By Dirk van Dijk
I recently came across this piece written by Larry Kudlow, the host of two shows on CNBC. It is from June 20, 2005:
Homebuilders led the stock parade this week with a fantastic 11 percent gain. This is a group that hedge funds and bubbleheads love to hate. All the bond bears have been dead wrong in predicting sky-high mortgage rates. So have all the bubbleheads who expect housing-price crashes in Las Vegas or Naples, Florida, to bring down the consumer, the rest of the economy, and the entire stock market. None of this has happened...[T]he homebuilders index has increased 76 percent over the past year, with particularly well-run companies like Toll Brothers (TOL) up about twice as much. The bubbleheads missed all this because they haven’t done their homework....
[I]t should not be shocking that home prices have tended to rise on a steady basis, averaging 6.5 percent price gains over the last 35 years. Upward price momentum has kicked into higher gear in recent years for two important reasons. First, housing is highly tax-advantaged. The 1997 tax-cut bill -- proposed by a Republican Congress and signed into law by a Democrat president, Bill Clinton -- permitted the first $500,000 of profits from the sale of a home to be tax-free. This came on top of existing law that permits mortgage expenses to be tax deductible...Since 1997, home prices have been increasing at a 6.5 percent pace on a yearly basis, with a 12 percent gain over the past year. In contrast, stock prices have gained only 3 percent yearly during the same period...
None of this is to argue that low mortgage rates haven’t been a plus in the housing picture. Of course they have. But the imbalance between excess demand over limited supply, resulting from tax factors and land-use restrictions, has made home buying even more profitable in recent years than has been the case in the past.
Which leads to a final thought: Why not apply the same tax laws that have benefited home owners to stock market investors and home buyers? If this were to come about, even more wealth would be created in America, leading to even more new business and job creation. Tax reform to create a level playing field could boost our economy’s potential to grow beyond almost anyone’s wildest dreams. Homeownership, stock ownership and small business ownership should be taxed at the same minimal rates as they are all key components of economic growth and wealth creation.
I started at Zacks a few months later, so I don’t have anything published from exactly the same time. Here, however, is the first thing I could find that I wrote on the housing issue for Zacks. It comes from my January 2006 Strategy Report, and was written in mid-December 2005. Thus I had the benefit of a few more months. I cannot say that I nailed the top of the housing bubble, but I was clearly much more on target than Kudlow was:
While these circles create imbalances which ultimately cause them to reverse, I don’t see any imbalances large enough now to throw the economy into a downward spiral. Longer term, there are many very real candidates, such as the stresses on retirement, both public in the form of Social Security and private pensions. Our growing and massive trade deficit is another, as is overvaluation in the real estate sector of the economy. However, these will not really bite in 2006.
I expect that home price appreciation will slow significantly in 2006, and this will put an end to the housing ATM. This will put a damper on consumer demand, since a significant stream of cash will no longer be available. The inventory of unsold houses is increasing and it is taking longer for houses to sell, but realtors are not about to turn into Maytag repairmen. In other words, not a popping of a bubble, but more a letting air out of a balloon.
"lso, real estate is all about location, location, location. While $750,000 for a starter house in the suburbs of New York does not seem to be justified by local salaries or by local rents, that is not the situation in most of the country. In Dayton, OH, you can buy a much larger house for one tenth the price (one-fifth the price if you want to be in the suburbs with a good school system). There are countless towns and cities around the country where housing prices more closely resemble Dayton than they do New York or L.A. If there is a bubble popping it will be local and not national.
Clearly I underestimated the scope of the decline and the amount of damage that it would do, and I became progressively more bearish on housing over the course of the next two years. The point of this post is not to beat up on Mr. Kudlow. What he was expressing was a pretty mainstream point of view back then. It is also not to pat myself on the back.
Only by examining our errors can we hope to learn from them. It is more about looking back and seeing how I was affected by the consensus thinking. In this business, predictions are made often -- that is sort of the point of what we do. However, if one is going to be making them, one really should go back and see if they pan out. If not, why not?
What was I missing that I could not have been more forthright in making a prediction that housing was about to come tumbling down, and bring the rest of the economy down with it. We all have the mantra of “past results are not guarantee of future returns” drilled into us. Still, there is a very strong tendency to want to extrapolate the past into the future, especially when it comes to the returns on a given asset class.
While I could see a bubble popping in a few markets, clearly I was not prepared for it happening on a national scale. I thought we would have a long period of stagnation on a national basis, not a crash that encompassed virtually every area of the country.
Was I overly influenced by the consensus view? Perhaps. Clearly there were warning signs out there that I should have been playing much closer attention to. I should have made a much clearer call.
Partly it was because I didn’t want to undermine my own past success in the area. That success was not widely known publicly, but it was to me and there was a psychological resistance to doing a 180 degree turn. In the late 1990’s through 2001, I was running a small cap mutual fund. I had stuffed it as full as the prospectus would allow with homebuilders and related industries. I had left the fund in early 2002, so it didn’t enjoy the full ride up in those names (some of which were simply spectacular).
There is also a very strong tendency to not want to be too far away from the crowd. Being all alone in a position can feel very lonely, and professionally can be very dangerous. However, it is those brave souls who are able to withstand that loneliness than can do their clients the most good.
Where to From Here?
So am I prepared to make a bold call on housing right now? Not really. I think we are far closer to the bottom than the top in terms of existing home prices, but that we still have at least a few more months of pain ahead of us. After that, prices are likely to stabilize, and then remain in the doldrums for a few more years. Nominal home prices are probably less than five percent from their eventual bottom, which should come by the end of 2011.
We will probably then face a few years in which housing prices fall in real terms, but not in nominal terms. We are starting to see pretty strong absorption of rental housing, and that should lead to higher rents. Very little new multi-family housing has come on in the past few years, and we have only recently seen a pick-up in multi-family housing starts.
While off the bottom, the absolute level of multi-family starts is still low. In any case, those apartments will not be ready to rent until next spring. In the meantime, REITs that specialize in apartments could be in a very sweet spot. Firms like Equity Residential (EQR), AvalonBay (AVB) and Mid-America Apartments (MAA) seem worthy of further investigation. However, all three have done very well over the last year and are not super-cheap, and are considered Holds based on the Zacks Rank. Still, they should have a fundamental tailwind at their back for a few years.
Rising rents will alter the rent vs. buy decision for many, and we will start to see more absorption of single family homes. We still have a big overhang of existing homes waiting to be sold, and a very large proportion of those are distressed sellers, banks that simply want to get the properties off their balance sheets.
New home sales will take longer to recover. However, the rate of housing creation has lagged well behind population growth for several years now. There is demand that is getting pent up. From the current run rate of 319,000, one does not have to be all that bold to think that we could more than double in the next three years or so. That would still leave us at a very mediocre rate by historical standards.
It is probably still to early to be buying into the homebuilders like D.R. Horton (DHI) or Standard Pacific (SPF). For the next year of so, they are probably dead money. However, when building does pick up, they will be very well positioned.
There are hundreds of small mom-and-pop homebuilders that have gone out of business during the housing crash. The national builders are going to have better access to credit and will probably pick up a lot of market share. Thus if new home sales were to double, their sales could easily triple.
It is hard to say what the earnings growth would be, since many of them are either losing money or just barely profitable right now (and if they are profitable it is just because of tax loss carry forwards). However, it is pretty clear that the growth rate could be extremely high. These stocks are not going to get a fancy multiple on their earnings, but they will not need to.
A Quick Calculation
Let us just suppose that these firms are able to get back to half of the level of earnings they had in 2005 (the peak year for most of them). Let us also assume that this happens four years from now, so we are talking about 2015 earnings. Then assume that the market puts a multiple of just seven times on those earnings then. The table below shows the results of just this back-of-the-envelope analysis of the potential return from them.
Clearly, if and when (and to my mind it is a question of when, not if) homebuilding does recover, there are very large rewards out there for those holding these stocks. Between now and then will be a bumpy ride. The 50% of 2005 is just a guess, it is not a formal estimate for any of them. Even if it is achieved, I might be too optimistic thinking that they will trade for a P/E of 7. Still, I think those are reasonable/conservative “estimates.”
To get those returns you will need a lot of patience and a strong stomach. The take-off is not going to happen right away, and there is no guarantee that any one of these firms will still be around to see the other side of the valley. The balance sheets of most of them are a mess and the turn is not happening yet. But if you are a patient long-term investor with a lot of nerve, there could be some very interesting returns from investing in these names. The consensus is very downbeat on them right now, and the consensus has clearly been very wrong about them in the past.
|Company||Ticker||2005 EPS||Current Price||'15 EPS (50% of '05)||Price @ 7x EPS||Potential Return|