In previous articles I've mentioned that I'm generally bearish on the market and as a result, I'm building a short portfolio. Two previous entries - Amazon.com (AMZN) and Tesla Motors (TSLA) - were added based on company-specific circumstances. Netflix (NFLX) was added for company specific reasons and because of general international "headwinds." Today's entry of Zillow (NASDAQ:Z) is a bit of departure from these, as the primary reason for its inclusion is sector related.
As a preamble, let me say a word about why - in the midst of a raging bull market - I'm building a longer-term short portfolio.
One of the questions I try to keep in mind when trading is: "what edges can I, as an individual investor, have over the institutions that make up the majority of the market?" Obviously it's not access to information. Instead, in my view, all the "edges" come down to not having to work within institutional constraints. First, of course, is the ability to focus on stocks that are off the beaten path and perhaps don't have the liquidity necessary for institutions to trade them. Certainly those types of situations figure in to my trading. But more germane to today's pick are three inter-related factors: not being subject to "career" risk, not needing to slavishly follow the trends of quarterly reports, and being willing to sell ahead of the crowd. Let me explain.
By "career" risk I'm contrasting the individual's independence to that of Wall Street analysts who are measured mainly by reference to their peers. Thus, if an analyst strays too far from the pack and turns out to be wrong, he's crucified for it, while if he's wrong but so is everyone else, it's not really an issue. (Not to mention that it's difficult to be negative on Wall Street since - even today - brokerages want IPO and secondary offering business, which isn't typically given to firms that are apt to publish bearish stances.) Career risk is therefore one reason why there are so many calls that essentially follow the current trend.
A second related point is that in building financial models, it's easiest and safest (again for career risk reasons) to take previous data and extrapolate from it. This works very well in non-cyclical sectors, and it even works during most of an up cycle or down cycle in cyclical markets. But as one gets to the latter stages of a cycle, it tends to cause massive overshoot, as risks appear to dwindle rather than increase. Or to put it another way, the longer a cycle goes, the less it looks cyclical and the more basis there seems to be to simply extrapolate the past few years forward. If analysts truly took cycles into account, multiples would contract the further into a bull market one got (and vice-versa for bear markets) but often it's the opposite - prolonged good periods breed complacency and result in multiple expansions.
These factors, in my opinion, conspire to provide an opportunity for individual investors to take carefully sized short positions in an over-extended bull market.
With that said, let me lay out the reasons for which I think we're in the later stages of a bull cycle in residential real-estate. The factors are listed in general order of importance, though I could be easily persuaded that some of the items mentioned later should be moved up the list.
1. Insiders are Selling
What initially drew my attention to the sector was the announcement that Re/Max plans to go public. Ostensibly it's just an estate planning move, but the timing of it is very suspicious in my view. Indeed, as the title of the linked article suggests, the founders are more than likely trying to sell shares to the public now because the market is hot AND earnings are at cyclical highs ("its best showing since 2007"). Moreover Re/Max isn't doing this in a vacuum, it has watched the results of others recently: Realogy (NYSE:RLGY) (owner of Century 21 and Coldwell Banker) went public on October 11, 2012; Trulia (NYSE:TRLA) on September 20, 2012 and Z on July 20, 2011. As of the close on September 4th, their share prices are up 22%, 83% and 193%, respectively. Moreover, given the hot market, several of these companies have done follow-on offerings (e.g. TRLA, Z), and insiders are selling at an accelerating pace.
The table below summarizes the insider sales of several representative companies in the sector as a function of year and as a percentage of insiders' current holdings (as given by Yahoo). The insider data comes from this site, but I had to clean up the Z data, as it contains extraneous sales from another company (NASDAQ:TTGT). (I did this by hand, so if anyone finds errors please alert me in the comments and I will fix them.) Furthermore the table includes only stock sales; I didn't include or make any adjustments for buys due to option exercises.
Finally, since the RLGY 2013 data jumps out, we should note that 99.9% of those insider sales came from Apollo Management - they're not widely distributed among many sellers.
Insider sales, particularly from newly established companies, are not unusual or alarming on their own. But when there's a general trend throughout the sector - including a rush to go public - I think it should set off a few warning bells.
2. Home Prices have Bounced Back Substantially and Sales are Strong
The following charts depict trends in home prices and home sales. Median home prices are close to the peaks set during the bubble years of 2006-2007 and the Case-Schiller index as of June 30 shows prices at 2004 levels. Moreover, sales are robust once again. None of these indicate a top in the market per se, but they all suggest that we're well into a cycle - not near its beginning. (And if you believe, as I do, that the levels reached in 2006-2007 were totally unsustainable, then by that measure we're in peaking territory.)
3. Interest Rates are Rising
One of the major impetuses to the bull market in real estate has been the secular down trend in interest rates. Yet there are signs that the lows of this long trend may be in. The graph below is one indication, but there are other reasons to think rates may be on the way up, including a re-assessment by lenders of the risks of default (see e.g. the many municipal bankruptcies now unfolding, a process that 5 years ago would have seemed impossible to most observers).
Rising interest rates not only put a damper on home sales, median home prices and home affordability; they also serve to increase the discount rate used in discounted cash flow analyses - another negative for stock prices.
4. Incomes Haven't Kept Pace with Home Price Increases
The increases in home prices seen in factor 2 do not seem to be driven by any fundamentals other than the Fed's low interest rate policy. Most notably, during the period from 2000 to today, real household income has fallen and unemployment is up. Thus affordability measures such as median home price/household income have increased substantially, making a continued run in the residential real estate market that much more unlikely. The point is even starker when looking at so called U6 unemployment.
5. Multiples are Expanding as Stocks Go Higher
As I mentioned at the outset, if stock prices reflected cycles, then there would a contraction in multiples as one got closer to cyclical peaks. But if all one does is extrapolate from recent data, then multiples expand as one progresses through the bull phase of an economic cycle. The figures below (P/S, P/CF, P/B) suggest that much of today's run in real estate stocks is due to multiple expansion, with multiples on some stocks reaching stratospheric levels (this is particularly true of the price to sales multiple). This is another bearish development.
In the early stages on a new market such as Z and TRLA are developing, it's natural to see buyouts and roll-ups as the market rationalizes and consolidates. But there's also another reason that roll-ups can be attractive, viz. that valuations in the public market are so much higher than in private markets, that almost any deal makes sense - and at almost any price. The pace and frequency of recent acquisitions in the space suggest to me that the latter factor is operative to a significant extent, and in my experience this is often a sign of an impending top.
7. Anecdotal Accounts
Finally there's a wealth of anecdotal evidence suggesting a new frenzy in the real estate market. For example, here in Southern California we're back to having lotteries for new home sales. Furthermore, up until July there were many homes being sold on the first day of listing at $10,000 to $20,000 above the asking price - and not an insignificant number of these were bought sight unseen! Take that for what it's worth, but to me it suggests an unsustainable boom; one which will reverse sooner rather than later.
The seven factors above constitute the bulk of the reasons for which I'm bearish on the residential real estate sector going forward. The question then is, how to play it?
My thought is to ease into a short position, choosing one company as a proxy and then adding more if and when market circumstances dictate. Looking at the valuations and insider sales shown above, I've chosen Zillow as being one of the more overheated stocks in the sector. Moreover, on September 4, it cleared the psychological $100 mark after receiving the good news of having a new significant holder: billionaire James Packer, who now owns 9.4% of the company. Typically I like to short after a news pop like today's, so choosing Z is also a trading decision. Finally, the idea that the company priced its latest offering at $82 just two weeks ago gives me more comfort shorting at $100. (For a more company-focused analysis outlining a short case against Z, see this recent SA article with which I generally agree.)
Before concluding, however, we should also acknowledge the risks that are entailed by shorting Z because, if nothing else, these help establish a position size. Following are the best reasons I can muster to be bullish on the sector in general and Z in particular. First off, the total market cap of the real-estate information companies is quite small; looking 5 to 10 years down the road one could easily imagine it being 2-5X its current size. Other positives are the size and growth of Z's "living" database (where users upload their data), the growth and uptake of mobile users, and the recent integration of Zillow with Google Now. (I see this as a positive for Z, though I suppose one could turn it around and say that because Google recognizes the value, it would be more likely to re-enter the field as a competitor?) Finally, the demographic that Z reaches (home buyers and renters) is an attractive one to advertisers, such that monetizing page views may be easier than in many other industries.
As I've tried to argue, there are many compelling reasons to want some residential real estate exposure in a short portfolio, and given its lofty valuation and persistent insider selling, Z is a good choice to achieve that. Nonetheless, considering the offsetting potential positives, in this case I've kept my short position smaller than previous entries; allocating 2% of my portfolio short Z at a basis of ~$100. Doing so allows me to benefit (at least somewhat) if the market turns soon, and if not; having skin in the game gives me incentive to follow the sector even more closely to find other opportunities that may arise over the next several months.