The Bear in Winter

BULLISH ANALYSTS AND INVESTORS have graced the pages of this column in recent months with their predictions that home builder stocks will go up. But ever wonder what the short sellers are thinking?

What makes them tick? Asset manager Doug Kass, general partner of Seabreeze Partners Short L.P. in Palm Beach, Fla., and regular columnist for TheStreet.com's sister site, Street Insight, is among the home building sector's most vocal short sellers. “The golden age of housing is now ending,” Kass says. There are several reasons for this, he says.

“Home prices have finally risen to levels unjustified by household incomes, household formations, and interest rates,” Kass asserts. In addition, the “market share” of adjustable-rate mortgages has more than doubled, he says. “This appears to be a sign of consumer stress as home buyers try to maintain affordability in an ever-higher home price environment.”

BEARISH BETS ON BUILDERS: Short interest as a percent of shares outstanding for many top builders was well above 5 percent in early February, a high number relative to other industry sectors, reflecting the belief of some investors that builder stocks will fall. Moreover, “the build-up in inventories in the Las Vegas real estate market raises broad questions about the similar potential in other regions of the country that have experienced far higher price appreciation in the last five years,” Kass says. Inventory expansion forced Pulte to slash prices by as much as 25 percent in Las Vegas in late 2004, he says. “The West Coast appears likely to be the next real estate market that will experience price weakness and lower sales,” Kass says, citing declining sales statistics for Southern California published in the Los Angeles Times.

Speculative activity is a thread that runs through Kass' analysis. “Speculation has run amok, leading to unsustainable price hikes” and artificially inflating builder margins and profits, he says. Investors are day-trading homes like they used to day-trade stocks, he says. He cites a Goldman Sachs report that the percentage of existing single-family homes changing owners each year has risen from its historical average of 6 percent to more than 9 percent in the last few years. Moreover, Yale professor Robert Shiller has found that nearly 30 percent of home buyers in Boston and L.A. expect home prices to increase 20 percent each year for the next decade. Unrealistic expectations usually signal trouble ahead, Kass says.

Kass calls declining interest rates “the straw that has stirred the drink of housing” and says that they “soon will likely reverse course [and] the tailwinds become head-winds.” Additional reasons Kass shorts the home builders include rental vacancies near an all-time high (over 10 percent) and execution risk and diseconomies of scale as big builders cope with rapid growth.

The Other Side Of Short Arguing the other side of the brief is Ethan McAfee, research director for Ramsey Asset Management, a hedge fund in McLean, Va. His firm uses shorting as a technique but did not short home builders as of January. He sees no reason to short, given that the top builders trade at around eight times earnings. “Builder growth rates are extraordinary, but share prices and PE multiples are not reflecting that,” McAfee says. NVR has grown earnings an average of 63 percent a year for the last 10 years but trades at only nine to 10 times earnings; Dell, which has a PE multiple of around 30, grew at about half that rate in the same period, he says.

Regarding inventory expansion, McAfee points to statistics showing that there was only a four-month supply of new home inventory in November, about half the historical average since 1970. “This completely disproves that there is a huge amount of unsold speculative inventory,” he says. Further, the short sellers have been making the same argument for the last five years, he says.

As for Kass' point about speculation, McAfee agrees that the argument is partly true and acknowledges that the number of people flipping houses has increased because prices are going up. However, this has been true for a number of years and it hasn't hurt home builder stocks yet, he says. Speculation might matter on the margin, he says, but a drop in speculative activity won't cause builder earnings to go down 50 percent, which is what it would take to erase the discount at which builders trade to the S&P 500, he says.

Similarly, Kass is sweating the small stuff when it comes to rental vacancies, McAfee says. “In most markets, it's more affordable to own a house than rent,” he says. Some 69 percent of Americans own their own homes, and this percentage is increasing, he says. If homeownership becomes less affordable, it would not cause a mass shift but instead take 10 years to play out and the home building business would take only about a 1 percent hit, he says.