LARGE INVESTORS SOUND A LOT like sell-side analysts when it comes to sizing up the prospects for home builder stocks. In this column a few months ago, analysts from UBS Investment Bank and BB&T Capital Markets indicated that home builder stocks should go up as early as next summer as consolidation in the industry continues to boost profits. Now, large investors have told BIG BUILDER magazine they share this view and are also bullish on the sector.
But first, let's take a look at large investors as a group. According to a list of the largest holders of home builder stocks making the rounds in the industry (dated Oct. 5, 2004), the top 10 investors hold a combined $12 billion in home builder stocks (but indexing at Barclays, State Street, and Vanguard accounts for some of this).
Among the top 10 investors, Fidelity Management holds $1.867 billion (13 companies) and a certain William J. Pulte owns $1.160 billion (one company—guess which one). Horton, Toll, and Putnam Investment Management are in the next 10.
Interest Rates Irrelevant Greenhaven Associates, an investment firm in Purchase, N.Y., with $2.8 billion under management, is seventh on the list. Greenhaven has substantial exposure to the sector, with $955 million in nine home building companies (according to the firm's 13F filings as summarized on the Nasdaq Web site), roughly a third of total portfolio value.
Ed Wachenheim, Greenhaven's chairman, is a long-term value investor and does not get derailed by transitory news about interest rates or housing starts. To him, the story here is industry consolidation. “It's a dynamic force and an exciting opportunity,” Wachenheim says. “There haven't been many times in my investment career that I've seen an industry so obviously consolidating.” He compares big builders to Wal-Mart, which consolidated retailing and put other merchants out of business.
“We're deep value investors, but we like growth companies, too,” Wachenheim says. “These really are growth stocks,” he says. He also say he thinks builders will grow revenue at 15 percent a year for the next several years. More of that revenue will hit the bottom line, Wachenheim says, as builders achieve economies of scale, exploit best practices, and otherwise learn how to build more cheaply. He says he expects annual earnings growth of 20 percent.
Money manager Ron Muhlenkamp, founder and president of Muhlenkamp & Co. (when he's not riding around on his Harley), also ignores short-term blips in interest rates and housing starts that make the sector a bumpy ride. Located near Pittsburgh, Muhlenkamp is 46th on the list and holds stock in seven builders worth $241 million (16 percent of total value), according to 13F filings.
Muhlenkamp didn't invest in home builders before 2000 because “the little guy was a factor,” he says. “But now it's hard for the little guy to get permits,” he says, making it easier for production builders to consolidate the industry. He predicts that top production builders will end up with 30 percent to 40 percent of the market, double the share they have now.
Low Valuations Excite Home builder stocks are attractively priced, Muhlenkamp says, with return on equity (ROE) at sustainable levels (an average 22 percent by his calculations) and share prices at just eight to 10 times earnings. The low valuations excite him given that the market PE is about 17. PE is not the only measure indicating good value, he says. At two-and-a-half times book value, builder stocks are fairly priced, he says, for current market conditions (1.5 percent inflation, 4.5 percent interest rates).
Earlier, a UBS analyst argued that home builder multiples will expand on strong fundamentals, consistent with previous cycles. Muhlenkamp concurs, saying that builder stocks are trading at a discount to the market because people have thought of them only as interest rate plays. Builder stocks went up when interest rates went down, and investors believe share prices will stop going up when interest rates rise. But if ROE on builder stocks continues in the 18 percent to 20 percent range, they'll eventually command Wall Street's respect and multiples will expand, he says.