In investing, it's easy to miss the forest for the trees. When analyzing a company, or even a whole sector, we get so caught up in what appears to be important or tradable information, only to have something much bigger and previously unseen completely negate our investment strategy. To save time and energy, investors don't concern themselves with red-herring events, and rightly so. And for better or worse, the average retail investor hardly even concerns himself with the macro environment of tomorrow.
Even professional buy-side analysts have to rely on the judgment of their respective chief economists. It seems macro opinions and insights have been delegated to others, and once again, investors are not thinking for themselves. Recently, I've come to the conclusion that all investments, and even the maintaining of investments, are macro bets. Accordingly, although we don't have to be a chief economist to invest, we should at least have some sort of cognizant rationale for what we believe is to come. Before explaining my thoughts on homebuilding, I'd like to explain my general investing mentality as of Q3 2017.
Full Disclosure, I hate the market. To be fair to those reading this, and to shed light on how I'm reading the current housing market, I need to explain a fairly complicated theory (to which I adhere) with brevity. The Austrian Business Cycle Theory is a fairly straightforward and very controversial theory. It revolves around time preferences, which we believe determine savings and consumption rates in the economy.
As we all know, saving is only possible through the lack of consumption, which pains us in the short run. However, savings also provide a collection of resources for which we can apply to investment opportunities. These investments will lead to more roundabout and efficient production procedures that provide us with the same consumer good as before. For example, think of Crusoe on an island who can forever catch one fish a day barehanded, or alternatively, save up fish and use those savings over a period of a week to spend the time making a net.
If successful, the net, which is a more roundabout production process than Crusoe's hands, will be far more productive. The point here is that there is no savings without the forgoing of consumption and that Crusoe's propensity to save/consume is dependent on his time preferences, the extent to which people value current consumption versus future consumption.
The overarching key point of ABC Theory is that "intervention in the monetary system creates a mismatch between consumer time preferences and entrepreneurial judgments regarding those preferences." (Quote from a simplified article from the Mises Institute).
In the real world, time preferences are reflected by interest rates. Interest rates demonstrate to entrepreneurs the price of borrowing and investing. When high, they can encourage savings and discourage investing. When low, the opposite. Also in the real world, investing does not require savings. How is this possible? Fractional reserve banking, fiduciary media and the Federal Reserve System.
There are two ways in which the current monetary system intervenes (for the worse). Firstly, in the existence of a federal reserve system, which allows for the practice of fractional reserve banking. In short, by making money out of thin air, banks issue out more loans than they have demand deposits in their vaults (i.e. using "savings" to invest, divorced from actually forgoing consumption). I assume readers on this platform to not be surprised by this reality, but if this is new to you, think "It's a wonderful life." You know that scene where George can't go on his honeymoon because there's a bank run and everyone has everyone else's money…
The second "intervention" is the Federal Reserve's artificial lowering of interest rates, which as already discussed, fosters cheaper investing, discourages saving and allows for the creation of newer more roundabout production processes.
Cheap borrowing by means of money creation means that entrepreneurs are using phony funds to invest in production processes, which would not have been invested in before. The result is misallocation. This misallocation is not unlike that of a bricklayer who is constructing a home on a sandy foundation. He spends weeks laying bricks and using capital to make his home. The instance he discovers his poor foundation, he tears down his work.
Where in this story is the problem, the recession or the misallocation of the boom? In our current world, instead of letting the homebuilder realize his mistake and tear down the misallocation, Central bankers get the builder drunk, encouraging him to build on (i.e. QE). When the day finally does comes when he sobers up for good, the "recession" is all the worse… I am convinced that the foundational problems of our economy, those problems that led to the last housing boom and bust, were never fundamentally reformed. The repercussions will be realized in the end. The malinvestment will be exposed.
Getting the builder drunk was exactly the response to the recent housing collapse. I don't want to go into great detail here in part because it has been extremely well covered and is a long story in its own right. The main takeaway is that government intuitions (Central Banks included) stepped in to buy toxic mortgage-backed securities and encouraged low interest rates.
This provided liquidity and stimulus to the market and saved home prices from total collapse. The following chart shows the growth in the Fed's balance sheet. Many of the new assets purchased were mortgage-backed securities, all of which were bought with money created out of thin air. Graph sponsored by Fed bank of St. Louis.
10 years after the fact, these financial measures continue to operate globally. Although the Fed's asset purchases have flattened since 2015 as seen above, global asset purchases of the ECG and BOJ have increased.
As to when our central bank will actually begin to normalize (and normalize they must) is as good as your guess as mine. What I do know is that the Fed has been warning for many months of its impending QT, and general indices (homebuilding included) have not exactly responded accordingly. I do not wish to time this quantitative tightening to the precise month or even quarter, just to point out that when the show does end, the indices that track housing (in particular) will be underperformers at best.
I say in particular because it is homebuilding, much more so than many other sectors, which relies on financing for strong sales. These financing procedures in turn rely on accommodating interest rates. Of course, homebuilding has also benefited greatly as central bankers have subsidized mortgage-backed securities in the secondary markets vis-a-vis asset purchase programs. The subsidies in the secondary market encourages primary markets lending and securitizing, without which lenders would need to carry these portfolios on their balance sheets for the full duration of the loans.
In short, it is thanks in large part to these central banking measures that the housing market has boomed. Bulls will claim that the general economy has made a comeback and therefore housing will continue to prosper. But remember Crusoe. In the homebuilding market, just like any other market, growth should not be divorced from real economic growth. Saving and investing is the only real way for foundational progress. With that in mind, let's examine the following chart. It shows the history of the Home Index Prices published by Standard and Poor's since 1984 and Median household Income since that same year.
Median Household income sourced from FRED, S&P index sourced from Online Data - Robert Shiller. Graph and effects created by yours truly.
In red, you can clearly see the home price stagnation of the 90s followed by the unprecedented boom and bust of the mid-late 2000s. Note that the inflation-adjusted real median incomes reached their all-time highs 17 years ago. Take a look at the data on the left and right axes and you will notice that since the depths of the crisis, home values have grown disproportionately compared to income.
Whereas income has grown from 52,600 to 56,500, the S&P home index has grown from 131.2 to 155.5. (2015 is the most recent year for data on median home income) That's a growth of 7.4 and 18.5 percent respectively. This analysis applied to other industries such as auto or student debt will reveal similar discrepancies.
There are only two possible ways in which Americans can be spending on housing faster than incomes are growing. Either, a) they are forgoing consumption elsewhere or b) debt. I'm going to take a wild shot in the dark and go with the latter. I'll even take that one step further and argue that these interest rates (which are near 5,000 year lows) have something to do with Americans' crave for debt… here are some charts to back me up.
These low interest rates have cheapened the cost of debt across all industries.
After deleveraging following the crisis, household debt now exceeds that of pre-crisis levels, although not as a percentage of GDP.
The data is almost impossible to come by, but in the early 20th century, our grandfathers would rarely finance their home purchases. Today, nobody bats an eye to buy a gallon of milk on credit. According to the National Association of Realtors in their 2017 report "Home Buyer and Seller Generation trends" 88% of all homebuyers financed their purchase.
The data is compelling. Our economy, our housing market specifically is built on sand. The only question remaining is when it will be made right. Until then, we face a huge dilemma. Those of us in the financial services industry have no other choice but to participate in this phony boom. (Mathew 25:14-30) We must not be the third servant. Then again we have a fiduciary duty to preserve our client's wealth. The issue is, as always, timing.
With this in mind, I would like to discuss the U.S. homebuilding market indices of today. Specifically, I will analyze the iShares U.S. Home Construction ETF (BATS:ITB), the hottest Exchange traded product covering this market, and its competitor, the SPDR Homebuilders ETF (NYSEARCA:XHB).
One of those indices
ITB is an Exchange Traded Fund, which generally tracks the Dow Jones U.S. Select Home Construction Index. That index follows companies involved in:
The constructors of residential homes, including manufacturers of mobile and prefabricated homes …manufacturers and distributors of furniture…retailers and wholesalers concentrating on the sale of home improvement…and producers of materials used in the construction and refurbishment of buildings and structures…
Naturally, the Index has appreciated significantly in the past 7 years. Also naturally, iShares isn't the only fund family to get in on the action. SPDR offers a similar ETF ticker name XHB. These two funds contain 1.3 and .86 billion in assets respectively.
ITB, unlike its competitor, does not equally weight its holdings and invests more directly in homebuilders such as NVR (NYSE:NVR) and less in peripheral companies such as Lowe's (NYSE:LOW). The reason for this is simple. There are not quite enough homebuilders and related companies to diversify here. Fund companies therefore have to either (A) overweight favorable companies or (B) search the fringes for less related firms. Look at these holdings.
Note that ITB overweights companies specifically dedicated to homebuilding. These holdings strategies have resulted in drastically different returns, especially in the last 3 quarters.
As ETF.com staff writer Cythia Murthy Points out in a recent article on the subject, the gap between the two has not been this large since 2012. Conversely in periods of decline, XHB maintains capital better than ITB. The following charts demonstrate how these ETFs perform in bear years. The first chart shows price actions from their pre-crisis highs to their recession lows. The second chart shows them from their highs to early 2012, the year in which the S&P home price index bottomed out.
The results demonstrate that XHB's holdings strategy allow it to maintain capital better than ITB in bear markets. Let's now take a glance at three of those top ITB holdings. Combined these comprise over 33% of ITB's allocations, and about 14% of XHB's allocations. I will also discuss the comparative advantage of ITB's strategy in overweighting these three equities as opposed to a more equal weighting strategy.
ITB Top Holdings
data from Y-charts
D.R. Horton (NYSE:DHI)
Operating in 26 states and with a market cap of 13.2 billion, D.R. Horton, Inc. is the largest homebuilding company in the United States as measured by revenues and the number of homes closed.
DHI operates under three branches, Homebuilding, Financing and other with homebuilding comprising 98% of consolidated revenues. The firm uses its financing business primarily to act as a streamlined and integrated part of their business model, providing quick and certain financing and communication with homebuilding teams. Perhaps inconsequentially but interesting to me nonetheless, DHI's cancellation rates are somewhat high at 23% and their capture rates are the lowest amongst their peers at 50, 51 and 55% for years ending 2014-2016.
DHI is a growing company, with 3-year annual revenue growth rates of 51%. That growth will undoubtedly be higher come their next 10-K release in late September. Although P/E ratios are inline with historical averages, it appears this growth is already factored into their stock price with a Price to Book of 1.8 versus an industry average of 1.33 (Price to Book Ratios)
The strong price actions have been in part due to recent positive sentiment in the homebuilding industry. For the majority of this bull market, homebuilding sentiment has been lackluster, yet especially since November, the homebuilding sector has experienced a sentiment renaissance as the index has risen to a 12-year high of 68. Historical readings at or above 70 (summer 1998 and the summer of 2005) have been followed by poor market years within the next 18 months.
As a side note, it seems to me that institutional investors have been weary of this newfound positive sentiment. Look at this chart examining the percentage of institutional holdings of the nation's three largest homebuilders.
Lennar Corporation (NYSE:LEN)
Founded in 1954 and IPO'd in '71, it's one of the largest homebuilders in the United States providing over 26 thousand homes in fiscal year 2016. The Miami firm operates primarily in 4 regions: East, Central, West and Other; and under 4 segments: Homebuilding, Financial Services, Rialto and Lennar Multifamily. 9.7 billion, or 89% of revenues, are from its primary segment, Homebuilding. Revenue breakdown by geographic region are 40% from "East" (VA through FL) and 23% from "Central" (AZ, CO & TX). (FY 2016 10-K)
Just like DHI, the financing services of LEN allow for better communication and fluidity in the homebuying and building process. The ability of LEN, and all other financing arms, to serve their larger firm is critical to sales. In fiscal year 2016, LEN experienced cancellation rates of 16% and a capture rate of 82%. I would like to note that it seems the firms that have managed high capture rates are also better able to maintain their cancellation rates. LEN has done so, perhaps reflecting superior management in relation to DHI. Like DHI, LEN sells almost all of their originations to the secondary market shortly after creation.
Lennar suffers from the lowest margins amongst its peers (though not by much), yields a safer and much smaller divided at .32% and a low payout ratio of 4.6%. From a simple valuation viewpoint, LEN is trading at a fair price to book of 1.65.
Using 5-year historical multiples of price to book, Len should be trading at around 1.9. Ceteris paribus, that's an implied stock price of nearly $57. At best, ITB may slightly benefit from overweighting LEN.
NVR is a Virginia-based firm which focuses on the construction and sale of single-family detached homes, townhomes and condominium buildings under three trade names. They market primarily to "first time and first-time move-up buyers," operating under the brand names RyanHomes, NVHomes and Heartland Homes. They are one of the largest homebuilders in the U.S. covering 19 metropolitan areas. FY 16' revenues were a record 1.7 billion, 33% of which is from the D.C. Baltimore Metropolitan area.
Compared to the previous two, NVR is a fairly unique builder. According to its most recent annual financial statement they:
Generally do not engage in land development…Instead, we typically acquire finished building lots at market prices from various third party land developers pursuant to fixed price finished lot purchase agreements ("Lot Purchase Agreements") that require deposits that may be forfeited if we fail to perform under the Lot Purchase Agreements.
NVR buys finished land via options contracts. This lowers their time to sale, mitigates risk, and perhaps explains NVR's lack of leverage (.06 compared to .23 and .6 for DHI and LEN Respectively). NVR's ability to streamline its operations AND concentrate on the hot real estate market surrounding our Central Government is and was so successful that in the depths of the financial crisis, they managed to make one billion in profits when all other homebuilders were in the red.
For these reasons, NVR remains a formidable company; however, its price already trades at a pretty fat premium at more than 6.5X book value and a P/E ratio of 21! The problem with valuating one company in relation to others is that no two companies are the same, and the same problem arises when comparing metrics now to historical multiples. However, in this instance, it seems pretty clear to me that a PB of 6 is far too much a good thing. In fact, NVR's book multiple has already grown over 36% YTD.
Let's do some calculations factoring in a PB ratio of 5 (very fair). That multiple is closer in line with competitors and about the 3-year average for NVR. Here are the calculations starting with the most recent 10-K and 10-Q balance sheet data.
What would happen if the equity remains the same, the number of shares outstanding remains constant but NVR begins trading back down to a PB of 5?
This all begs the question as to why NVR has begun to trade at a premium in the past 3 quarters and why traders may now discount that premium. I believe that the growth is more or less based on political optimism, which disproportionately benefits D.C. area markets. We see this in the six-month price actions of the SPDR S&P 500 Trust ETF (SPY), NVR and the NAHB Housing Market Index following the election. To some extent, the optimism has been market-wide and in my opinion, overly speculative. Reform has so far been elusive.
Unfortunately, and to the disdain of many readers, much of my macro analysis can be compared to the economy overall. Some of these other major industries of the economy do deserve some scrutiny and some of them offer excellent candidates for those willing to short. The first that comes to mind is the auto industry which has not seen the regulatory response to the financial collapse that the housing market has, thus, the ease with which auto loans are established is much more fluid.
I have already covered the Auto Industry in previous articles. Here I wanted to talk about housing, not because this sector provides more opportunity for longs or shorts, but because it is still the cornerstone of our economy.
My conclusion is anti-climactic and conservative. There are two reasons I do not suggest investors go about shorting ITB. The first reason is momentum. As good or right as the thesis of one retail investor can be, he can't beat the multitudes of "buy the dip" institutions who are wrong, and he certainly can't beat the massive liquidity programs of the Central Banks.
The second reason is that the timing as to when our bricklayer will sober up and see the sand beneath his feet is nearly impossible to determine. Although I personally believe in the opportunity for increased volatility, QE unwinds and geopolitical risks in the coming quarters make the next correction imminent, the risk here is too high. Instead, I suggest finding individual securities within the weak cyclical market to short.
However, my general reasoning stands. The Homebuilding market is not built on a solid foundation. As opposed to real economic growth, vis-a-vis innovation, saving and investing, the housing market has ballooned on easy monetary policy. The past 9 months in particular have seen a strong growth in housing market securities and funds in the mere hopes of political change.
Little has come. For these reasons, I suggest investors take their profits from the housing market. ITB is the primary product in this industry, its growth has been fun but the party may soon be over. Its overweight position in DHI, LEN and NVR will only disproportionately hurt it should a market correction occur.
For retail investors who do not have a fiduciary obligation to find yield, now is the time to move to cash. For money managers, I still suggest reducing positions in housing, however, a middle-of-the-road option is still available to you. I believe that ITB's competitor XHB will provide a better investment choice in the coming months. From my analysis of ITB's top holdings, I believe that at best the first and last of these three securities are fully priced with LEN showing potential for slight upside.
At worst two of the three are fully priced with NVR suffering a significant correction. For managers reviewing their allocations, I suggest selling all of your ITB position. Convert 50-75% to XHB, and move the rest into safer assets such as short-term treasury bills or cash. Doing so will capture any further upside in the general homebuilding market, while preserving capital on the downside.
I hope this long-winded article was of help to you. As always, Happy Investing!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.