Here's the excerpt from Bill Miller's Q2 letter to shareholders of his Legg Mason Value Trust in which he discusses his position in housing stocks Beazer Homes USA, Inc. (NYSE:BZH), Centex Corporation (CTX), Pulte Homes, Inc. (NYSE:PHM), and The Ryland Group, Inc. (NYSE:RYL):
The third area where we have not fared well has been in homebuilding, where our exposure is roughly 5% of the portfolio. Here we clearly made a mistake by initiating positions too early. The homebuilders had performed much like the managed care stocks, handily outperforming the market for several years. We were waiting for a significant sell-off to establish positions as we thought the valuations at single digit multiples were too low given the secular advantages of the large builders. When that sell-off occurred late last year, we jumped in, knowing that the news flow would be bad for about 12 months as the super-hot housing market slowed sharply and began to return to normalcy.
We expected (and still do) the path of the US housing stocks to follow that of the United Kingdom and Australia, where a housing slowdown led to a sharp sell-off, followed by a re-establishment of the secular outperformance seen earlier. While the statistics in the space have come in roughly as expected, the stocks havemoved down significantly more than we expected. We have witnessed p/e multiples contract from roughly 6-7x a year ago, to, in some extreme cases, 3-5x earnings. Although estimates came down as we expected, multiples contracted on the lower estimates, which we did not expect.
Usually multiples expand as estimates decline in cyclical industries. We did not expect the stocks to decline to book value, or book value adjusted for land inventory value, which has been a traditional buy point, since we thought the market had figured out these companies were far less cyclical with better returns on capital than they were 10 or 20 years ago. We were wrong, hence early, and now the stocks sell around book, and we think the bottom is either in place or within squinting distance. All our companies expect to convert about 100% of earnings next year to free cash flow, and to use a large portion of that to buy back stock, as most are doing now. That is usually a recipe for excellent results.
As of June 30th, the Legg Mason Value Trust held 3.92% of its assets in housing stocks. The Legg Mason Value Trust portfolio holdings as of June 30th, 2006 are here.