I have a warm affection for housebuilders. This is unusual among value investors, who (if the blogs I read and the people I talk to are anything to go by) typically tend to see them as horribly cyclical, commoditised land banks run by executives with an uncanny knack for leveraging into recessions and mis-timing the market. There is certainly some truth in this.
I’d probably hate them too, if it wasn’t for the good they’ve done me. My first ever investment was in Barratt Developments in the depths of the recession when, armed with only a notebook of valuation metrics and the sort of blind confidence only a true rookie could muster, I stuck the vast majority of my (admittedly meagre!) savings on the beleaguered builder. Sure enough, it was a blow-out bet, and probably has a small part in me being here today. Had the coinflip come up tails, I’d probably have quit and become a dentist. I’m thankful for my early fortune – ‘Expecting Dentures’ doesn’t have quite the same ring to it.
But let me lay out the discussion in this post. This is that, in my eyes, housebuilding is one of the few sectors the market understands well. It values housebuilders in a way fairly consistent with what I’ve highlighted in the first paragraph above. How is this? Typically, it is on a book value basis. A book value basis makes sense in a commoditised industry where your biggest input is capital; because the capital you employ in your operations will be the best guide to how much profit you make. It is difficult to see how any one player could earn a supernormal return on capital – the biggest chunk of your cost base (land) is subject to intense competition from other builders, and the margins on your finished project are inherently constrained by the availability of other houses nearby… which is doubtless the basis on which the acquired land was priced. Consider that Bovis called the biggest challenge in 2014 ‘the availability and cost of subcontract labour’. This bears all the hallmarks of a commoditised sector, where the economic profits flow through to the inputs.
In the UK, over the last 15 years, the listed housebuilders have earned a return on capital of something like 10.7%. There are a few things I would say about this figure:
– It is high; though it should be. Industries with a higher degree of cyclicality, and extremes from peak to trough (look at housebuilders in ’08-’09) have a higher cost of capital than more stable industries.
– In comparison with the US, UK housebuilders fare much better. I suspect this is because of the UK land situation – the 3-4% additional ‘spread’ the UK housebuilders have earned compared to their US counterparts may arise from the fact that their land inventory has, due to a number of powerful (political and otherwise) forces, consistently ticked upwards over the last couple of decades. To my knowledge, this is far more prevalent here than in the US.
One might suspect we’re now coming out of the trough of the cycle, and we have a few good years ahead of us. Where are we in terms of valuation?
Well, on some bases, extremely cheap. There are few sectors in the market you are able to buy as cheaply as homebuilding on a near-term earnings basis. In the graph below I’ve used forward price to earnings, using broker forecasts, though the pack is also cheap on a historic basis. I don’t think the forecasts are unduly bullish given the ‘tugs’ the housebuilders have going for them at the moment. The average P/E is indicated by the black dotted line, at 10.
There has to be a reason the market is valuing them so poorly on an earnings basis, and I suspect it’s because the market doesn’t really look at homebuilders on an earnings basis. It has been drilled in, by boom and bust, that valuations are more fairly tethered to the value of their books and not the (volatile) yearly earnings numbers:
After all, if you believe that the homebuilders will regress to earning a return on equity in line with their cost of equity, a price to tangible book of 1 is probably what you should be happy paying. 2 is, hence, expensive. The current market pricing – at a high multiple of book, but a low multiple of earnings – is reflective of a deep sense of scepticism about the sustainability of those earnings.
But here’s the real surprise to me, and is the crux that investors with their eye on a quick buck should consider. Housebuilders, on a historic basis, are actually as expensive as they have ever been – as expensive as in 2006/7, even. Don’t buy in expecting a quick pop when housebuilders get re-rated to a market multiple – because it’s a sector where the market, generally, has a pretty good grasp of the inherent cyclicality involved. Housebuilders simply don’t trade on ‘normal’ market earnings multiples in the good times, because the good times are seen as being just that.
If you can’t expect a re-rating, all you can hope for is fundamental improvement. In the case of these companies, these drivers are fairly unsurprising:
– Mortgage availability
– Government planning policy
– Foreign investment/immigration
– Household formation etc.
And I should say, for the iota that my opinion is worth, that I’m pretty bullish on more or less all of these factors. There is an entrenched swathe of political interests focused on keeping house prices mildly positive in the country, combined with a general consensus that more houses need to be built. This strikes me as the best environment housebuilders could see. Mortgage approvals are still subject to a heightened awareness of the risk of lending (as is to be expected after a blow-up) and a rise in interest rates will almost certainly be concurrent with an improvement in real wages that should net off at worst.
… but to buy a housebuilder, you still have to be comfortable that you’re paying significantly more than book for a collection of assets that the market will certainly not value at book in a market crash. You’re paying for the gross margin already baked into the land they’ve bought, as well as the expectation that they will be able to continue to buy extra-profitable land.
For what this collection of musings is worth, it’s probably best to point out one thing. I don’t often agree with the market, or think it is being perhaps too harsh with its assessment of a sector’s prospects, but this is one such case. That perverse reason – my agreement – is a great reason for posting it. Because, for all construction’s inherent cyclicality and the problems it causes, there are a multitude of sectors dependent on it – think vertically – yet which, at times, trade on values deeply disconnected from the mechanics I’ve described above.
I hope to explore some of those in the future, along with a more indepth look at the couple of housebuilders in particular (likely to be Berkeley and Bovis).