Barratt Developments (BDEV)

Change of Tack

Barratt are one of the shares that have been with me the whole last year and a half since I formed the portfolio. While my approach has changed – clearly vastly for the better – they’re one I’ve stuck with, and even bought more on their significant dip a little way in. My original premise was completely oversimplified  but I still think there’s merit in it; essentially, I bought because it was trading at something like 35% of book value. Something I gave nowhere near enough credit to at the time was how book value was actually calculated. It sounds obvious, but as a rookie I put too much faith in the financial statements – something that had me come a cropper in other investments later on.

As safe as houses

The fact is, the valuation of inventory, work in progress, land with development potential etc. isn’t quite as black and white or clear cut as I first assumed. Given the huge amount of impaired land Barratt had on their books, this is fairly critical. Even impaired land though, assuming it’s been impaired ‘perfectly’ to its recoverable value, is nothing like similar to un-impaired land; impaired land sits on books at recoverable amount. You only have to look at the margins the company earns on land bought and impaired at different timings to see how the total carrying value has read-through problems to future cashflows. There are a lot of other bits of information to need to really know the true economic value beyond that one figure.

This is something I vastly underestimated – and didn’t particularly understand. Frankly, the exact accounting still isn’t something I’m hugely comfortable with. I’m getting better; such is the value of writing and practicing – but it means I should treat my own judgements with a large dose of skepticism. Hopefully this comes through in most of my posts; rarely am I hugely confident. It is a balancing of odds, or an attempt to do so.

Where we stand now

With Barratt now, then, we’ve passed the point where my original investment idea becomes irrelevant – we’re now a bit over tangible book value, instead of 40% thereof. That means it’s been a big success for the portfolio – I bought at about 116p, topped up at 80p, and we currently sit at 230p, but it also means I should consider selling. The question I then have to ask myself is this – given that my first investment theory was a touch naive, what is my best appraisal of the stock’s value now?

The reason it’s difficult is the same reason it’s always been difficult – the cyclicality. Housebuilding is the definition of a boom and bust industry. I suspect that’s what makes it relatively good value when everything looks dire, and terrible value when things are good – in reality, the good times are always too good and unsustainable, and the bad times are equally unsustainable. Houses are still very much needed, indeed in far excess of what has been built in the last few years.

It’s all in the hocus-pocus

Essentially the difficulty with Barratt is now deciding what value to assign the ‘entity’ – the intangibles that go beyond the value of just the stock and the balance sheet. What power does Barratt have, as a brand and as an organisation, to earn returns about its cost of capital? We probably have to attribute it some given simply its size. Housebuilding isn’t really a small player’s game. There are scale efficiencies that are exploitable by the big firms. Pre-crisis Barratt hit a P/TBV of closer to 2 – far removed from the recent valuation of it at significantly less than the stock on its balance sheet. That was, in hindsight, clearly an inflated value, but it’s obvious that even then there was cyclicality priced in. Barratt never traded at an ‘expensive’ P/E. Clearly there was at least some recognition of the risk of a flop, though probably not enough.

Finally, though, I should probably point to a slightly more contentious reason why Barratt could still be undervalued. Contentious, I should note, because discussions on the price of housing seem to spark a level of vitriol between the sides that’s pretty rare to find – except perhaps in the case of gold. Either way, if the housing bulls are right – a side I edge towards – we’ve had a few  years of undersupply in an industry that was never really oversupplied in the first place. Personally, I suspect government planning regulations are an inherent and hugely powerful distortion on a market that’d otherwise be building a lot more homes, particularly in the south. My default position, then, is that there’s more upward potential (rules get slackened) than downward potential there. Houses are prohibitively expensive in the UK.

That sort of hints at another bonus in being a big housebuilder, I guess – you need capital and you need knowledge to navigate the maze of planning restrictions, to keep the banks of cheaper ‘strategic land’ and so on.

I don’t delude myself that it’s a particularly ‘stockpicking’ type decision, which is why I’m a little torn with the online portfolio – I want this to be about stockpicking, not about my long-term macroeconomic and political guesswork – if you’ll permit me to construct straight lines in a blurry world. I’ll probably continue to sell down and trim my position to something much smaller than where it currently stands. A bit of extra disclosure, though – Barratt were the first stock on the blog I ever bought in real life, and I suspect I’ll continue to hold at least a little bit there, too. Partly for the reasons above, and partly because it’s a neat hedge given that I don’t own a house yet. Imperfect, I suppose, but intellectually attractive!

14 Replies to “Barratt Developments (BDEV)”

  1. red.

    Interesting post as always, Lewis.

    I agree with you that it doesn’t really matter all that much to BDEV if housing will or won’t grow unless one believes that BDEV has some sort of advantage that allows it to earn above -normal profits.

    And the latter, I think, is a testable proposition: if the average return on net operating assets in the years between a the cyclical peak and cyclical trough is less than, say, 10%, the kind of return an investor in a boom-and-bust sector would demand, then I think it’s unlikely that size and capital are true advantages in the property development game.

    My own guess is that property development in the England & Wales, tied as it is to local knowledge about local planning authorities and local demand, is at least as much a game for the small entrepeneur as it is for the big boys. Likely more so. That big property residential developers almost without exception fail to earn their cost of capital over a full business cycle is indicative, I think, of just how unstable and unattractive an industry it is.

    Looking over BDEV’s ROC from 2007 to 2012, I see returns of 10.5%, 10.9%, 1.0%, 2.7%, 4.1% and 6.2%, for a cycle average ROC of 5.9%. So, it just about earns its cost of capital during the best of times and, at ~6% average return, it’s not the kind a business for which a private buyer would pay full price — why buy BDEV at 6% when, for example, Tesco’s dividend alone returns almost as much.

    And, therefore, if it indeed earns less than its cost of capital, — if it’s more or less in the same position as every other (and future potential) residential property developer in a transparent country relatively free of bribery (it doesn’t have special access to specific, valuable land, basically) — then growth will hurt rather than help shareholders.

    By my quick count, therefore, BDEV is, at a maxumum, worth:

    Net operating assets = 1727
    +
    Equity investments & avail for sale assets = 393
    less
    debt equivalents = 244
    =
    1877 or 192p per share.

    imho

    • Lewis

      Red – using ROC from ’07 – ’12 seems rather harsh given the relative velocities of the upside and downside of the cycle. You’ve captured the precipitous tumble and market crash, but not a huge amount of the relatively steady upward momentum for the decade prior to it. Am I misunderstanding your intentions?

      • red.

        Oops. I assumed from looking at the price chart that 2007 was the peak. Going back to 2002, I see now that the peak was 2004. And. assuming that it works its way up of the cycle the same way that it worked its way down it, the cycle average (peak-to-trough) ROC looks like 10.4% which, is just about the same as its cost of capital. In which case, by my way of looking at things, it’s probably worth tangible book. Better than very many of the res prop developers that I’ve looked at in the US and elsewhere.

        • Lewis

          Thanks for the clarification.

          I would’ve hesitantly throw out 8-9% as an approximate cost of capital if I was pushed – but I see their weighted interest rate on debt is 8.5%, which is much higher than I anticipated. Even given that they had to refinance when things were not looking as rosy, I suppose the cyclicality pushes the cost of capital higher than my gut feeling would’ve said.

          “assuming that it works its way up of the cycle the same way that it worked its way down it”
          – how do you feel about this assumption? Again I suspect I may be misunderstanding, but my relatively short experience would suggest a rather assymetric cycle, with a far slower pace on the way up than the way down.

          • red.

            I think the long term run rate in the UK is probably 200K new housing starts per year. It would probably be 250K to keep up with notional demand but I don’t think that there would be land enough for that. The peak of the last cycle saw 170k annual housing starts so it seems likely to me that your insight is the correct one. How long it would take to work back up the cycle is, of course, a more difficult question since it depends on interest rates and the banks’ psychic and balance sheet health..

            A year or so ago, in looking up and down the UK residential housing value chain, I considered Howdens Joinery as a preferred way to play the housing recovery: high quality, stable, with some hidden features, and, I see now, still some way away from fair value of about 250p. (The “downside”, I think, is about 220p). But that’s me, with my ROIC fetish — at this price level, I’m comfortable with Travis Perkins and the other specialist housing supply distribution firms (though not Kingfisher or Home Retail).

            in any case, congrats on BDEV and may there be many more of those 3-baggers!

            • Lewis

              Yes, here’s to that!

              I do hold Howden Joinery as well, and have done since the start of the portfolio there, too. Rather differently from Barratt, the more I’ve learned the more I’ve liked Howdens. It’s a well run company, the annual reports are an absolute pleasure to read (which I think has good read-throughs for management and the company in general) and it’s still fairly cheap.

              Again, not as cheap as it was, but for the quality of the company that’s one I’m going to continue to hold.

  2. Mark Carter

    Although you called your analysis “naive”, perhaps “simple” would be a better term.

    I noticed a couple of years ago that housebuilders were writing down the value of their land banks (you can see it in the reports, where they state they have professional valuations). That, of course, lowers the company book value, so if you can buy even at a substantial discount to that written down value, you just got to suspect that your odds are good.

    I think many investors try to overcomplicate things and feel they have to come up with arguments that would dazzle even Einhorn or Ackman, but I think that simple and correct arguments as likely to be more effective.

    You doubled-up when the trade was down, and made even more money.

    So, basically, well done.

    A question for you to think about: what was the performance of this share relative to the rest of your portfolio? If it was more, which is what I suspect, then you should take your cue from this observation … namely that buying beaten-up cyclicals that you think will survive is a profitable strategy. I’m trying to develop some ideas on this with turnarounds.

    I notice that people are still moaning about housing, and that BDEV has a Piotroski score of 9. It is on a ROE of 2.6%, which still looks very poor in terms of profitability. Analyst forecasts look robust, too, so these factors combined suggest to me that we’ve still got a way to go before value is fully outed. It’s true that BDEV doesn’t look so cheap on a PBV basis, though. I’m not trying to influence your decision, I’ll leave it up to you. Best of luck with whatever you decide.

    • Lewis

      Mark – naive, simple – I’d go for both!

      “That, of course, lowers the company book value, so if you can buy even at a substantial discount to that written down value, you just got to suspect that your odds are good.”

      Yeah – this was a key point of mine at the time. It’s still somewhat true, I’d say, though I didn’t realise at the time that impaired land was still significantly different from unimpaired with regard to how much the company expected to earn on it in the future. Margins are ridiculously thin on land that was impaired.

      And thanks; luck or judgement I’m not entirely sure, but I suspect time – and lots of it – will tell!

      To reply to this and your comment below in one, I think what you’re driving at is that you suspect these turnarounds – the cyclicals – are offering better value than some of the more standard value situations I look at. I think you might be right. It’s a higher variance game, so maybe those excess returns are to be expected, but I agree I should look at more of them.

      Thanks for the comment and suggestions, it’s always thought-provoking and only helps me out.

  3. Mike Maynard

    That is a good analysis. I think you might find something else that will offer a better return. I tend to be a ‘death or glory’ investor; recently there has been more glory than death! I am avoiding anything that might be seen as a ‘safe harbour’ because those are the safe ones now, but risky in the long term. When the fund traders start selling their safe bets and taking more risks, the safe shares will suffer and the risky ones will rocket. How long do we have to wait? How long is a piece of string? 🙂

    • Mark Carter

      Mike, you raise an excellent point, and it is one I have been pondering of late.

      Conventionally, as value investors, we are supposed to look for safe companies trading at below our estimate of intrinsic value … the kind of company that any competent investor should be able to say “yes, that’s a safe company”. I’m increasingly beginning to believe that this is not a particularly attractive setup, though, as the reward to risk is relatively low. I think it may be better to look at situations where value investors typically wont go, into situations where the reward to risk is much higher. Opportunities might be in turnarounds, for example, where you think there might be circumstances where the chances of success are much more favourable than average, but the share price is dirt cheap.

      FWIW, I think we’re already in the situation where traders are taking on more risk. Look at the relative strength of DXNS (Dixons) for example, which has RS6m (Relative 6 month Strength) of 61%, or TNI (Trinity Mirror) at 245%, or PIC (Pace) at 80%, or TCG (Thomas Cook) at 224%, plus many many others.

      BTW, your website seems slow as molasses to load.

    • Lewis

      More or less the contrarian instinct, yes!

      Safe harbours are always suspicious. If I might step outside my remit slightly, I wouldn’t touch government bonds with a barge pole. Safety is a function of both quality and price. They may have the first, but the second is off the charts.

  4. Shaun

    Nice post congrats on this pick. It seems that you chose this one originally because of low price to assets. It was a value play or bargain! Now you are lokking to invest in house builders because you anticipate the market growing…quite different approaches. Now its realised the discrepancy between price and assets you seem to be looking for reasons to continue holding. I would suggest perhaps there is a little bias creeping in and its more comfortable to stay with a share you know etc. For me i would simply ask myself, are there other shares that present better value right now…. More upside less downside. If so then switch up. if this is the best you can find atm then stay where you are. Regards, Shaun

    • Lewis

      Thanks Shaun.

      You’re right – I try to be vigiliant against this but I constantly try to ask myself how biased I am. ‘Looking for a reason to hold’ might well sum it up.

      “its more comfortable to stay with a share you know”

      And this is also a good point. Barratt is far and away the share I spent the most time looking at. It was the first stock I ever analysed, and I’ve looked at it regularly since I bought it. There probably is a sense of comfort and ease just holding!

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