Friday, June 6, 2008

Can the Market Predict Land Values?

Although rarely exactly equal, we've seen how market values tend to track the book values of home builders over time here and here. Here's an example of a particularly volatile home builder when it comes to its price to book over time. Orleans Homebuilders (OHB) operates in 14 markets across the US:

But what is causing this volatility? Is the market price bouncing around all over the place, or is the book value constantly changing, or some combination thereof? Here's a look at the price and book values separated out to see how they've moved over the same period:

Clearly, market values are more volatile than book values, suggesting one can take advantage of the situation by buying when market values are low and selling when they're high.

However, we do see the market having some ability to predict the direction of the book value. In the late 80s, we notice market values are lower than book values, correctly predicting that book values are about to fall (which it appears they do for this company throughout the late 80s). Again in the early 2000s we see the market correctly predict book values are about to shoot up, and soon enough, book values shoot up thereafter.

At the same time, despite the market's accuracy in predicting the direction of book values, it overshoots its mark almost every time. Once again, this is clearest in the late 80s where markets are far below book values ever reach (creating a buying opportunity) and again in the early 2000s where markets clearly overshoot the top.

Most recently we've correctly seen markets punish home builders (with OHB being no exception) in advance of the drop in book values. The question is, at what point will it have overshot its mark? By having enough of a margin of safety between the market and book value, you can protect your downside. Here we calculate how well that would work.

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