already painted a picture imbued with sufficient foreboding, there is more. I am concerned that if this pattern were to continue or to accelerate, it could negatively affect the US economy as a whole, for the following reason. Over the past few years, consumers have felt very rich because they have made large equity gains in their homes, with some areas of the country experiencing 100%+ gains. These increases have created a wealth effect that has permitted the same consumers to borrow off this equity, particularly since banks and mortgage lenders have flooded the market with opportunities for second mortgages, home improvement loans, and credit card offers. So now we have consumers who have exploited the strong equity in their homes in order to buy cars, furniture, take trips, or renovate their homes, if not to buy a second home. When lending money, creditors based their decisions on the accumulated equity in the applicant’s home.

If we were to have a few more rate hikes by the Federal Reserve, then the pressures on homeowners will increase and they may panic. When those ARM loans get adjusted to current interest rates, we may see nationwide sticker shock. This will force many to put their homes up for sale immediately in order to avoid bankruptcy. If the number of homes put up for sale grows to the point where there are not enough buyers to purchase them, then the lender community will be forced to start foreclosing on those who can not make their mortgage payments. When this starts to happen, then banks and financial institutions will be required to take what would have been their profits and set that money aside for “reserves for bad loans.” Consumers will begin loading up their credit cards in order to pay their loans and the credit card industry will start to have problems as well. Consumer spending will be anticipated to dry up and other industries such as the retail industry will suffer. Companies that supply these industries will also be forced to slow down operations and thus a spiral effect will take place in the economy. Housing is the backbone of the wealth effect and when people become concerned that they will not be able to pay their bills, then consumer spending all but stops.

In conclusion, it is important that the Federal Reserve stop raising interest rates. With every rate hike comes further increase in the probability of personal bankruptcy or worse, the risk of a recession. Recessions are ugly beasts and everyone suffers. For those interested in the extent of damage caused by a recession to the Real Estate Industry, look at the years 1989-1991. Any way you look at it, the Homebuilder Industry is a dangerous place to invest unless interest rates were to be reduced.

Note: Peter George Psaras is not an Investment Advisor and nothing mentioned above can be construed as investment advice. All Research is written and produced as an information source only, and is not a solicitation to buy or sell securities. Investing in securities is speculative and carries a high degree of risk. All information contained in this research should be independently verified. Investors are reminded to perform their own due diligence with respect to any investment decision. Factual material is obtained from sources believed to be reliable, but Peter George Psaras is not responsible for any errors or omissions. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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11 Comments »

  • Jason said:

    Great article, Peter. You depict a very plausible recession scenario should rate hikes continue. Let’s hope the Fed doesn’t take any of this for granted.

    On behalf of the InvestorGeeks founders, I want to publicly state that we are very pleased to have Peter on board. His market analysis shows a deep understanding of how both wall street and “main street” work.

    You can find more of Peter’s great writing at http://www.righttimeinvesting.org/.

  • JoeBloggsInHisLateTwenties said:

    Well, as someone who can’t afford a house unless I completely dangerously overcommit, I certainly hope for further interest rate rises, and a more realistic and affordable property market.

    I haven’t benefited from the property bubble, I don’t feel ‘very rich’ and are currently left with no choice except to rent.

    We need further monetary policy tightening.

  • JoeBloggsInHisLateTwenties said:

    Either that, or a wages explosion to restore affordability to the property market, and this obviously has serious inflation consequences.

  • Dan said:

    Excellent analysis. Like you I would not be in a rush to invest in homebuilder stock right now.

    At the same time, I’ve noticed many people going to the other extreme of panic – suggesting we are experiencing a housing bubble. Quantitative analysis can help put things in perspective here – not analysis of stocks, but rather of housing cycles. I’ve posted an article on this called Housing Cycles, This Time With Pictures” that suggest that at least nationally, we’re at the peak of a cycle, but not a bubble (though local bubbles undoubtedly exist).

    While this only speaks to the national scene (and of course all real estate is local), it does corroborate what you say. Those who have purchased or refinanced with ARMs, particularly those on a Treasury index, are in for a shock – most of them will already adjust to higher than today’s fixed rates. But those who took advantage of historic low fixed rates will be just fine. Those whose ARMs are indexed to the 11th district cost of funds won’t be hurt as badly either (depending on how stretched they were and where rates go moving forward).

    The other people who will be hurt are speculators – those who purchased in order to flip homes – they are the ones who will sell as their equity starts dropping. But I wouldn’t expect most homeowners to sell as the market drops. Unlike stocks, people want to live somewhere, and unless someone needs to move they are more likely to ride out the cycle. The result is a lower level of real estate sales (bad news for realtors, but not necessarily for homeowners). Those who purchased before 2003 will still be ahead, and even those who bought later have no real incentive to sell – their loan may be underwater, but as long as they can carry the payments, there’s no benefit to selling (the equity lost at sale might make purchasing another house tough) – they’re more likely to ride out the cycle.

    In terms of my area (Silicon Valley), it seems to have realtors puzzled. A recent report showed lower sales volume and houses on the market longer, but prices still rising. Seems like sellers who don’t need to sell, aren’t – at least not yet. And in my neighborhood there aren’t many for sale signs this season, but those that show up are selling quickly.

  • Vince said:

    I’m sorry, I have to laugh at that last trackback, because I understood what it meant (reading the chinese characters)… I bet you do too. It’s about Amanda Congdon leaving RocketBoom. I wonder why it showed up on this page?

    By the way, great article Peter. I like the fact that you are telling us some of the trends that are happening in Main Street.

  • John Rhodes said:

    “with every interest rate hike, it gets that much tougher for new home buyers to afford to buy a home”

    I would say it gets tougher but not *much* tougher. On a 30 year mortgage, one hike is a small amount of money per month. It is the cumulation that hurts.

  • Chris said:

    I think you’ve hit the nail on the head here, Peter. Time will tell how fast the spiral turns, but it could potentially be a slippery slope for those that paid too much for their homes.

    As an aside, I’ve seen very much the same thing as in Seattle in Montclair, NJ. I’m seeing more For Sale signs staying up for longer periods of time.

  • Carnival of the Capitalists - July 10, 2006 - Fat Pitch Financials said:

    [...] Homebuilder Industry Analysis [...]

  • Two highlights worth reading from this week’s financial Carnivals | Experiments in Finance said:

    [...] From the Carnival of Capitalists: A nice article from InvestorGeeks examining the housing market and housing stocks. I agree with almost all of the points made, except one. The author claims housing stocks are actually attractive from a numbers (e.g. quantitative) point of view, though not from a “qualitative” point of view. I would argue that they’re also unattractive from a quantative point of view. The lesson here is that you always need to put numbers (in this case, P/Es) in their right context. [...]

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  • J G said:

    I’m telling you, there’s NO BUBBLE! Trust me, I’m in the mortgage business. Er, I was in the mortgage business, that is. But, I swear, there’s no bubble. Bubble shmubble!

    Okay, okay! So, housing prices have dropped to what they were at before this VERY-NON-BUBBLE-BECAUSE-IT’S-NOT-A-BUBBLE thing started happening in the housing market. Okay, okay! So, home sales are at there lowest in decades. So what! What does that prove? That there’s a bubble? That’s impossible, because we’re telling you there’s no bubble, for criminy out loud! Foreclosures at an all-time high? So what, I say!! How old is the U.S. now, a couple hundred years? England! Now, there’s an old country. There’s stone antiquities sitting on the side of motorways that were built over 1,000 years ago! We’re babies here! No bubble, I say. Trust me.

    Listen, I’m not the best source of info in the mortgage industry, because I went to college. Listen to the people who didn’t waste there time with all that college silliness and are telling you, in their wise and learned opinion, I’m talking about the 28-year old whiz-kid brokers, here! If they say there’s no bubble, then there’s no goddamn bubble, okay?!?

    I rest my well-researched case. Thank you. No bubble!