Complete Book Value Analysis

After years riding the wave of 45-year lows in mortgage rates and nonexistent lending standards, home building began facing the music in 2006. I suspect that 2007 will prove to be worse, as lenders react by instituting what used to be normal requirements for mortgages. Adjustments in sub-prime may squelch first-time buyer purchases, with ricochet effects all the way up the price points.

The industry will have to absorb the over-supply from 2004?2005 at the same time that sustainable demand will be much lower than most care to acknowledge. Still-high-home prices and tighter lending are ratcheting affordability downward, even with flat mortgage rates.

Barbara Allen Although the Public Builder Report Card analysis provides details on the public builders' perfomance in 2006, we'll examine the long-term performance of these companies. Two assumptions are at work:

Cyclicality is the norm. Home building is a cyclical business, and financial performance must be assessed in that context to be meaningful. I use measurements from one cyclical peak to the most recent one in 2005.

Book value per share over the cycle measures management skill. Warren Buffett apparently believes that examining the compound annual growth rate (CAGR) in book value per share over time provides a compact measurement of how well a management spends shareholders' funds. While accounting conventions can mislead, book value per share is as good a single measurement as we can find. It incorporates earnings, losses, asset sales, shares issued for acquisitions, stock repurchases, as well as dividends and distributions.

Maybe sell-side analysts should start examining true performance rather than the faux analysis done by most. Emphasis on quarterly results and meaningless data points (backlog conversion ratios? Who are you kidding? In a favorable demand environment, rising conversion ratios simply mean that the builder is doing more speculative construction.) provide little insight.

I calculate EPS growth over the cycle to show where stronger participants take advantage of favorable macro-economic factors to expand at a rapid pace. Home builders have always been growth cyclicals and this cycle was no different, except that the environment was unusually supportive.

  • M.D.C Holdings ranks as the best performer, with a CAGR of 33.7 percent from 1994?2005, while Horton was a close second at 33 percent, demonstrating that both were true growth companies within this sector. In any other stock market group, MDC and DHI would have been accorded far-higher P/E multiples than anything either has received.
  • KB Home and Standard Pacific Corp., the worst performers at 13.4 percent and 7.6 percent, respectively, were heavily weighted to California when the cycle began.

Now that the cycle's positive supports have been removed, better managements should show their stuff. Not losing money in a downturn will be a strong indicator of good cyclical management.

Our group of nine posted double-digit gains in book value per share, which places them in the top quintile among U.S. companies. Nominal GDP grows about 7 percent to 9 percent annually, so these companies are outperforming the economy overall, even with 8 of the 9 paying regular dividends (reducing book value). The entire group posted better-than-average growth in book value per share, with most registering impressive levels compared with any industry group.

Amid the painful adjustments to a more-normal environment this year, investment opportunities resemble those of 1990. Combining the long-term records with 2006 measurements–especially debt levels–should serve as a guideline to investors. Although I don't believe the next up cycle will be as powerful as the last (interest rates are likely to be generally higher and lenders more discerning), returns should be quite healthy, particularly when buying near the bottom–that is, at book value or below.

Barbara Allen covered home building for 22 years before retiring as an analyst from Avondale Partners in 2006. E-mail: