Friday, May 18, 2007

Home builder earnings

I made this plot of earnings and book value for two of the oldest buiders Pulte Homes (PHM) and Centex (CTX). Black is PHM and red is CTX. The solid lines are book value per share (BV) and the dashed line is earnings (E), multiplied by 10.

They have grown BV by a factor of about 1000 since 1968. Pretty impressive. That is a 19.9% annualized growth rate for PHM and 17.8% for CTX.

You can also see how volatile the earnings are. Earnings are the change in BV from year to year: the derivative of the BV curve. The ratio of the two E/BV is the return on equity (ROE). You can see that the average ROE is roughly 10%. For the past 10 years, the ROE has been much higher. The dotted lines are about twice the solid so ROE is about 20% similar to the late 1970s.

You can also see the major recessions in 1973-1974 (the OPEC oil crisis) , 1980-1981 (Volcker's recession), and the 1991 Bush recession. The 1973-1974 recession appears to have been the worst for these builders. PHM nearly lost all of its earnings but still managed to avoid a loss. For both companies, BV has never declined in nearly 40 years. They have never had a loss.

Despite these terrible recessions, builders have managed to recover after a couple of bad one or two years. I think they will do likewise after this recession. Will the profitability of builders return to ROE=10 like they did in the 80s? Perhaps. However, the future may not resemble the past. What really matters in terms of growth for the builders is population growth. It appears that the government is passing immigration "reform" which should allow not only higher than average population growth but also plenty of cheap labor which will add to builder profitability. I think it is true that the long term picture is still rosey for home building in the US. However in the shorter term, we are likely to see a recession and the housing slump is likely to get worse before it gets better. There are still lots of uncertainty over how this will all play out. I think we are likely to see massive intervention on the part of the government aided by the Fed to prevent a full blown deflationary collapse. As an investor, my job is to decide whether builders will survive, whether they will grow thereafter and to decide when all this bad news is sufficiently priced in to create a good entry point in the stocks. I like Meritage Homes (MTH) best at this point although they are probably not the most conservative pick. Still, they seem to have the most long term potential and seem to be most feared by market participants presumeably because they only build in the southwest. They are trading at 0.88 BV and may go a bit lower. I have some shares, purchased at around this valuation and may acquire more if they drift lower towards half book and I see a rise on the Fear Meter which is now registering only Medium-High.

Of course one should be prepared for some volatility in prices. In the 1973-1974 recession, CTX tumbled in price from 2.78 to 0.3 (split corrected) which is a factor of 9.3,Yikes! Of course, they started off that priced 4.8 times book (way overvalued)and bottomed at half book (way undervalued). It seems half book is about the maximum fear point. MTH may not be there yet.