Trading the Homebuilders Profitably
Fair warning: I’m still working on the research here, but I’ve come up with an idea on profiting from the homebuilders’ continued weakness and overselling.
It’s fairly simple: buy the builders trading below book value (Beazer, CHCI, etc, etc) and short an appropriate amount (i.e. buy puts on) of the Case-Shiller housing price index.
The thesis is as follows: several of the builders are trading at mere fractions of book, largely due to the fact that investors anticipate plenty more writeoffs of inventory, consisting of unsold homes and land, going forward. This inventory comprises the vast majority of these companies’ tangible asset values, so it naturally makes sense that discounts to book are largely due to fear that the asset values are overstated. Normally I’d simply buy and hold such cheaply priced companies, but the truth is that I haven’t a clue where housing prices are headed going forward or how much in charges to inventory the builders will take.
What I do know is that a company like Beazer Homes (BZH), for instance, has a geographically diversified portfolio of decidedly normal homes which I believe, on average, to be well-representative of the typical American house. The average unit price is listed on the company’s books at around $220,000, and, interestingly, the average composite home price can be shorted via Case-Shiller at around the same price.
This means a savvy investor can effectively profit from the spread/discrepancy between book value and price of Beazer’s stock by hedging out the writedown risk via a short position in the Case-Shiller composite. While I’m not positive, I’m fairly confident that an inefficiency in the smaller homebuilders’ pricing exists since most investors are not considering how they can come close to eliminating the risk of writedowns. Of course, this is assuming that investors are also willing to stomach the risk of heavy debt, poor management, etc., but for some it may be worth these risks.
Note: I do not currently have a position in Case-Shiller futures or any homebuilding stocks.
Dave said,
July 16, 2007 @ 3:33am
I am not so sure that I agree with that one. The risk to homebuilders is not really that their assets will degrade. That is fairly predictable. The real risk is liquidity risks. Every homebuilder that has failed has failed because of running out of liquidity. They are highly leveraged and dependent on continuing financing. If they stop producing cash (most have already) then they need to borrow to pay interest on their current debt. This raises their debt load. If the debt gets too high, lenders may decide to stop providing the money. When this happens they go bankrupt.
Look into homebuilders that have gone belly up. The best example is probably US Homes. Others are NVR and UDC. All got killed for the same reason: liquidity being shut off due to high debt levels and negative cash flow.
I own one builder, Meritage Homes. Another good one is MDC which has one of the best looking balance sheets.
Mark said,
July 16, 2007 @ 1:04pm
Has potential but I see a lot of basis risk in this. Your hedge is traded in the same or even an overlapping market as the security you are hedging. Technical reasons in individual markets may cause them to move differently than fundamentals would suggest. If you’re researching their correlation, I’d be curious to see the result. In addition to basis risk, you have the risk of individual stock vs index to consider. Volatilities should be different but I don’t know. Finally the Case Shiller index relates to just one factor in the homebuilding company’s performance. Dave has pointed out a risk to the long position that is not hedged - liquidity of the homebuilders. So to hedge that you may need to consider adding a position that goes inverse to credit deterioration, specifically as to the name or generally as to HY, although these do add more basis risk.
I have no positions in this sector. Being a homeowner provides me so much exposure to RE, I tend to avoid this sector.
Yaser Anwar said,
July 19, 2007 @ 12:03am
Good stuff!