Annual Growth Rates |
In the next graph, we can see how equity and total real estate market value tended to grow together until the monetary crisis caused homes to be overleveraged. Also, we can see that a homebuilder revenue forecast (on a YOY basis) based only on home equity levels has pretty accurately tracked actual revenue, especially over 2 to 3 year periods.
So, as a broad brush framing for speculative opportunities among homebuilders, I will compare the gains to equity holders, given certain increases in revenues, with forecast valuations based on EV/Rev=1. In the 2000's, firms tended to converge at a Market Cap / Enterprise Value ratio of about 50%, so in this broad comparison, I will assume that operational liabilities will eventually limit market cap to this ratio.
Below is a table of homebuilders comparing several metrics:
The first column compares the potential equity returns of the various major homebuilders, given a growth of 90% in revenues.
The third column compares consensus 2 year revenue growth estimates for 2014-2015.
I think it is interesting that the weighted average 2 year growth rate is under 40%, with a standard deviation of about 16%. This is very low compared to any year since 1996, outside of the crisis years. The 120% break even growth rate suggests that the market has already priced in high expectations for future homebuilder revenue growth. But, this isn't reflected in the conservative analyst growth expectations.
It is a common dilemma in forecasting that forecasts tend to have less variance than actual outcomes. So, I think it is likely that homebuilder prices reflect expected growth that isn't being reflected in published analyst estimates. This could reflect a consideration of highly negative outcomes in the analyst estimate figures, bringing the expected values down, or it could arise from anchoring effects where, in highly volatile contexts, the most accurate forecasts will seem unreasonable ex ante. The market seems to be generally pricing in a bullish revenue expectation.
When I compare the expected returns to equity for each homebuilder to each homebuilder's current financial leverage (estimated with MC/EV), I find a systematic relationship where the less leveraged firms have the lowest expected returns and the most leveraged firms have the highest expected returns.
The expected returns of the safest homebuilders (in terms of leverage) show here as negative because I am using a static valuation forecast of EV/Rev.=1. But, for the least leveraged firms, lower equity risk premiums due to the lower leverage would lift their static relative valuation levels. So, while I haven't engaged in this adjustment here, one can imagine the right hand of this relationship being pushed up by this factor, so that the returns of the least leveraged firms will tend to be higher. My broad measure here does not account for the accumulation of profits during the 3 years elapsed, so if we imagine the healthiest homebuilders earning reasonable profits during this time, as they certainly would, then a firm showing a negative return in my estimate could still provide investors with reasonable expected returns, due to both earned profits and to the higher terminal relative valuation.
In effect, this has simply been a long exercise in finding high forward-beta equities. The forward-betas of the most leveraged homebuilders should be extremely high, since a bear market would probably kill them and a bull market will lead to positive results from operating and financial leverage, including additional leverage through options on land. The hypothetical exposure of these builders to fluctuations correlating with the broader market are probably well in excess of 2.
So, this really is just a regular, crude beta play. Not that there is anything wrong with that. If you are confident in a bullish forecast, especially in a high equity risk premium environment, grab some beta - as long as you know the risks. But, I think when betas get this high, there is an added kick that is available to expected returns. Because, with such highly variable securities, where the terminal valuations will almost certainly be very different than the beginning valuation, the position becomes more of a play on the first derivative of the beta. If these positions go south, beta will be irrelevant. The equities will have little or no value in any case. But, if conditions evolve such that these positions accrue gains, leverage will decrease, operations will normalize, and these firms will start to look normal. I'm not sure that in extreme contexts, this potential gain from changing beta is efficiently priced. And, in extreme contexts, this can be a significant source of gains.
One last point from the scatterplot graph. The most leveraged firms also tend to still have the highest levels of tax assets remaining from the losses they recorded during the downturn. The red series in the graph reflects market cap with tax assets (both on- and off-balance sheet) subtracted. Beazer and Hovnanian had market caps at the end of 2013 barely as large as their tax assets, and both have seen falling market caps since then. And tax assets reflected about half of KBH's equity value. This adds another layer of leverage. To a certain extent, with these three builders, there is a discount being applied by the market to their tax assets, based on uncertainty about whether they will be able to utilize them. This also is a factor which might not be efficiently priced, due to the highly variable, bilateral distribution of probable outcomes. And, this should be another source of additional gains, to the extent that a bullish forecast is accurate.
It might be the case that the market is generally pricing in a bullish expectation for the industry, but is discounting the lowest quality equities using less bullish expectations. Or, it could be that the prices of the safer builders reflect the potential gains that would come to them in bad scenarios from the exit of the less stable builders from the market. This seems unlikely, though, since the riskier homebuilders represent a fairly small portion of the industry.
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