How to Handle the Homebuilders 'Rally'

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Includes: KBH, RYL, TOL
by: Tom Armistead

Homebuilders have been rallying, on favorable analyst commentary and glimmers of hope that housing may be hitting a bottom. The WSJ recently had an article about the effect of California's new home buyer credit of $10,000, which is working as intended, stimulating sales. The last time I wrote on homebuilders, in December last year, I planned on selling covered strangles of about 6 months duration. The thinking was, the homebuilders keep trying to rally, but the long expected housing recovery keeps receding into the future. I am long-term bullish on homebuilders, but continue to advocate selling out of the money covered calls in order to either 1) collect rent while waiting on developments, or 2) have the stock called away if the rally continues.

Buy land – they ain't making any more of it. The primary asset of homebuilders is land. To the extent that the land is well-located and suitable for development, it is a scarce resource and will eventually increase in value. It will also do well in an inflationary environment, like any physical resource. Historically, it was always possible to make money by buying homebuilders at a Price/Tangible Book ratio of less than 1.0 and selling for something in excess of 1.5. That strategy developed problems as the housing market went into a deep downward spiral. The homebuilders kept writing down their assets, decreasing book value. To the extent that it was goodwill from acquisitions, it was not that upsetting, but when it got to be land that they still owed money on it was cause for concern. Also, many of them were forced to write off the value of deferred tax assets, on the grounds they were unable to project sufficient profits going forward.

On the other hand, write-downs shield cash flow from taxation. If the land is kept and not sold, the lost profits may reappear further down the road when business conditions improve. In effect, the write-downs create “phantom” book value.

Shrinking Book Values. Here is a table showing how book value and tangible book value developed for the three homebuilders I follow: Toll Brothers (NYSE:TOL), Ryland (NYSE:RYL) and KB Home (NYSE:KBH).

Symbol

Metric (per share)

4Q 2007

1Q 2008

2Q 2008

3Q 2008

4Q 2008

1Q 2009

KBH

GAAP Book

23.93

20.22

16.48

14.59

10.69

9.92

Tangible Book

23.05

19.34

15.92

14.05

10.69

9.92

RYL

GAAP Book

33.89

25.92

20.10

18.41

16.97

Tangible Book

Same, Ryland did not do acquisitions

TOL

GAAP Book

22.49

21.62

20.97

20.79

20.27

19.67

Tangible Book

22.37

21.51

20.85

20.68

20.15

19.56

This table shows that the strategy of buying at less than 1X tangible book and selling at more than 1.5X has had its problems in the environment that has been in place for the past year or more.

Options strategies . Late last year I sold strangles, one contract for each 100 shares of all my homebuilders, using 3 or 4 month expirations. The calls expired worthless, and I bought back all the puts at a small profit. As the market started heading down in late February I wanted to reduce the cash devoted to backing the puts and avoid being squeezed if something horrible happened.

Then I turned around and started buying shares on 3/12 at prices somewhat higher than the strike on the puts I just bought back. Not too logical, and I gave up most of my profits on the puts. But it worked out OK: as Warren Buffett has said, selling puts will not get you into a stock at the bottom. So the strangles strategy, while logically appealing, didn't work out as well as I hoped it would. Buying at the bottom is more effective.

Last week I sold out of the money calls over about two thirds of my homebuilders, using 3 or 4 month expirations. I was a little early: they continued to rally, and I could have got more for my calls or sold at higher strikes if I had waited. I got disoriented with the stocks trading so low in March and lost track of my 1.5 X tangible book target. But if they continue to rally next week I will sell calls over the rest of them.

A Digression on Decompression. The sell-off in March created a situation that really has me disoriented. Many of the high beta stocks I follow have been so compressed that I temporarily forget what I think they're really worth. I loaded up in the days after the bottom, and I have been selling steadily into the rally, at this point building up a cash reserve.

But it feels weird to keep selling stocks at prices that seem way low on any of the common metrics. If I think in LIFO terms, I have wonderful profits on shares I bought a few weeks ago: in FIFO terms I am taking horrible losses on shares I bought a year of more ago.

The best I can come up with right now is I was buying at the bottom so I am going to be selling at the top. Every time the S&P goes up 1% I am going to sell off 2% of my portfolio, or sell another batch of covered calls. I spend some time thinking what to sell and why, but my discipline is: the market goes up 1%, I sell 2%. For now, value is relative.

Questioning the Homebuilders Rally . Most of the homebuilders have operations in California and the tax credit will probably help them for a few quarters. Other states are considering similar programs. But it really doesn't make a lot of sense to encourage the building of new homes when foreclosures are a glut on the market. It's a supply and demand issue, and creating more supply is not going to solve the problem. It's like putting out a fire with gasoline.

The mass production efficiency of building hundreds of homes in a short period of time in one development may not come back. The business is not going to go back to the way it was in 2005.

Houses will be somewhat smaller and it will be hard to pump profits by adding a lot of extra features – more likely the extra features will have to be discounted to provide buyer incentives.

Finally, there is still a large inventory of unsold homes, with many foreclosures coming out of moratorium. Some banks may have been holding foreclosed properties without putting them on the market, so there is inventory that isn't even being counted.

Disclosure: long TOL, RYL and KBH, hedged by selling calls as discussed.