Homebuilders Ranked By Discount to Book Value

We saw that market values tend to rotate around book values for home builders here. We also saw that markets tend to overreact both to the upside and the downside here, creating buy opportunities. Currently, most home builders are trading well below book value. Could this be a buying opportunity? Here they are, ranked by biggest discount to book:

Why such a spread between the top of the list (discounts in excess of 75% book values) and the bottom (barely any discounts!)? It could be that investors believe there are way more writedowns coming for those at the top. Investors may also have more confidence in certain managements' abilities to navigate through these difficult times.

Upon closer examination, notice the largest builders tend to have the smallest discounts. If we take a look at the discounts relative to the sizes of the companies, we get a chart that looks like this:

Notice how the largest discounts to book value (in excess of 50%) are for companies smaller than $250M. Also note that the largest companies tend to have the smallest discounts. Could it be that managements for the smaller companies are worse, or that they are more risky, or have higher debt levels? It's possible. Another reason could be that the stock market is less efficient for those smaller companies as we've discussed here (hence we see more variation among the discounts for the smaller companies), since they are too small for many institutions to buy.

It's worth taking a closer look at the companies with the largest discounts to book to see if they offer large margins of safety!

Homebuilder Values Overshot to the Downside?

We saw here with Orleans Homebuilding that markets can be fairly adept at figuring out whether book values will increase or decrease, but that they tend to overshoot their marks, offering buy opportunities when they overshoot to the downside. But was Orleans a one-off? Let's look at a few more builders to see if there's a common theme emerging.

Here's a look at Dominion Homes, operating in 3 states in the US:

We do see here once again several occasions where the market predicts the direction of book values before they occur (1994, 1996, 2001,2006). However, we do see occasions where the market is wrong as well, with a big drop in 1998 and 2002. Once again, we also see that on almost each of these occasions, the market overshoots, offering dramatic buy opportunities in 1996, 2000, and possibly today?

The next chart is of California Coastal Communities:

This one is a bit perplexing, with market values taking a huge plunge in the early nineties. Market value continues to underperform book throughout the 2000s (until a bout of irrational exuberance in 2004), suggesting for some reason investors were turned off by this company. I'd be interested to dig into why this was trading at such a sharp discount.

The last chart is of Meritage Homes:

This is a bit more typical from what we saw earlier, with markets correctly predicting directions of book value, while nevertheless overshooting both to the downside and upside, providing opportunities when market values are much less than book values.

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.

Small Homebuilders Are A Bargain vs Book Value

In this post, we saw that home builders' market values track decently well with their book values. But those were the largest of home builders. Here, we look at Price to Book values for the smallest cap builders. All of these companies (Brookfield, Comstock, Meritage, Orleans, California Coastal, and Tousa) have market caps under $500 million, so they may present opportunities that the large builders don't, as we've discussed here in our discussion about why small caps are better investments.

Once again, we see periods of fear as well as exuberance for these stocks. In the early 90s, there is some tremendous opportunity to buy these companies for presumably much less than the land they own! It takes several years, but eventually by the mid to late 90s, those investors got rewarded.

In the first half of this decade, we see clear evidence that the market is extremely optimistic on land values, as investors are willing to pay more than 3 times book value for many of these companies.

Today, we see some possibilities for some great opportunities. Many of these small companies are trading for much less than their book values! Of course, P/B is just a screening tool. One still has to dig into the financial statements of these companies and make sure there is value there to be had. But if this screen is any indication, there may be an opportunity to buy real estate at bargain prices through these companies, presuming there is a margin of safety to cover any write downs!

What's Book Value Worth?

Do people care about price to book value when they buy a stock? For a given stock on Google Finance, you won't find the price to book value shown anywhere on the page. On Yahoo's finance site, you have to scroll down the 12th page of info (titled 'Statistics') to find the P/B. It would seem P/B is not an important measure in investor's minds.

For companies like Microsoft and Accenture, book value won't help you figure out the intrinsic value of the company. Their assets are knowledge based. But are there some companies out there where book value is an appropriate measure for intrinsic value?

Consider land developers. They acquire land for the purpose of development, and for the most part try to sell those developments as soon as they can. I would argue that book value is a pretty decent approximation of the intrinsic value of those companies. Sure, it's not perfect. In some cases, land could have been purchased years ago, and is therefore underestimated at strictly book value. So you still have to dig into the financial statements of the company to figure out what the properties are worth, but as a screening tool, looking for a low P/B ratio can be useful.

Here's the price to book ratio since 1985 for several large US homebuilders (Centex, Hovnanian, Lennar, Toll, DR Horton, Beazer):

A couple of interesting things going on here. We do see some irrational exuberance at times, where companies are trading for 3 or more times book value, but they come crashing back down when times aren't so great. In the 1980s we may be seeing the high inflationary times drive up the appetite for hard assets such as real-estate. In the early 2000s we see the runup in valuations of pretty much every builder.

We can also see times when it looks like these stocks are great bargains. During the 1991 recession, they're all trading below book value, and in many cases with large margins of safety!

Today, we see these stocks trading near the bottom of their P/B range. Could this be a buying opportunity? This chart clearly shows there currently aren't huge expectations built into these stocks. But there could still be more writedowns to come, which would reduce book value. Therefore, you'll want to look for a healthy margin of safety before jumping in.

Also consider that these are the largest, most famous US homebuilders. Smaller builders may have less analyst coverage and so may represent bigger bargains!

Let's get rid of Sundry Assets!

Considering the cool weather we've been having to this point, you must think I'm insane for wanting to get rid of something that sounds so warm and fuzzy. Who couldn't like something called Sundry right? Unfortunately, Sundry Assets do nothing to warm the hearts of those who wade through corporate financial statements.

When a company has a Balance Sheet entry titled "Sundry Assets", it's totally unclear what's included in that account. Sundry literally means 'various or diverse'...so what gets included under Sundry Assets? Anything and everything that management doesn't want to provide a separate line item for. Since investors have no idea what's in there, it becomes almost impossible to value.

Some companies throw expenses in there that they haven't used up. For example, if a company bought $500 of wood to knock on (following rosy statements), but only wore out $400 worth, they can stuff Sundry with the extra $100 (with the expectation of expensing it later). For small items such as this, it's not such a big deal. However, companies have also stuffed this account with items like private investments in other companies.

Usually, Sundry accounts are small and so aren't worth bothering about. But I recently encountered a company whereby the contents of those assets would make a valuation difference...if only I knew what they were! Such accounting reeks of management hiding information from shareholders, and is a signal to stay away!

Directional Hedge Funds

Hedge funds can be broadly classified into three categories:

1) Relative Value

2) Event-Driven

3) Directional

I've discussed the first two here and here. Directional funds are the most risky of the lot, as they involve taking massive bets on the direction of the market. Why do I call them massive bets as opposed to regular bets? Because they often involved a large amount of leverage, which magnifies both gains and losses.

As an example, if you invest $10 and achieve a 10% return, you'll have $11. However, if instead of just investing $10, you borrowed another $10, well that same 10% return would net you $12 (after paying the lender back), a return of 20% on your original $10. This amplifying of your gains will do the same for your losses as well.

Such hedge funds will take large long or short bets on equities, bonds, indexes, currencies or any derivatives. Many hedge funds of this nature also focus on emerging markets, as they are often less efficient due to lack of investor interest and information flow.