Home Builders (DHI, PHM, TOL, CTX)

Since I started looking at possibility of buying the home-builders in July 2006, they went up considerably, but have dropped back down in the first few months of 2007, so that they’re back around their July 2006 levels. Meanwhile, the rest of the stock market also dropped off and all the talking ehads are talking about the risks of sub-prime mortgages and so on. So, I decided that I better not wait; six months from now, the pessimism may disappear.

Since Bill Miller had opted for PHM, I was tending toward that choice, but decided to look at some of the competitors: TOL (sells more expensive houses), DHI (sells slightly less expensive houses), and CTX. Here’s what I found:

Firstly, I found that all four companies are pretty good and pretty similar. CTX has the best 10 year fundamental averages, but they swing all over the place, so I’m discarding them rather than expect myself to be able to figure out if that swings are about seizing the moment, or about poor prediction. So, I’m left with three that have very similar patterms of profit movement. Of these, though I was slightly predisposed to PHM, I’m now a little wary of their Michigan exposure. A look at the numbers shows PHM having dived a bit more than the other two.

The S&P analysts use book value and a multiple while evaluating these builders. I prefer to use a normalized EPS approach. In my estimate, the normalized 5-year EPS for these three are: (PHM = $ 2.60, TOL = $3.0, DHI = $3.30). With a normalized home-builder P/E of 8, that gives me valuations as follows: (PHM = $ 20.8, TOL = $ 24, DHI = $ 26.4). The prices today, 3/22/2007, are: (PHM = $ 27.50, TOL = $ 29.50, DHI = $ 23.50).

The top-line and bottom line growth rates are pretty good for all three, not much to go on there. So, I bought a little DHI, and …surprize, surprize, when I checked Gurufocus, I found that the Sequoia Fund had bought a little PHM in 2005, but they recently bought a larger chunk of DHI. With that second opinion, I plan to add to the DHI holding in the coming weeks.

My original plan was to buy and see if it goes down further, with the growing nervousness. However, the Fed might be coming near a turning point, and if they start to reduce rates, people might assume it’s good for home-builders, sending the stocks up.

DHI also comes with a 2.6% dividend yield, so I can see myself holding onto it for 5 years or so, though a whole cycle.

Update Jan 2009: The market went down as expected, but almost nobody expected how bad it would be. The S&P500 was down 45%. The excess home inventory shows no sign of abating. I took my loss, and got out of the one home-building stock I owned (DHI) some time last year.

Sardar Biglari – A person to watch

A post on the Gannon on Investing blog alerted me to a guy named Sardar Biglari. He’s a 29 year old who started an ISP company when he was in college, then read about Buffett and realized that — qua investor — he does not want to be in an unpredictable business. He now runs The Lion Fund (hedge fund).

I’m very wary of smart talkers. Over the years, I’ve learnt that the wolf-like car-salesmen types are not the ones to worry about. The dangerous operators come in sheep’s clothing. The dangerous ones appear completely genuine and different, until you’re checking your wounds. So, out of curiosity, I read the one interview that I could find, and what was available on the site of Western-Sizzlin a company Biglari recently took over, and some stuff in the press.

Aside: I would have liked to read Biglari’s letters to his investors, which were public until recently, but it turn out that someone commented to his company that, since he runs a hedge fund, and since hedge funds aren’t supposed to solicit investments from the general public, putting his letters on the site might be construed as an illegal solicitation. In other words, my bloody government is trying to protect me from being tempted to invest in The Lion Fund, even though they already have a rule that prevents anyone with less than $1 million of net worth from investing in such fund. Oh, the tangled web of socialism! (I’ve emailed them asking if I can be given access.)

Anyhow, back on story: so far, everything adds up with this guy and the typical warning flags (things said, ways in which said, things left unsaid). In fact, I’m sufficiently convinced to have invested a small sum of money in Western-Sizzlin, where Biglari is Chairman.

Update (Oct 18, 2006): I should have added that I like the way Biglari is planning the new financing for Western-Sizzlin, using rights shares instead of debt. All too often, take-over firms will bring their own money in the form of convertible debt to the new company that gives some shareholders better treatment than others. The rights share way (or a debt from a truly unrelated third-party, if that makes sense) indicates a sense of fairplay.

Whither Rates

Summary: The Fed is probably going to raise rates another 50 basis point during the second half of 2007, after which it will probably start a multi-year descent.

Here’s a graph that shows the Fed Funds rate and the 30-Year mortgage rate from 1972 to mid-2006.

• There has rarely been a time in this period where the rise in Fed Funds rate has not been accompanied by a rise in Mortgage rates.
• The duration for which the Fed has raised rates has varied considerably, but the current uptrend has been slightly above average, in terms of duration and quantity of increase. Therefore, by “naive” historical pattern, one would expect the Fed to pause and begin to let rates go back down again.
• Given that the Fed has a new Chairman, he wants to prove himself good at controlling inlfation and also wants to show that he does not stifle growth. However, with current ideology what it is, the chances are that if he has to err, it will be on the side of wanting to control inflation. The current ideology would therefore point to a little more of a raise, until the economy actually squeals just a little bit.
• In 2000, the Fed took the rate just above 6%, to “kill the bubble”. Chances are it will want to stop shy of that, since it’s hard to see that the Fed perceives as much of a bubble today as in 2000.
• The net of this would be an expectation that the Fed will raise rates another 50 basis points over the latter half of this year (perhaps with a skipped meeting during which they will pasue). Then, they will probably pause again and go back to dropping rates.
• The speed at which they resume dropping rates would depend on whether something hits, particularly on how housing fairs in some of the frothy markets.

Update (July 28th): We’re about a week away from the next FOMC meeting. In the meanwhile, Bernarnke spoke about a slowing economy, causing people to speculate that he’s predicting a “soft landing”. While today’s GDP figures point to slower GDP and housing, they also point to a high (2.9%) jump in “core inflation”. From the Fed’s perspective, sticking with an August 8th hike, despite the slowing GDP will demonstrate their inflation-hawkinshness for good. I’m guessing they opt for a raise, rather than pausing this time and raising at the next meeting (which in their view would demonstrate that they are “reluctant raisers”).

Update Aug 04: PIMCO thinks the Fed is almost done, and see rates being eased in 2007. Also, in the morning, the jobs data came in lower than expected, with the official unemployment number going from 4.6% back to 4.8%. The market zoomed up briefly in an almost knee-jerk “ah! they will not raise rates” fashion. However, it was short-lived. In a couple of hours, it was going back down… not sure why.

Update Aug 9th 2006: In the end, the Fed did not raise rates. After an extremelt short and weak upturn, the market sunk. I figure that people realize that the rate cut is coming and has simply been postponed. So, rather than a quick end to the uptrend in rates, they see a longer, drawn out (though less steep) trend. In essence, the misery has been prolonged.

Update Oct 17th 2006: The Fed is in “pause mode” now, waiting to see what happens next. If inflation stays high for too long or goes further up, they might tighten again. On the other hand, if inflation seems low and the economy begins to slow (e.g. driven by below-inflation house-values) the Fed may start a lowering phase. Today, Goldman Sachs predicted that by the end of next year (i.e. end 2007) the Fed rate will drop from the current 5.25% to 4%. On the other hand, J.P.Morgan predicted that it will rise to 6%. (via Bloomberg)

Guru Commentary – 2005

A summary of what some of my favorite investment gurus said in their 2005 Quarterly reports.

2005	Q1	Q2	Q3	Q4
Cash balances /Opportunities / Valuations	Some high (Clipper, LongLeaf and Wietz);others retain their usual low cash(Bill Miller says, “No point holding cash @ 2%) Dodge & Cox has only 6% in cashValuations are not demanding; just about right.	Slightly more opportunities than Q1. But, not much excitment and notthing bad either.	“For the first time in two-and-a-half years all three Funds have cash below 10%…” and “…we are more optimistic about our portfolios than we have been in over two years…” [Longleaf]finding things to invest in. [Dodge & Cox]“…now we are getting excited” [Weitz]	still finding things to invest in. Opportunities from globalization. Cash balance is about 5% [Dodge & Cox]2005 was stable and 2006 appears to be a generally positive environment as well. Real-estate might cool, and there’ll be scary headline, but on balance things look fine. Fund underperformed the S&P for 2005, but underlying values increased.
Other		Hurricane Katrina in New Orleans affected Q2 for some firms; but the market seems to have shrugged it off even though 400,000 job losses are expected and a loss of over $30 billion.	xxxx	xxxx
Market	Despair amidst good profitability	xxx	xxxx	xxxx
Misc predictions	Long rates will go up at some point, pushed by short rates (Wietz)Miller thinks the Euro is overvalued	xxx	“Three long-term trends appear to be pushing the world economy into a fertile and productive period” (Tech, Globalization, & strong U.S. economy) [Dodge & Cox]	“Real-estate might cool, and there’ll be scary headline, but on balance things look fine ” [Weitz]
CPI (Yr/Yr)	3.1%	2.5%	4.6%	3.4%
Unemployment	5.2%	5.0%	5.0%	4.9%
Gold	$420	$440	$495	$500
Fed Funds	2.63%	3.04%	3.62%	4.16%
S&P (Qtr)	-2.2%	+1.4%	+3.6%
S&P Yr/Yr	6.7%	6.3%	12.2%	4.9%

Bill Miller [Q1 report], quotes Sir John Templeton (though he isn’t sure if he’s really the source), speaking of bull markets. They are: born in Pessimism (2001-2002)grow in Skepticism (2002- ???)mature in Optimism die of Euphoria.

Why is Microsoft failing?

The title is supposed to be tongue-in-cheek. Gates is the richest guy in the world. His partners are among the richest. Microsoft (MSFT) created thousands of employee-millionaires. MSFT produces a net profit, of about $150,000 per employee per year. Over the last five years revenue and income have grown about 10%, which is twice the growth of US GDP. If only we could all fail like this!

The kernel of truth is that MSFT is growing slower than it once did. Instead of today’s 10%, the late 90’s saw it grow 20-25%. Net profit per employee was once more than double today’s figure. [The stock has been flat for a while, but that's "Mr. Market".]

MSFT’s has three profitable businesses that have long been central to MSFT:
Operating systems for PCsOffice s/w [Word/Excel/etc.]Servers and Tools [Visual Studio etc.]The first two dominate their market, with little market share left to be grabbed from others. In the hands of an ordinary company, these might have declined, being eaten by Linux and Open-Office, respectively. Yet, MSFT grows them around 5% a year. Servers and Tools got hit for a while by the Java wave, but are growing vigorously again.

However, the criticism is not levelled at these mature business-lines. The real criticism is: why aren’t they doing something new? Why did AOL take a huge chunk of market-share, with MSN playing catch-up and losing money? Why did Yahoo bring out the first good Web-directory? Why did Google bring out the first good Web-search?

In other words: why isn’t Gates the guy with all the ideas? how come someone else gets good ideas now and then?

To be continued…

[Given the title of the blog, I figured I needed a software-related post. So there.]

Investment advice from the Guru’s

“Read WSJ every day and Barron’s every week.” That would be typical advice about the bare minimum to read if one wants to be make stock buy/sell decision. The Economist has concise writing, packing a wealth of information into each paragraph. A good source of information, not such a good source of correct economics — with a hopelessly left-of-center Keynesian viewpoint (long live LSE).

For great writing by a great businessman, Berkshire Hathaway’s site has three links: an “Owner’s Manual”, the Annual Reports by Warren Buffett, and the Wesco Annual Reports by Charles Munger. In the latter two, the commentary is the interesting and enduring part. Ignore the P&L and other numbers, unless you want to invest rather than just read great business writing.

The best current-commentary of all is not to be found in magazines and newsletters at all. It is found in quarterly and annual reports of certain fund managers. The following is not a list of fund recommendations. I am recommending the reports only. I own many of these funds, but I am NOT recommending these funds.

The Clipper Fund
PIMCO: Specifically Bill Gross’s monthly ‘Investment Outlook’
The Weitz Funds
The Longleaf Partners
Dodge and Cox Funds
Bill Miller’s Commentary (not other) at Legg Mason’s “Value Trust” fund
Mr. Whitman’s reports as Third Avenue funds

If you really want an education in Finance, the list above is enough to keep you busy for a long, long time!

U.S. Jobs Data

Every month, the press reports the latest “jobs data” in the U.S.

Here is the latest example. The New York Times reports that, “after the government reported that only 78,000 new jobs were created in May, the smallest monthly gain since August 2003, stocks fell as the slow-growth theme took hold for at least a day.“

On the west coast, this L.A.Times story reported the same event thus: “The Labor Department issued its May data showing that only 78,000 nonfarm jobs were added to payrolls — less than half the amount economists had expected and a steep drop from the 274,000 created in April.”

The same event, was reported by the Washington Post thus: “The U.S. economy created 78,000 new jobs in May, the Labor Department reported today, about half as many as economists expected and the lowest payroll growth rate since August 2003.”

If the above seems repetitive, bear with me while I present one more example. This is from “the horse’s mouth”. It is a “summary” issued by the Bureau of Labor Statistics. In part, it begins: “Nonfarm employment edged up by 78,000 in May following a much larger increase in April,…”

If you read any of the above, you’d reasonably conclude that (say) X new jobs were added, Y jobs were lost and that the difference (X – Y) was 78,000. Not so! I was surprised to read Gene Epstein (Barron’s Austrian economist) write that the economy actually added 707,000 jobs in May. I did not trust Mr. Epstein and thought he was trying to “spin” his own version. So, I delved a little deeper into the report by the Bureau of Labor Stats.

To my surprise he was right. In May, the U.S. economy added 707,000 net jobs.
If you wish to check up on this, here is the link.

Reminded me of Benjamin Disraeli’s famous line: “lies, damn lies, and statistics

Short Term Thinking

I was standing behind two 7 year olds, as they watched the soccer game scheduled before their own. The red team had just scored a goal. One of them turned to me and asked: “Who do you think will win?”

“I don’t know”, I answered. “We just came in. I haven’t seen enough of the game.”

“I think Red will win”, said the little forecaster.

Just minutes later, the blue team scored.

He turned to me and said: “No, I think Blue will win”.

No, markets are not irrational; they merely reflect the opinions of the people who participate in them. Sometimes those people can be irrational. Unwarranted fear or greed is often a sign of short term thinking. A success may be irrationally projected as: “wow! if this firm can do this every quarter… it will be worth gazillions.”

Right now appears to be a normal time, not really a good time to buy or sell stocks. If you are interested in the long term, shouldn’t you wish for a period of “irrational fear” or a period of “irrational exhuberance”?

Is the stock market a so-called “zero-sum game”?

Do we have a Real Estate Bubble?

Summary: Some slow-down is coming, with largest downturns probably in places that saw the largest upturns (aka, not in the mid-West)

Over the last year, many have been saying that we are nearing the peak of a real-estate bubble. A few voices say that “real estate is local”, so any forthcoming bust will be geographically-specific.

At the recent Berkshire shareholder meeting Warren Buffett said that there may be a bubble at the high end of the market. Charles Munger went further, saying that he thought there was a bubble in Washington D.C. and some parts of California.

I have seen too many Buffett predictions come true to take this lightly (though this time he was not whole heartedly endorsing the idea of a bubble).

Our house is far from top-end, and we don’t live in a city where prices have sky-rocketed. In fact, if it is a bubble and it does burst, I should consider waiting 4 or 5 years and then “trading up” around the year 2010.