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(Andrew Vaughan/The Canadian Press)
(Andrew Vaughan/The Canadian Press)

The Buy Side

Beaten up industries worth a second look Add to ...

Since April I've been harping on the market being precarious, and on the need to be cautious and to make a list of bargain prices for mainline stocks. Because no matter the environment, long-term investing relies on "reversion to the mean," which means buying good companies below their fair value, if and when the market hands them to you. To do this, however, you should be able to answer the following three questions:

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1. How do we know which stock is well below its fair value?

2. How do we know this fair value is still valid?

3. Finally, even if we can answer 1 and 2, what is reasonable future fair value of this stock, and what price should we be willing to pay for it?

The first question can be answered by screening for mainline stocks trading at low multiples of earnings, book value, etc., compared to their past history.

The second can be answered via diligent analysis, to see whether the business has indeed a chance of recovery to past profitability (as measured by return on equity, margins, or what have you).

The third task is to estimate future BV, EPS, etc., (minding potential dilution due to needed equity financing, etc.), and then estimate what are reasonable future multiples we can put on them.

That's it. The rest is 90 per cent due diligence and 10 per cent art. (Though grey hair helps.)

Let's go through an example, then. First, choosing the down-and-out stocks: If you have access to databases and screening techniques such as Capital IQ, you can use them; however, there's a simpler method - just look for the most disparaged, dejected, and disrespected industry of the moment.

Why do I say "industry," and not "stock?" Because individual stocks may have individual troubles, so the solution may also often be individual. But when an entire industry is seen as undesirable, it may imply a potential coming trough, and then I can become very interested. To get a feel for industries in or out of favour, I often look at analysts' opinions of the S&P 500 stocks, because these are big, mainline companies, so collective disdain is usually telling.

And which industry is so disparaged today that no analyst likes it?

Clearly, home builders. Why are home builders shunned by analysts? Let me count the ways. First, they lost a ton of money following the mortgage debacle - especially since most went into financial services. By that I mean many were borrowing, then selling mortgages to home buyers, hoping that the "spread" would increase their earnings. Instead, it sank them when homeowners defaulted. Second, there's a glut of unsold homes in the U.S., so who needs companies who build more? Third, pockets of unemployment are rampant, especially where there's a glut of unsold homes. Fourth, although interest rates have not begun to go up, money supply is beginning to be squeezed (look at the U.S. Federal Reserve's FRED data). Fifth, demand for homes is at a 47-year low. Sixth ... but why belabour it? With the glut of unsold homes, big losses, and poor immediate prospects, home builders seem like a foolish research target.

Or is it? Will the home building industry never recover? And if one day it does, which home builders shall survive? And what would be a fair value for the survivors?

Take Pulte for instance. The stock rose from about $1 (U.S.) in 1990 to about $45 in 2005. (Talk about a growth story, that's a 45-times return in 15 years!) Then it crashed to $8 and change today. All analysts' EPS forecasts are negative (though they have been inching up).

But forget estimates for now. What's PHM's fair value? Can we estimate it? Let's go for the Warren Buffett method: estimate future book value and future ROE, and from this, potential EPS, then apply the average historical P/E.

Now please note: this is not yet analysis, just a Fermi-type estimation to see whether it's worth our while to spend time on analysis here. And is it?

Let's see, now. BV today is about $8 and change - about the same as the stock. Over the last few years it grew at about 12 per cent per year, but then BV declined with losses. ROE - that is, EPS divided by BV - ranged from low teens per cent to about 20 per cent, before turning negative. If we assume BV grows to about $10 to $12 in 5 years, with ROE optimistically at 13 per cent - midpoint of the recent range - then $1.30 to $1.50 in EPS in a few years is not outlandish. And if we apply earnings multiples of 10- to 12-times, we get a target of $13 - $18. Analysts see $9 - $15 as the target range. So we are not far off. However, their target is one to two years hence; ours is five years out. So, for a stock price of $8, this is too skinny for me. For this target I'd like to see the stock in the mid single digits before I'm interested.

Note again, I am not saying PHM should get there, nor that I'd automatically buy it if it does. Only that it may be worth doing some more analysis here - and it may be worth looking at other home builders as well, despite their being universally disparaged.

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