Home Builders (DHI, PHM, TOL, CTX)

March 23, 2007

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.


The Little Book that Beats the Market

March 23, 2007

I usually avoid books that promise a “magic formula” to investing; but, author Joel Greenblatt, is a successful money-manager, and the library had an audio version of his book “The Little Book that Beats the Market“, and the book had good reviews.

Using a simple example of a kid selling gum in school, Greenblatt asks how much one would pay to become a partner, getting half of the gum-selling business. The first five chapters are a great summary for someone who has never thought about stock-investing.

Next, Greenblatt explains his “magic formula”. Among the various measures that make a stock attractive, he isolates two factors and explains why those two are fundamental. He argues that many other factors depend on these two, or are simply not as important. He tells individual laymen investors to ignore most other factors, rate companies using only the two publicly available measures, and promises that they will beat the market in the process.

Even though the Greenblatt is substantially correct in the metrics he identifies, and has back-tested his formula over data from the past 20 years or so, that is dangerous advice to someone who knows nothing about stocks. Everyone who invests should also understand the basic objections to stock-picking, made by the “Efficient Market” school. (Not that I agree with the latter, but one should understand the point that they make, and why average-performing “Index Funds” are suitable for many investors. John Bogle’s little book should be a good companion read.)

Also, from any ‘mechanical’ screen, the investor would need to exclude certain companies that are in there for the wrong reason. (Greenblatt mentions, in passing, that one should remove Financials and Utilities. Given the times, perhaps he ought to have added a caution about natural-resource companies as well.) [Check this Barron’s article for a critique.]

Greenblatt has a web-site where one can get a list of (say) top 25 companies, using his criteria. When I tried the site though, the “Return on Assets (ROA)” numbers were way off. For instance, DLX showed up with an ROA of over 100%, while both S&P and Yahoo-Finance calculate it to be around 10% (and the latter is definitely closer to reality). So, if a novice tries to follow the “magic formula”, without reading anything else, he actually will not follow the advice after all, because he’s probably going to be using bad data!

I think the real audience of the book is the large contingent of amateur individual investors who lean toward “value-investing”, and are at least knowledgeable enough to spot basic data problems. For such an audience, the early chapters are slow, explaining basic concepts from scratch. Nevertheless, the basic theme — Greenblatt’s isolation of two factors as being fundamental — is definitely food for thought.

So, if you’re a novice, read the book but you’ll need to read some others as well, before acting. If you do invest in individual stocks, it’s a book worth reading and thinking about.