When Size Matters

NO MATTER WHAT MEASURE of operational or financial performance you choose, public home builders have grown up quite a bit over the past decade. Along the way, they have also done much to curry favor with institutional investors. However, one criterion for investment by certain funds—equity market capitalization—continues to be a stumbling block beyond the direct control of builder executives.

UBS home building analyst Margaret Whelan recently highlighted the kind of progress that would seemingly catch investor interest in a report titled, “No Fairy Tale Here, It's Different This Time.” Between 1995 and 2003, home builders as a group reduced their debt as a percentage of total capitalization by 25 percent and the cost of that debt by 20 percent. Operational improvements further enhanced profitability with return on equity rising from 10 percent to 28 percent. Meanwhile, the top 10 builders in the U.S. increased their combined market share from 10 percent to 23 percent.

Investor Scrutiny Home builder executives were also responsive to the desires of the market. When tax reform increased the attractiveness of dividends relative to share repurchases, many responded by initiating or raising payouts. When investors scrutinized corporate governance practices, builders shined. In 2003, Bloomfield Hills, Mich.-based Pulte Homes earned a corporate governance score from Institutional Shareholder Services that ranked it higher than 95.1 percent of the companies in the S&P 500.

MINDING MARKET CAP As the home building industry developed the characteristics of attractive equity investments, it also became increasingly accessible to institutional investors. The combined market capitalization of the entire universe of home builders covered by UBS grew from only $2.5 billion in 1995 to $41.5 billion in 2003. Liquidity improved even more dramatically with an average daily trading volume of 993,545 shares in 2003 versus only 76,960 in 1995.

Size Wise Size matters to institutional investors for several reasons. The Investment Company Act of 1940 prohibits funds that market themselves as diversified from owning more than 10 percent of a company's outstanding voting securities. Some funds impose additional restrictions on themselves through the investment strategy described in their prospectus.

Two funds managed by renowned stock-picker Ken Heebner offer examples. The Boston-based CGM Mutual Fund “may invest in companies of any size, but primarily invests in companies with market capitalizations of over $500 million,” he says. The CGM Advisor Targeted Equity Fund “will generally invest in a focused portfolio of common stocks of large capitalization companies that CGM expects will grow at a faster rate than that of the overall United States economy … . The Fund will not invest in small capitalization companies.”

How does one determine what category a particular stock belongs in? According to Morningstar, a Chicago-based provider of mutual fund research and ratings, many fund managers classify stocks by capitalization using a system of static break-points. However, the precise threshold for large-, mid-, or small-cap status may vary from manager to manager.

Morningstar, on the other hand, uses a system that fluctuates with the value of the market. “Morningstar defines large cap to include the largest 70 percent of the market's value. Mid-cap is the next largest 20 percent. And small cap is the smallest 10 percent of the equity market,” says Morningstar senior analyst Emily Hall in a recent report titled, “Market Caps: How Large is Large?” In March 2004, companies larger than $8.5 billion qualified as large cap, while those smaller than $1.5 billion were considered small cap. Morningstar then categorizes funds based on how they've actually invested over the past three years.

Message For Builders There are also practical considerations for fund managers. “Some funds of large size may be concerned about the impact on their performance of small holdings, but we think that is a mistake,” says Ron Muhlenkamp, founder and president of Wexford, Pa.-based Muhlenkamp & Co. and portfolio manager for the Muhlenkamp fund. According to Muhlenkamp, “They've missed a quadruple in the past four years. One good way to get size is simply to buy several stocks. We own seven of the top home builders.” Some managers may also question whether stocks offer the liquidity they desire.

“Liquidity is only a problem if you trade a lot,” says Muhlenkamp. “The question for companies is: ‘Do you want to attract investors who trade a lot?' It's a two-edged sword.”

While builders may have struggled to generate interest from large-cap funds in the past, an examination of current ownership indicates that is no longer the case. The four companies topping the Builder 100—D.R. Horton, Pulte Homes, Lennar Corp., and Centex Corp.—are held by a broad range of institutions and funds. Of the 20 mutual funds that are collectively the largest owners of these stocks, 10 are described by Morningstar as large cap. The list also includes growth and value funds, suggesting that style may not be a limiting factor in the universe of potential builder investors.

Even smaller firms such as Meritage Corp., whose market capitalization would place it in Morningstar's small-cap category, are widely owned. The largest mutual fund holders of Meritage include several of the same mid-cap funds that own its larger peers.

Perhaps the message for builder executives is best stated by Muhlenkamp. “We find market cap and value-growth labels of minimal importance in choosing companies for investment,” he says. “We want to own companies that are well-run and we want to own them indefinitely. Size is irrelevant.”