Sorting by Value

January 6, 2011

Dear Investor:

Complacency is returning to markets. Risk aversion is evaporating. Recovery is in the air. Even the animal spirits are returning, with M&A activity reborn and speculation back in vogue.

From a contrarian perspective, these signs are worrisome. The newly positive sentiment on stocks is bringing dollars back into the market and baking those optimistic expectations into stock prices. Still, macro difficulties such as the euro crisis and unemployment remain.

As you know, I don’t believe anyone can time the market consistently or effectively-so I won’t try. The direction of security prices in the short-term is unknowable, much like the next spin on a roulette wheel. The only thing knowable is value: the current price in relationship to fundamentals, and whether that price represents a discount or premium.

From a value perspective, stocks still look cheap. By some measures they are the cheapest in a generation. Not all sectors, however, look compelling. Some appear downright expensive. We are shifting assets from the overvalued to the undervalued. Here’s our list of relative value by sector (in order of magnitude from most to least):

Large Capitalization Companies (and Multinationals)
Business Services (including Software)

Commodities (and Commodity Stocks such as Gold Miners)
Treasury Bonds
Asia (except Japan)
Emerging Markets
Energy (both conventional and alternative)
Small Capitalization Companies
Consumer Discretionary
High-Yield Bonds

Our recent allocation shift has been from Gold Miners to Homebuilders. We believe the former category is at bubble levels while the latter is as cheap as it gets. To participate in the homebuilding sector, we’ve purchased the ITB (iShares Dow Jones US Home Construction Exchange-Traded Fund) which owns stocks of both homebuilders and home-related retailers such as Lowe’s, Home Depot and Sherwin-Williams. The top five holdings are: NVR, D.R. Horton, Lennar, Pulte and Toll Brothers. Rarely have I seen a sector as out of favor as the homebuilders. In classic post-bust style, these stocks have been kicked to the curb with abandon. The ITB portfolio trades at five times operating cash flows, as opposed to approximately 25 times in 2005 (at the height of the real estate bubble). The ITB trades at $13/sh, down from over $45/sh at the peak-a 71% decline. The only comparable sector collapses in recent memory are Japan in 1991, Tech in 2002, and Financials in 2009.

Meanwhile, the financial condition of such companies has never been better. In 2005, the top five holdings in the ITB had a combined $3.9 billion in cash and $13.9 billion in debt. Today, they have $7.5 billion and $10.8 billion respectively. By issuing new shares and dramatically cutting costs, the homebuilders have restored their balance sheets. These actions came at the expense of prior shareholders and employees, but new shareholders can benefit from expected re-leveraging over time. Whether or not real estate recovers this year, next year, or in 2013 (agnostic is the only honest position), expectations are so low, and valuations so distressed, that even the most modest stabilization should bring a rebound in share prices. The situation with homebuilders looks most like regional banks after the savings and loan crisis of the early nineties-when post-crisis price collapses, consolidation and retrenchment set the stage for an enormous rally over the subsequent decade.

You don’t want to overdo it with Homebuilders. As classically cyclical businesses with few competitive barriers to entry, they are not the type of business we normally like. There’s also no guarantee homebuilders will have the same fate as the regional banks, but history suggests that they will. While a couple of the weakest homebuilders may still go bust, the vast majority should easily make up for it.