Friday, April 21, 2006

Home Sweet Home

People will always need a place to call home. Indeed, housing has been a hot topic of discussion lately. The consensus goes something like this: The Fed is raising rates which will render mortgages expensive for consumers. Cracks are beginning to show in the foundation as orders for new homes are on the decline and new home sales are hitting their lowest levels in recent years. Of course, this is supposed to spell doom for homebuilders such as Pulte Homes (NYSE: PHM) and Centex (NYSE: CTX).

Wall Street's reaction has been swift and punishing. Homebuilders stocks have retreated from their highs and are trading at extremely low P/E ratios by historical standards. In fact, the hombuilders have the lowest P/E of any major industry sector on the stock market (Dreman anyone?!). On a forward P/E basis, the leading companies are trading at a 2 to 3 times discount to the S&P 500. But people forget that these companies have been around for decades and have been through many cycles. That experience has served them well as they have transformed their businesses into conservatively capitalized enterprises, managing cash while focusing on shareholder returns. Just look at the return on equity they are delivering. They don't own excess land and are dominant enough to drive a wave of consolidation through the sector should things go awry and the smaller rivals begin to falter.

Don't forget that the Fed should be close to ending its string of rate hikes. That should lessen the severity of the gloom and doom scenario predicted by naysayers who believe higher rates will destroy the consumers' appetite for homes. Meanwhile, the economy seems resilient and wages are on the rise giving the consumer enhanced buying power. Sure, the housing market in some markets is frothy to say the least and homebuilders themselves admit as much. But a softening market or a gradual leveling out is the more likely scenario than a severe crash.

It is practically impossible to call a bottom on a stock. Pulte and Centex are the two largest homebuilders by revenue and are both repurchasing shares. Their book value (which is a conservative estimate of the liquidation value for these companies) puts a nice support under the shares. I think the downside is manageable while there could be a 25% to 35% upside in the shares.

The Contrarian

"Nobody beats the market, they say. Except for those of us who do."
David Dreman January 21, 1998

You would not be a value investor without having a contrarian edge and a thorough understanding of investor psychology. The contrarian of them all is David Dreman. He has been a Forbes columnist for many years and is considered the father of contrarian investing.

In Contrarian Investment Strategies: The Next Generation, Dreman reminds us that the opinion of a Wall Street analyst is not gospel. He will also remind you that markets are far from efficient and that investors overreact in predictable irrational ways which you can profit from. He presents compelling data and statistics which show low P/E, low P/Book and low P/Dividend stocks have outperformed the market over time. He recommends sticking with high quality companies and staying away from bonds which have seriously underperformed stocks when adjusted for inflation and tax.

His 41 Contrarian Investment Rules are valuable reminders of how hard it can be to avoid the herd mentality. Here are a few:

Rule 1 - Do not use market-timing or technical analysis. These techniques can only cost you money.

Rule 2 - Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits. (AA note: for more on the powers of rapid cognition without the need for exhaustive deliberation, you should read Malcom Gladwell's Blink)

Rule 6 - Analysts' forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimates.

Rule 10 - Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

Rule 11 - Positive and negative surprises affect "best" and "worst" stocks in diametrically opposite manner.

Rule 14 - Buy solid companies currently out of market favor, as measured by their low P/E, P/Cash Flow or P/Book ratios, or by their high yields.

Rule 20 - Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

Rule 25 - Don't be seduced by recent rates of return for individual stocks or the market when they deviate sharply from the past. Long term returns of stocks are far more likely to be established again.

Rule 29 - Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don't sell.

Rule 30 - In a crisis, carefully analyze the reason put forward to support lower stock prices - more often than not they will disintegrate under scrutiny.

Rule 32 - Volatility is not risk. Avoid investment advice based on volatility.

Rule 41 - A given in markets is that perceptions change rapidly.

Mentally, these rules can be hard to adhere to especially when the value stocks you own do not participate in hot-stocks-du-jour rallies. A disciplined and patient value investor with a contrarian psyche is a rare breed. But I believe such an investor has the best shot at mastering the stock market. It's a good thing markets are not efficient after all.

Thursday, April 06, 2006


A few days ago a friend asked me about my opinion about Intel (Nasdaq: INTC). I have been an Intel shareholder for many years and I have continued to add to my position even as the shares have continued their rather dramatic decline recently. At current levels, Intel is not your pure value play, but it's getting there. I believe the shares provide a reasonable Margin of Safety and would expect any further declines to be relatively moderate from these levels. The company is buying its shares back aggressively and I expect will continue to increase dividends. Here is an excerpt of the email I sent back in reply earlier today.

“Intel is definitely a disliked stock right now, which is why it’s on my radar screen. The company has had some missteps lately. AMD (NYSE: AMD) is hot on its tails and has been taking share especially in server market. And there are rumors DELL (Nasdaq: DELL) might soon start using AMD chips and stop being exclusive to Intel. All these are negative overhangs on the stock. Plus you have the likes of Texas Instruments (NYSE: TXN) and Marvel (Nasdaq: MRVL)) which seem to have products which are better targeted at today’s most popular consumer electronic gadgets. But Intel is not sitting still either. They continue to spend on R&D and have managed to stay ahead of AMD in cranking out chips more efficiently, leveraging the company’s economies of scale. AMD has made up some ground though. Intel is also diversifying into other areas as evident by their recent partnership with Micron. Not to mention the fact that Microsoft’s Vista will be rolling out next year (hopefully!) and it should bring with it a whole new round of upgrades. Finally, there are the emerging markets, where Intel and AMD are trying to gain a foothold, and which will eventually present the companies with growth opportunities. Worst case scenario, by the way, is that Intel will use a price war to crush AMD. A strategy it has used in the past.

Intel remains the powerhouse of the industry. The company has solid Return on Equity and profit margins (although some think the margins have peaked for the company). The stock pays a 2% dividend at these levels. Not bad and I think they will continue to raise the dividend. On a forward P/E basis, the stock is trading at around 18.5 times 2006 projections and about 15.2 2007 projections. That is compared to the S&P 500 which is trading at 16.1 times 2006 estimates and 15.5 times 2007 estimates. So the question is, does Intel deserve a premium multiple to the market. My position is that the answer is yes. So you could buy the stock just on this basis if you are a long-term investor.

Here is another way to look at things.

Is the stock a value play? In my opinion, it’s not a true value play but if you believe Intel can continue to grow and earn above its cost of capital for every additional dollar of investment, then there might be a reasonable margin of safety provided by that growth assumption. Based on my calculations, Intel is currently trading at about 1.8 times adjusted book value. Not the cheapest it has been historically. Also, I have calculated the company’s Earnings Power Value to be about $80 billion dollars. EPV assumes no growth. Intel would be a beautiful value play if the market cap was closer to this number, because then you would be getting the growth for free. That was the case for Intel in the early ‘90s, for example.

So on this basis, we would not buy Intel today as a pure value play. But we should consider the possibility that growth may provide us with a Margin of Safety above and beyond the EPV we have calculated. I have made the following assumptions (which you could challenge of course), but I think they are reasonable:

Return on Equity: 23%
WACC: 12%
Growth rate: 8%

With those assumptions, I get a Present Value/EPV ratio of about 2. This means Intel’s PV = 2 * EPV = $160 billion or about $26.3 providing us with a margin of safety of 36% over the current price of $19.3.

The closer the market cap gets to my EPV figure, the more comfortable I will be. But for the market cap to be equal to EPV, the stock would have to drop to $14. Possible? Sure. I think it is unlikely, unless the entire market crashes of course (but that is just systematic risk we can’t do anything about). Could the stock hit $17 or $18 in the near term? Sure. But that is why I think you can take a half position now and the rest after the earnings announcement.

One more thing to think about. This company is a cash machine with a squeaky clean balance sheet. They can take on more debt if they want to and they might end up paying a special dividend a la Microsoft (Nasdaq: MSFT) if they can’t figure out what to do with that cash. The stock traded at these levels back in 1996!”