During any market advance, there are stocks that trade higher because they have significant merit, and of course there are those which are just along for the ride. The axiom “a rising tide floats all boats” certainly applies for at least a time as professional and personal investors alike grasp for exposure to a rising market. But it has also been said that “a bear market returns capital to its rightful owners.” This usually applies to markets where speculative buyers have bid up prices to unsustainable levels, and then when the irrefutable laws of fundamental valuation come back into play, the capital invested quickly disappears. I fear we will soon enter another period where capital is taken away from speculative investors.
One of the areas that seems most prone to a swift decline is the homebuilding industry. From a business standpoint, the environment is definitely getting better. After all, it’s not exactly hard to beat the devastating period builders have endured for the last 18 to 24 months. But while business is beginning to show the signs of a recovery in infancy, the market is pricing in a full-fledged mature recovery and bidding stock prices higher as if they were fully functioning healthy businesses.
Take MDC Holdings Inc. (MDC) for instance. The stock has no official PE because the “E” part is nonexistant – the company hasn’t earned a dime since sometime in 2006. And this year analysts expect the company to lose another 44 cents per share. But of course losing 44 cents is good news considering the fact that the company lost $10.44 per share in 2007, and lost $8.25 per share in 2008. MDC is trading at roughly 40% of its high logged in 2005, and the value of its stock still appears to be very high.
If you read the company’s fourth quarter earnings report, you will immediately see that the company reported impressive earnings. But it quickly becomes apparent that the earnings are entirely due to a tax code revision that allows the company to carry forward losses more than 2 years. This is definitely a positive announcement for the company, but not one that will cause the long-term health of their business to improve.
The revenue picture is one that investors should look at carefully. Quarter after quarter, the company has seen sales decline when compared to last year. However the fourth quarter actually saw a pick up in sales – which is good news right? Well it’s actually not all that impressive considering the fourth quarter of 2008 featured a decline of 62%. So one would hope that MDC could at least match this dismal performance and even exceed it to a small degree.
MDC is not without signs of improvement. The company’s new orders for the fourth quarter totaled 637 homes which is much better than the 350 homes ordered during the fourth quarter last year. Separately, the backlog of homes under contract has risen to 826 compared to 533 homes to end 2008. Hopefully the majority of these contracts are honored and buyers are able to secure financing (although mortgage standards continue to be relatively stringent).
Investors who decide to buy the company based on the book value of the company’s assets need to realize that property values fluctuate wildly because of the illiquidity in the market. MDC holds more than a half billion in “housing completed or under construction” and “land and land under development.” The value of these properties has been revised lower in the past due to market conditions and if another wave of foreclosures hits the market, this valuation will likely be hit again. The stock price requires investors to pay 150% of book value to own the company and book value still seems suspect in my opinion.
I wouldn’t be surprised to see MDC trade down to parity with book value (near $22.75) or even lower if management takes another write down on inventory levels. Sure, the market for real estate may be improving, but with a shadow inventory of foreclosed properties being sold by banks, and many consumers stuck in homes they can’t afford, I believe the environment will be challenging for homebuilders for years to come.
FD: Author does not have a position in MDC
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