Last time, I laid out my framework for thinking about housebuilders. It was convoluted and a bit mixed, frankly, but in that it did quite a good job of reflecting my thinking. I suspect it also captured some of the market’s struggle to value these assets. I left by saying that Berkeley Group and Bovis were particularly interesting to me, for different reasons. Bovis is a volume housebuilder – I’ll cover them in a separate post – but Berkeley is a law unto itself.
So for this post: welcome to London!
Before I dive into the financials and what makes it interesting, a little background.
Berkeley are a British housebuilding/urban development company, operating predominantly in London & the South East; by some distance the most expensive regions in the UK. They have a long history of seriously big brownfield development (like the picture above) – a tick, as far as I’m concerned, since it lends some credence to their claim to be adding a bit more value than the volume housebuilders, who (if you’re being harsh) spend a lot of their time figuring out ways to persuade people to let them build on the easiest place possible – big, flat, greenbelt fields.
Berkeley is also one of those stocks that just has an eminently likeable story and culture. Here’s a passage from the Independent in 1993 on Tony Pidgley, one half of the co-founding duo, and owner of £181m worth of shares in the company:
… A Barnardo boy, he was adopted at the age of four by travellers and lived in a railway carriage. His first introduction to the need to pay attention to costs was when he was deputed to drain the radiators of the family’s lorries last thing at night and refill them the following morning, to save money on anti-freeze. And he first discovered the joys of trading at the age of 10, when he bought a sow and made profits on selling her piglets.
His adoptive father could neither read nor write and Pidgley’s literary skills (albeit, he admits, only half-formed) made him the blue-eyed boy. But educated or not, the accounting lessons he learned at his father’s knee taught him almost as much about company finances as any formal tuition could.
‘He always used to carry a little book. It was very simple,’ he said. It had three columns: A, B and C. In column A, his father would record what he paid for something – say a horse. In column B, he would write the value of offers he turned down for the animal. In the final column, he put the price he eventually sold for.
‘I asked him once what (column B) meant and he said ‘Well that horse now owes us £12, because that’s what we’ve turned down.’ The profit was measured not against what his father had paid, but the value of the offers he refused.
That graphic illustration of the risks of holding out for a better offer may explain Pidgley’s skill in reading the housing market in 1988, when it soared to undreamt-of peaks. Unlike practically every other house-builder, Berkeley did not believe the good times would go on forever, and instead of rushing to buy land at inflated prices, it took the decision to cut its land holdings.
‘We don’t know why the rest didn’t see it,’ said Pidgley. ‘House-builders weren’t making money, they were printing it. We were selling houses and their prices were going up in leaps and bounds. Just because you sell gobstoppers one week at more than three times what they’re worth, you wouldn’t go out and buy four years’ supply, would you?’…
One thing I hate – and something that is very human – is the ‘reverse-attribution’ of certain qualities based on things you already know. The way parents of footballers will tell you their kids were always kicking when they were babies. Still, if I might indulge, the section above highlights two characteristics that I reckon are as relevant as any to Berkeley’s long-term success. Firstly, a grasp of opportunity cost and not just outcomes; comparing your profit not to what you paid, but what you could have made. Secondly, a clear delineation between what something is worth, and what something is sold for. The last one is a an enduring problem for investors everywhere, who have constantly fluctuating prices burrowing into their minds and influencing their perception of a company’s value.
A brash, almost aggressive style makes Pidgley too rich for some people’s tastes; others, however, find his openness and liveliness appealing. Now 45, he got involved in house-building soon after leaving school, aged 15 and with no formal qualifications. The lack of a formal education is still one of his biggest regrets. ‘There is no doubt about it, they (his colleagues) knocked the rough spots off me in the early days.’
A short spell in the family business did not work out and he set up on his own, cleaning cars, mowing lawns, cutting hedges – virtually anything for money. That evolved into P & J Haulage and Plant Hire, which specialised in site clearance and demolition.
Crest Nicholson, one of his customers, let him an office for £3 a week, and when he was there doing the books on Saturdays he met Crest’s founder, Brian Skinner. He liked what he saw and offered Pidgley pounds 1m, ostensibly for his business but actually to get his skills into the company. Two weeks later, aged just 21, Pidgley was asked to be Crest’s building director and given a seat on the main board.
He would possibly still be there today but for a disagreement with David Donne, Crest’s chairman. ‘It was suggested I was a maverick,’ said Pidgley – a description which clearly amuses him as much as it offends. Donne suggested that rather than humouring mavericks ‘you take them outside and shoot them’.
So Pidgley left and Jim Farrer – a co-founder of Crest – resigned in sympathy. Together, they decided to set up on their own and Berkeley Group was born.
That article was written in 1993. How has it translated into financial performance? I plotted it a little further back, since 1989:
My measure is rather convoluted, but patchy data availability going back this far – combined with Berkeley’s changing ways of distributing cash to shareholders – make the calculations slightly more difficult than they might be. The chart above is an attempt to map the underlying value of £1,000 put into Berkeley Group in 1989, as if you could reinvest all distributions.
If you want a more intuitive snapshot, consider that you could’ve picked up a share in Berkeley Group in 2000 for £5 a piece. If you left the account entirely untouched, you’d look now and see that it had about £12.50 in cash (you weren’t smart enough to set up reinvestment) – not a terrible return in itself – and the share would be worth £26. I estimate that the management at Berkeley have compounded owners’ capital by something like 12% historically. This is a solid return, particularly if you consider the leverage profile of the group – very little, particularly compared to other housbuilders – and the lack of cyclicality you would expect to find in this sort of company. The group has never made a net loss.
Berkeley is not like other housebuilders!
One accusation you might level against them – indeed, the very first thing I went about testing – is the notion that the main reason they’ve done so well is simply because they operate mostly in London and the South East. These are the two best performing regions over the last couple of decades, so their performance would hence be predominantly down to simple luck and not any sort of operational skill.And while there is a correlation, it’s not a complete explanation by any means. In the decade before, the relationship is even less clear.
More importantly, there’s clear evidence to suggest that they’re not just milking the inexorable rise in land prices – which is a very easy way to make money if you add leverage, as the volume housebuilders do in the good times. The assets side of Berkeley’s balance sheet actually shrunk from 2003 – 2007, by over 10%. Most of the other housebuilders got around twice as big over this period, leveraging up to buy as much as possible… but most of the other housebuilders were then too busy dealing with land impairments and credit availability to double the size of their inventory holdings from ’09 – ’14, buying when the market was genuinely cheap.
This is great counter-cyclicality. They’re not lazy with the money, either – in 2005, 2007 and 2008 they made substantial returns of owners’ capital, which cumulatively totalled more than the whole share price in 2005. They were also planning to give money back in 2009 to finish their return-of-capital scheme, but politely nudged shareholders into letting them keep the money to reinvest in land holdings.
So, assuming I’ve persuaded you that Berkeley is a good company, how do you go about valuing it? Well, I’ll again start by pointing out three metrics:
Price to tangible book: 2.3
Return on Equity: 20.3%
Price to earnings (historic): 12.3
(both valuation figures go up if you dilute the sharecount. The company is very generous with long-term incentives. The historic dilution this has caused is captured by my historic RoE figures discussed above, without which would be much better)
Essentially, this is the same story as the rest of the housebuilders, but even more exaggerated – elevated levels of return on equity, a high multiple of tangible book (if you believe it’s a commoditised business) and, when you put them together, still a very reasonable price-to-earnings multiple.
Why might Berkeley be considered cheap at this multiple, despite it trading at 2.3x tangible book, my ‘grounding’ metric? There are a few reasons I can come up with:
– Their book value is understated. The book value of most housebuilding companies has at least some composition of impaired assets, bought before 2009, which were then subject to accountants’ determinations of their value based on several suppositions. Their land banks also comprise more land bought in the last two years – after confidence had started picking back up – which is hence more expensive, and is obviously held at cost. Berkeley, being the shrewd guys that they are, bought lots in 2011. Their book, hence, is implicitly much more conservative than the others. One way you can capture this is in the ‘gross margin in land holdings’ that Berkeley report – which currently sits at just over £3bn. Put simply – if Berkeley put up houses on their consented land at typical margins, it’d be worth £3bn more than it’s on book at. This would likely take them about 5 years. You can play around with a DCF to figure out what that equates to. Also bear in mind Berkeley’s excellent history with ‘strategic’ land – land bought without any imminent prospect of development or planning consent. This is held at cost but, if they manage to actually figure out how to get a building approved on it, would be worth multiplicatively more.
– Their RoE is sustainably higher than the sector and/or the market. Again, as I mentioned in the last post, book value is a fair tethering for companies which act in commoditised industries and are hence constrained to earning only a normal return on their capital over the cycle. For the last 30 years in Berkeley Group, this has not been the case. Once you start supposing that a group has a sustainable advantage, book value becomes a less intuitive way of thinking about things. You have to be comfortable that the ‘London effect’ isn’t too big, though. On the flip side, one might argue that the next three years will be a bonanza for Berkeley, as projects they acquired cheaply will start to come on stream, and we seem to be out of cycle-trough.
– Their cost of equity is lower than people might think. The cost of equity is an expression of the risk of an investment. Risky investments have higher hurdle rates for investors. This is why large, stable companies can sustainably maintain very high P/Es with little growth – because they are seen as low-risk, and hence the cost of equity is low. Berkeley is treated like a volume housebuilder in terms of valuation. Is this fair? Maybe. Look around at the London market, though – London REITs, for instance, or just the property market generally (driven as it is by foreign capital and investors) – and you might conclude that the sort of assets Berkeley group is holding deserve a much lower cost of equity than is implied in the current price.
– You have an internal reason for liking the asset. I rent in London. I look around me at the rising cost of living in London. Owning London assets in some form gives me a neat hedge against the main ‘input costs’ in my life.
And, to be fair, I find all of these reasons quite persuasive. You still have to be positive on the macro – it is a housebuilder, of course – but I find the argument about the relative appeal of investments in our beloved capital an interesting avenue. The implied rental yield on the studio flat I rent in London, for instance, is less than 4% – gross – and I don’t even think that’s particularly low. Investors are clearly willing to accept absurdly low rates of return on London-based assets, in exchange for the apparent stability and long-term capital appreciation. I should, of course, point out that Berkeley aren’t entirely London based, but it’s a relevant principle across the south east, which (while not quite up there with London) enjoys a radiant outward glow.
I realise I haven’t done much concrete valuation in this post, but again I hope I’ve provided at least some intuition into the way one investor is currently thinking about the company. I have glided over a number of important issues – the company’s long term incentive plans being one of them. Let me know your thoughts.