What place does a housebuilder have in your portfolio?
As a value guy, I’m not really sure. If I were to take a stab at valuing a housebuilder, it would comprise of two elements. It’s sort of like valuing insurance companies, really:
a) Value the land on their book. This sounds trivial – we have accounting book values for a reason – but the actual sums are more complicated than that. Housebuilders have portfolios which faced differing degrees of impairment during the crisis, and the companies which had the financial strength to restart big land-buying programs in the depths of 2009/2010 – while everyone else was battening down the hatches and staving off the baying banks – have a portfolio of land which allows for higher margin building today. They also have differing quantities of land, which are best modelled by comparing their land bank (in number of plots) versus their last-year completions. This is like valuing an insurance company’s in-force book; you’re essentially asking yourself how well-written their previous policies were, or how well bought their previous land was, and how benign the environment will be for that profitability over the next few years.
In sum, all you’re doing is adjusting the value of their book to take into account the expected profitability of that land and when it’ll be built on – the discount factor. That’s why housebuilders – in the good times – show such great figures. Anyone can make money by buying land, sitting on it for 3 years (and watching it increase in value by 25%), and then building a house on it and ‘making 40% margin’.
For what it’s worth, this was why I bought Barratt in 2010. I flatter myself – I was a rookie investor armed only with 3 basic metrics and an overinflated sense of my own skill… but I was buying it at 0.3 times tangible book, after a number of write-downs. I think if I put myself back in that spot today, I still buy Barratt. You can put in all sorts of assumptions about profitability or lack thereof and feel comfortable when you’re buying it for that price.
What about when they aren’t available at 0.3 times tangible book, but at 1.2 – 2.5 (depending on what you look at), like today? Well, again, you should probably adjust that figure to remove all the noise.. but you’re still, in part, relying on:
b) Value the future profitability. Again, this is like an insurance company. You’ve got your in-force book, of course, but you’re also writing new business, or acquiring new land to be built on in the future. What’s the expected value of this?
Here’s where the problem starts: housebuilding is not a particularly complicated business, or a business with particularly steep barriers to entry. Probably the only one is to have sufficient capital to acquire and fund the development of large plots. Arguably there are more intangible barriers – the real skill in housebuilding is probably the ability in acquiring land cheaper than anyone else. Don’t ask me how you do this – probably something to do with knowing people in the right places.
This simple fact of life – a commoditised sector – makes me nervous to buy housebuilders at any valuation whereby a big chunk of price is implicitly paid for future profitability, because I don’t like paying for future profitability when I don’t think that profitability is ring-fenced or, at the very least, likely to flow to that company by virtue of its market position or a quirk of the competitive structure.
So what’s my angle?
c) I don’t think the assumptions of a free and efficient market hold. I say this having sat through, this weekend, another torrent of news about how committed the politicians are to housebuilding – one more proposal, for instance, of an effective 20% subsidy for first time buyers, and Labour promising to build ‘200,000 new homes a year’ – presumably by loosening planning restrictions.
I hope I don’t have to outline too thickly the absolute absurdity of subsidising a sector to make it more affordable for first time buyers; it is an endless ponzi scheme where the problem is pushed back a generation. What I do see, though, is a market whereby the powers that be are brazenly and openly admitting they will effectively fix prices to maintain the capital of their constituents. Their obsession comes from a constant courtship of the builders – an important part of the economy – and a simultaneous terror at the prospect of houses ever not rising in price. Perhaps I’m being a little harsh in my analysis – never attribute to malice/conspiracy that which could be adequately explained by stupidity, I’m reminded – and the simple fact is that successive governments haven’t realised that having prolonged periods of housebuilding significantly below household formation (due to planning or otherwise) is just a pretty bad idea.
What am I trying to say?
d) I’m always sceptical of cycles – but this one I believe in. Where are the housebuilders now? In their usual post-recessionary stage of having solid, relatively unlevered balance sheets, and at a point where they’re beginning to ramp up completions and profitability. House prices are ticking along happily. Returns on capital are picking up and – in that tell-tale merry go round – the rhetoric which was so recently focused on reducing leverage, like a schoolboy rapped on the hand for getting too excited, we’re now seeing talk of more efficient capital structures. That’s a code word for debt, if it wasn’t obvious.
Maybe my decision making is skewed by the bitter, twisted perspective of someone who’s seen a Hayekian nightmare – the real ‘too big to fail’ – and wants to jump on board a train that’s already left the station. I don’t own a house, after all – and it says something about the times we live in that I almost feel an obligation to buy a housebuilder to hedge the implicit and inexorable price rise that my gut’s telling me is coming.
Or maybe I’m making a good trading call, on a bunch of housebuilders that should make their forward P/Es of ~8, riding into what looks like (perhaps this is the folly?) an extremely favourable environment in the next few years.
If you can’t tell, I’m all up in the air. Is there a place for a housebuilder – a pretty uninspiring company, let’s face it – among a mid-cap portfolio of solid, well-run businesses with competitive advantages?