Out Of Whack On Wall Street

The frustration is palpable these days among the executives of publicly traded home building companies - the giants of the Giants. On one hand, most can point confidently to the current prolonged era of strong earnings growth, better margins and floor plans tailor-made for newly emerging demographic trends. On the other hand, unprecedented results and solid strategy have not translated into the expected positive response from investors. Upticks in the stock prices of home builders are rare these days and generally short-lived.

"Aren’t we a screaming buy? Why isn’t our stock at $50?" Kaufman & Broad CEO Bruce Karatz asked a writer from Forbes magazine last summer when home building stocks were generally trading for more than they do today despite good results since then. Over the past year, K&B stock has only twice made a move toward Karatz’ $50 target, moving up to the mid-to-high $20 range before drifting back down to the mid-to-high teens.

Market value comparisons - typically expressed in multiples of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) - illustrate the wide disparities that are the source of frustration. For many months, home builders been trading at extremely low multiples ranging from five to eight times EBITDA -at or near the book value for most companies. John Stanley, an analyst with Warburg Dillon Read in New York City, thinks multiples in the normally modest 10 to 15 range would be fairer based on the excellent performance of home builders. A 15 multiple for K&B would mean a jump in stock price to a level above Karatz’ $50 target.

Particularly galling to many is the price disparity between home builders’ stocks and those of the dot-com companies. It is almost obscene. K&B had a market capitalization of $795.5 million on March 10 on net income of $147.5 million. Meanwhile, Amazon.com Inc., the celebrated Internet retailer had a market capitalization of $22.8 billion on with no earnings and $355 million in revenue.

And K&B is definitely not alone. Dow Jones & Co.’s Home Construction index is down 39.3% in value over the past year. The ten companies that comprise that index are some of the most respected names in home building: Centex Corp., Champion Enterprises Inc., Clayton Homes Inc., Kaufman & Broad Home Corp., Lennar Corp., Oakwood Homes Corp., Pulte Corp., Toll Brothers, Inc., D.R. Horton, Inc., and Walter Industries Inc.

What is the problem? The answer, analysts say, is a strange and unprecedented market psychology that has descended on investors, one that has intensified in recent months. It is a type of thinking that victimizes home building stocks twice - once for its tendency to be among the first industries to feel an economic downturn and once for not being technology based.

At this point, there is very little these frustrated executives can do to change this reality. To suddenly look attractive to investors "would take an act of God," says analyst Timothy L. Jones of Ryan, Beck and & Co.’s Southeast Research in Boca Raton, Fla. The strange investor psychology has fashioned a dichotomy between Old Economy companies and those that are promoted as being part of the New Economy, he says.

Set aside, for a moment, the laundry list of economic cycle issues that have traditionally driven investors away from owning home building companies late in a cycle. The current market is in many ways a struggle for investor attention between the types of companies that comprise the Dow Jones Industrial Average and others that comprise the technology-driven NASDAQ Composite Index. It is The Walgreen Co. versus Drugstore.com and the upstarts are winning.

Home builders can argue that many industry stocks have strong fundamentals and that they deserve to shed their unflattering tag within the investment community as "trading vehicles" - purchased and held only at the leading edge of an economic recovery. For now these arguments are moot. They are for another day when the market broadens and investors are paying attention to actual performance. Home builders should take heart, however, that they are just one of many sectors struggling with what it means to be stuck in the vacuum of investment money created by surging technology issues.

A Stealth Bear Market
There are numerous theories being put forth everyday about the nature of the divide that exists in the current stock market. But there is no shortage of evidence that the dichotomy is real. Robert Topping, managing director of The Vintox Fund in Chicago, calls the current market "humbling." He points to the recent demise of value stocks like Proctor & Gamble, Berkshire Hathaway and Owens Corning that have recently lost 40% to 60% of their value.

"A lot of people, from a big picture standpoint, might argue that we have been in a bear market since April 1998," says Topping, who sees the last two years as being worse than the bear market of 1973-74 and on a par with 1929. If it were not for a handful of high-flying sectors of the market, we would be in an official bear market, one where stocks trade 10% or more below their peak levels. "A lot of times this is how bear markets start," he notes. "They go on for a couple years and nobody recognizes it."

For Topping - a value-oriented fund manager - home building stocks are intriguing with their strong performance and low prices, but they are problematic as well. He says the problem begins with the changing makeup of the typical investor. Until the last three to five years, large institutional investors like banks and pension funds controlled the majority of the volume of stocks transacted in any given period. Today, a larger and more fragmented group of individual investors have come to control better than 50% of the stock volume. And many individual investors have shown that they often go with the momentum of the market as opposed to relying on research-based investing. To free up cash to purchase tech stocks, individuals are redeeming shares in blue chip and value-oriented mutual funds in record numbers—giving fund managers little choice but to sell.

"The value managers are having to liquidate stocks no matter what they think they are worth," says Topping. "I know managers that had been in the business 20 years with great track records and they were selling stocks at four and five bucks that they knew were worth $10 or $15. And this phenomenon just feeds on itself.

"Not only are they selling, but all the buyers like myself aren’t buying because every time you try to buy, you are immediately in the hole. I don’t mind buying things early if I don’t lose much money in them, but if I am buying things early that day-after-day go down, you just end up throwing in the towel and say ‘I am going to look at this group of stocks later.’ "

Many of the sell-side analysts that cover the home building sector agree that these stocks have been "early" buys since the last real rally in the sector-a rally that came on the heels of the recession caused by the Persian Gulf War in the early 1990s. A few years later, when investors first began to think the end of the expansion was near, they turned away not only from home building stocks, but also other ‘cyclicals’ like the airlines and auto makers. And though the home building industry was, at that point, set to enter a period of unprecedented growth, investors stayed away and have generally "passed over" home builders says Kaufman & Broad’s Karatz, who has been active in making a case for higher valuations, not only for K&B stock but other home builders as well.

Karatz is among the legions of those in the industry that think that demographics and the U.S. economy continue to favor home builders in the near and long term despite apparent plans for further interest rate hikes by the Federal Reserve Board of Governors. According to Karatz, this underlying strength in the market for new homes means a continuation of better earnings for home builders and, at the same time, a potential continuation of lower valuations. So the good news might be bad, says Karatz. "If you believe these valuations can continue at this low level there certainly is a question as to whether or not home builders should be public."

Scott Buescher, chief operating officer of Mercedes Homes, a 16-year-old firm based in Melbourne, Fla., remembers precisely when the investment community began its current shift away from home builders. It was the early part of 1994 at the same time that Mercedes was in the final stages of doing an initial public offering. The IPO was so far along that plane tickets had even been purchased for a "road show" in which bankers and company management visit scores of institutional investors and fund managers around the country to ensure that the offering is 100% pre-subscribed and to drive interest in the stock going forward. At that point, Buescher says, he got a call from one of the investment bankers saying that the offering would be "delayed a few days" due to unfavorable interest rate news.

"Then," says Buescher, "they called back and said, ‘It looks like we are going to have to hold off for another two weeks to a month.’ Finally they called back and said, ‘We are going to have to hold off indefinitely because the market is starting to tank and builders are not looked upon nearly as favorably as they were when we started this process.’ "

In retrospect, Buescher is glad that Mercedes did not go public. Without the money from the offering, Mercedes managed to still grow quickly with the help of traditional bank-based lending relationships that have become more favorable to Mercedes with each passing year. In 1994, the situation was different. Each of the principals of the company had personally signed notes and they looked to the public offering as a way to pay those debts and to expand. The current low valuations for the builder stocks, combined with the burden of the extra reporting that goes along with issuing shares to the public, are not attractive to Buescher now.

Since then, little has changed with respect to investor interest, says home building analyst John Stanley of Warburg, Dillon & Reed in New York City. Unlike Karatz, he believes that the Federal Reserve will ultimately succeed in its current effort to "put the brakes" on the economy, and that home builders will feel the effects, and that may be a good thing. He thinks the conversation about builder stocks could be very different a year from now.

Restarting the Clock
There are several reasons why there are those in the home building industry that would welcome a moderate slowdown in the demand for homes. First and foremost, the tight labor market is likely to loosen up, in favor of home builders still positioned to grow in any circumstance. Secondly, material shortage glitches have already begun to clear up. Both of these issues put pressure on margins in 1999. For the 50 or so companies that have publicly traded stock, a downturn is likely to have another benefit: it could define the trough from which there is no where to go but up, says Ivy Zelman an analyst with CS First Boston in New York City.

"Until we see a downturn, I don’t think we will see anybody coming back to these stocks," says Zelman. "Once we are in a downturn and people think that we have bottomed in that downturn, yes, that will signal that it is time to start buying these stocks. Usually that is the case."

Zelman says she tells her clients that if they are long-term investors, they should buy the stocks now, that they currently reflect recessionary price levels and that there is very little downside risk in owning these stocks. The problem, she says, is that investors are not in a hurry to hold something that is at worst "dead money" when they think they can get a 20% return in the interim by having the money someplace else. With that advice, most wait for a signal that the economy is back on an upward slope and that home builders could potentially have three to four years of solid earnings growth ahead of them. But defining that bottom is in the eye of the beholder, as evidenced by the economy’s growth slowdown of the mid-90s. Builders excelled through that period and did not attract the attention of momentum investors, because no one thought of it as a downturn.

Warburg Dillon’s Stanley agrees that market psychology about cyclical stocks in general is a hurdle that home building stocks must invariably surmount. "At some point the economic cycle turns down and you kind of restart the clock. Valuations for cyclicals go from where they are right now, across the board, to meaningfully higher levels."

What are "meaningfully higher levels?" Ivy Zelman puts a cap on the bounce from a rush of cyclical buyers, when the time comes, at 20% higher initially. She speculates that a 20% bounce is the kind that could come quickly in the wake of an announcement by the Fed that it is finished raising interest rates for awhile. But there is a question about how well the home building sector would fare in a sustained rally like the one the industry witnessed the last time ‘the clock was reset’ in 1992 and 1993. During that period, home builders and other cyclicals outperformed the rest of the market. If the old-economy versus new economy trend continues, it is hard to imagine that home builders would outperform technology stocks. In short, the upside could be good in the wake of a downturn, but not good enough to rival the ongoing rally in technology stocks that has no end in sight.

Aside from what will happen to the value of home building companies at the beginning of a new economic cycle, there is undoubtedly something larger at stake for those industry executives that continue to argue that they can beat the cycle-credibility. If, for example, there is a downturn in the economy and Toll Brothers Inc. continues to expand using its admired luxury-niche strategy, they would then be in a stronger position to make the argument that some builders deserve to have their stocks held over the long term. The same goes for Centex and its long-held strategy of offsetting cyclical construction declines with profits from other businesses.

Indeed, there are a number of other public home builders that have, during this period of recent stock price decline, pointed to demographic figures showing strong demand coming from millions of immigrants as well as from soon-to-begin-retiring baby boomers. To them, a downturn is an opportunity to shine. On this, most home building analysts agree. If some of these companies can prove that they are in positions to continue to beat the cycle, the public home building sector stands to enhance its stature with investors.

Meanwhile, the community of analysts that follow home building stocks has been waiting out the longest expansion in the country’s history for the tide to turn in favor of home building stocks again.

"I gave up holding my breath some years ago," says Warburg, Dillon’s John Stanley. "We are turning blue and starting to die. And when we all give up, that will be about the time that it happens."

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