Tom A's Stock Picks

Fractional Valuations

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When a stock trades for a fraction of its future (or former) value, you are right where money can be made or lost in large amounts, a strange logical landscape where normal analysis seems to break down. You don't need a computer or a calculator, all you have to do is divide or multiply by 2, the question is how many times you do it; also, whether you get it right as to which way it's going to go.

I suppose we have all had experience with it - my most successful case involved Corning (GLW) which made a run from over 100 in 2000 to under 2 in 2002. I started buying at 13, added at 9, and bought as much as I dared at 2. I sold out at 9 in 2003, quadrupling from my buy at 2, and ever since I have been hoping to find myself in a similar situation. It's easy to look at a stock's price history after the fact and notice that a person who had the luck or skill to buy at the low point could have doubled, quadrupled, or octupled their money within a few years. But having the courage to get in at the lowest point, with enough invested to make a difference, is nowhere near as easy.

I have been thinking about shares prices as fractions, because it accurately describes the behavior of my two troubled cases, bond insurers MBI and ABK. Take ABK.

ABK has made a run from from over 90 in May last year to a low of 3.08 in April this year. I bought in at 25, 8, and then at prices around 3 and 4 recently. What drives that kind of a swoon? Is it reversible, and if so, how does that happen?

In ABK's case, it was expected losses from insuring sub-prime backed ABS, exacerbated by the uncertainty about their triple A ratings and the extent of dilutive equity offerings that would be needed to maintain their rating, all of it magnified by fear on the part of shareholders and greed on the part of short sellers. So, if the losses will cut it in half, and the share offerings will dilute that by half, and those who provide capital need to double their money, you are at 1/8 of your beginning point. If short-sellers expect to hammer away at the shares while the offering goes forward, you could cut it in half again, so now you are at 1/16. What if this cycle repeats itself? Do the facts fit this scenario?

ABK's adjusted Book Value stood at 55.20 as of 12/31/2007, prior to the company raising capital by selling shares. Shares traded as low as 4.50 in January, 1/12 of adjusted book value, and the equity offering priced at 6.75, more or less 1/8.

When ABK announced their 1Q 2008 earnings, adjusted book value stood at 15.83. The losses were worse than many expected, which tanked the stock to as low as 3.08 - less than ¼ of the metric. An analyst at Goldman Sachs issued a proclamation that ABK would need to raise capital, and that the shares were worth 2 - again, 1/8 of adjusted book value. Looking back to your starting point, 55.20, 1/16 of that would be 3.45 and the share price got as low as 3.08...

As you can see, this is a very negative kind of math, how many times can you cut the thing in half and have anything left. Like Zeno's tortoise, you know it eventually reaches it goal, or gets to zero in this case. There has been some similar math on cases like WM and NCC, banks that had big losses and needed to raise capital. Sometimes you need to divide by 3 instead of 2, that could make the math more challenging, maybe you couldn't do it in your head.

Does the thing run in reverse? ABK asserted in their earnings press release, and again during the conference call, that they expect to meet Moody's target capital by the end of the 2nd quarter and that they have no intention of issuing shares to raise capital. Moody's commented that the losses incurred were within their stress case scenario, which makes it possible that they will not require ABK to raise additional capital within the near future. If there is no need to raise additional capital by a further dilutive offering, shouldn't the share price quadruple? Remember, you divided by 2 for the dilution and again by 2 because the new shareholders would expect to double their money.

If there isn't going to be a dilutive stock offering, the short-sellers have lost a large part of their power. They were going to cut it in half; so, can you double it again?

What if the expected losses, consisting of mark to market that may revert, do not materialize? They are included in the adjusted book value, if they revert, shouldn't you double it again? Remember, that was what started the ball rolling to begin with.

I like the math better when it's doubling instead of dividing by two.

Tom

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Has Berkshire Lost Its Hathaway?

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How is Buffett doing in his plan to take over the municipal bond insurance market? The Berkshire Hathaway shareholders meeting featured a discussion of progress to date, as well as the potential risk to the financial system posed by the large amount of outstanding credit default swaps. For a person who once characterized derivatives as financial instruments of mass destruction, Buffett is very comfortable with them, remarking that Berkshire has written two types of them and expects to make very good money doing so. These instruments aren't that scary, apparently, when he is using them.

On bond insurance, Berkshire wrote 400 million premium during the first quarter, more than any other player, and possibly more than all others combined. Buffett was very pleased with Ajit Jain's performance: he was able to command a premium of 2.25% in order to backstop insurance that was originally written at 1%. That to me illustrates Buffett's approach - he always has extra capital and employs it to write risks at generous premiums when market conditions permit. This opportunitic approach serves him well but may limit Berkshire's long term prospects in the muni-bond business, as other players return to the market and rates return to normal.

There has been a lot of concern lately that the counterparty risk on the 60 trillion of CDS outstanding as of the end of last year may lead to a collapse of the financial system. Asked to comment on the topic, Buffett's response seemed to lean toward the idea that it's a zero sum game: there will be winners and losers, but to the financial system as a whole the outcome doesn't make any difference. He doesn't think the amount of CDS in and of itself will cause a problem, although it would exacerbate chaos in the event of financial stress from other sources, such as the Bear Stearns crisis.

Buffet's partner, Charlie Munger, endeared himself to me by commenting that the amount of CDS insurance on some bonds greatly exceeded the face amount of the bonds, leading to efforts to make the loss bigger so the payout would be bigger. Then he talked about how in life insurance it used to be illegal to buy insurance on people you didn't know, to get a big payout on their death. This plays to my pet peeve, the moral hazard created by permitting credit default swaps without any requirement of an insurable interest. Munger criticized this is reflecting inadequate regulation, an opinion I heartily agree with.

Apparently recording devices are not allowed at the Berkshire Hathaway shareholders meeting. I found a fairly detailed set of notes on Seeking Alpha, where I have occasionally been able to find transcripts of earnings conference calls. After reading the notes, one thing that stood out to me was that a large part of Buffett's strength comes from always having extra capital. He has been criticized recently due to the amount of cash on hand at Berkshire, but over the years he has been able to achieve a lot by always being fully credible and always being able to write a check.

Berkshire is a formidable competitor in the triple A rated bond insurance business, because total crediblility of the insurer is necessary to achieve its desired effect of reducing the borrower's interest costs. While I don't think the realities of competition will enable Berkshire to maintain the very high premiums they have received to date, it is possible that this credibility may crate a situation where Ambac (ABK) and MBIA (MBI) will need to go to great lengths to demonstrate that they are equally as solid. One thing is certain - Berkshire is a responsible competitor and will not write coverage at inadequate premiums. That may make the business more profitable for all insurers going forward.

Buffett's words of wisdom are always worth reading - but, is Berkshire Hathaway a great investment today? Buffett himself thinks returns will be less in the future than they have been in the past, mainly because given Berkshire's size there simply aren't enough big opportunities out there to generate outsize returns. He said he would be happy if they could earn 10% pretax, including dividends - margins less than in recent years.

First quarter 2008 results were not impressive: revenue was down, primarily due to unwillingness to write reinsurance at inadequate rates; and EPS were down, primarily due to mark to market losses on derivatives, which management does not regard as significant or permanent. The property and casualty business is cyclical, and in the current competitive environment Berkshire's growth and earnings will be affected.

Berkshire has traded at a well-deserved premium for many years: but given the difficult insurance environment, decreasing margins and growth will put pressure on share prices. While the successful entry into the bond insurance business is a coup, earnings were not material to Berkshire's results and will not be for some time. I would not buy Berkshire at today's price, which seems to reflect unrealistic expectations about future growth and profitability.

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AIG - more Mark to Market

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American International Group (AIG) is the nation's largest insurer, and operates on a global scale. The company just reported a very large loss for the 1st quarter, 7.8 billion, and in addition to bearing the blame for the market's poor start this morning was rewarded with downgrades from S&P and Fitch. The company plans to raise 12.5 billion in order to fortify their balance sheet: as they explain it, to restore their capital cushion to around 20 billion which they consider optimal. The board voted to increase the dividend by 10%, explaining that they think the long term future is good. I listened to the conference call, while watching the stock trade down about 6% in morning trading.

AIG is heavily involved in Credit Default Swaps on RMBS and CDOs - bond insurance. They reduced their exposure to sub-prime backed RMBS starting in 2006 and have very little of the dread 2006 and 2007 vinatages. The business is essentially in runoff. What amazed me was that the company has 20 billion in cumulative mark to market losses on this business but only expects to pay between 1.2 and 2.4 billion in actual losses.

So, they post 18 billion in losses they don't really expect to pay and then they plan to raise 12.5 billion of capital to fortify their balance sheet. Existing shareholders, of which I am not one, will have to bear some dilution to make this happen. Mark to market accounting (in this case) does not satisfy the primary objective of accounting, which is to accurately reflect the financial status of the company. Various analysts will have a field day speculating as to what the actual losses will be.

U.S. Commercial Lines, another large segment of their business, is in a down cycle of excessive competition leading to reduced premiums and profits. Investments include a large amount of RMBS, and they took markdowns on that too.

I have followed AIG for over a year, under the belief that it is a very large, strong company and will eventually become a good buy. The stock has gone from a high of 72.97 to as low as 38.50 during the past year, and was trading around 41 this morning. At today's prices it is trading very low to its 5 year average earnings or to its new, reduced book value. Given that much of the recent losses are mark to market, and indeed fantasy if you subscribe to AIG's opinion as to the ultimate losses on bond insurance, this is an interesting value candidate.

However, the fundamentals in the US P&C business are deteriorating, losses on sub-prime are still questionable, and the equity capital raise will be dilutive. There may be more punishment in store. I think buying at today's price would be profitable long-term, but suspect that it will be possible to buy this stock at a better price over the next few months.

Tom

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MBIA's road to recovery starts here

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MBIA (MBI) reported a first quarter loss of 2.41, or 13.03 per share. This was not surprising, given the equally horrendous results posted by Ambac (ABK) and American International (AIG). It is important when looking at results for any of these insurers to distinguish between Mark to Market and actual expected losses. Forming an opinion of the value of the shares requires 1) an estimate of future losses from insuring mortgage backed securities, 2) an opinion as to whether they will need to raise dilutive equity capital, and 3) a time frame within which they can restore credibility and resume writing new business under profitable terms.

My preferred metric for MBI and ABK has been adjusted book value. This is a nonGAAP statistic furnished by the companies which includes the future value of unearned premiums and future installments. Bond insurance policies run for 30 years or more and both companies have substantial and predictable future earnings from business that is already on the books.

Readers may recall my concept of "phantom" book value, which restores mark to market losses to the extent they understate amounts that will be realized in the future. MBI has come up with a more formal name for it: they call it Analytical Adjusted Book Value, and provide it in their press release. It adds back mark to market losses on insurance provided by Credit Default Swaps to the extent they exceed estimated impairments.

I had never thought of giving this idea a more respectable name: but now that I think of it, something like "Enhanced Core Book Value" would have been catchier, or perhaps "Extended Entrepreneurial Book Value." Maybe "existential book value" would have added an aura of intellectual sophistication.

Consider these alternative computations for MBI, from their press release: Book Value, 8.70; Analytical Book Value, 24.18, Adjusted Book Value, 26.67; Analytical Adjusted Book Value, 42.15. The shares were trading around 9.00 before the market opened, but were up yesterday over 10.00 at mid morning. Depending on which version of book value you prefer, the price to book varies from .25 to 1. The same statistics for ABK would be 4.52, 15.83, 16.00 (a guess) and 35.60 (the last is my computation.) ABK was trading at around 4.40 this morning.

Mark to market is amazing in its implications for the reported financial results of these bond insurance companies. It seems slightly unreal, how you can get from a book value of 8.70 up to 42.15, but to me the latter value is far more rational, because it reflects management's best estimates of value.

But wait! there is more - MBI's mark to market losses were reduced by 3.6 billion to reflect the market's perception of their creditworthiness. The fair value of the liabilities is less because of the perception that they may not be able to pay their claims. That is correct, according to GAAP, but seems strange, coming from a triple A rated company. Sometimes when you stretch the fabric of reality far enough it unravels: it rips, it runs, and cannot be restored.

Any of these companies would be an open and shut value case except for one main difficulty: management's credibility - do they actually understand their business? Do they have any visibility into the future? After all, these are the people who looked at the whole sub-prime/mortgage crisis in August and just didn't see any problems. In November they saw problems, but the magnitude was manageable. Now in May we have massive mark to market losses, coupled with the assertion that they may not be reflective of future claims, backed by impairment estimates which may be as little as 1/10 of what the market implies. In the case of AIG, they as much as tell you the losses are imaginary but then they plan to go ahead and raise the capital anyway? Who to believe? I believed ABK & MBI in August and again in November, to the detriment of my finances.

MBI's Gary Dunton and ABK's Bob Genader have been replaced by Jay Brown and Mike Callan respectively. MBI has made substantial changes in the underwriting staff, and ABK has restructured their risk management. Most of those who provided the former information, or made the poor decisions, are "no longer with the company." The models being used to project stress scenarios have been updated and revised. The previous ratings-driven methodologies have been replaced with drill-downs and roll-ups, where the securities involved are analyzed by reference to their own performance as well as realistic expectations for future home price deterioration, delinquencies, etc. The rating agencies have made substantial strides in their methods also. Based on these changes, I think current loss estimates are a lot closer to reality.

MBI stated the assumptions that drive their numbers, which include a further 10 to 15% home price reduction from today's levels and a housing market that stabilizes in late 2009. The losses reported are designed to be such that they will not need to be revised unless the assumptions about the future are revised. If the market develops an improved opinion of MBI's ability to pay their claims, the loss estimates will increase accordingly. I think ABK's 1st quarter losses, reported last month, were also intended to be large enough to prevent the need of repeated upward revisions in future quarters. Nobody knows how the housing crisis will play out, but after a study of the S&P/Case-Shiller and OFHEO HPI indexes, both of which measure house price changes, I think the 10-15% further decline from today's prices is realistic.

S&P and Moody's responded to ABK's horrendous losses by noting that they fell within the "stress case" scenario and as such no immediate further review of their ratings was needed. Assuming they respond along similar lines to MBI's announcement, both MBI and ABK will be able to replenish their capital by remaining in "hibernation" - limited new business. That would mean no more punishment for shareholders from further dilution due to the need to raise equity capital. MBI's conference call materials assert that their results fall within agency stress scenarios and that they will meet Moody's triple A target capital during the 3rd quarter.

The viability of these businesses going forward rests on restoring the public perception of their financial strength and ability to pay their claims. A few quarters of stable operating results would go a long way toward making that happen. As time provides more information on the mortgage crisis, the values of MBS should stabilize, probably at a level somewhat higher than today, and future mark to market losses should be less extreme. The benefit of their insurance - that their policyholders received timely principal and interest - will speak for itself. The financial guarantee market place will change, but there will be ample profits to be made, because so much capital has been removed from the competition. Meanwhile, there is a heightened awareness of risk and the need control it by insurance.

This requires patience, but from today's 10 per share MBI, under an ideal scenario, should trend upwards toward the 42 Analytical Adjusted Book Value per share, perhaps over the next 3 years. The bonus structure for the employees starts at a share price of 12.50 and maxes out at 40. I am guessing that when they developed this structure the board set goals that were reachable, if optimistic. ABK could develop along similar lines, moving from today's 4.40 to around 30 dollars. The most recent earnings announcements may mark a turning point for bond insurers.

Some will question my willingness to use nonGAAP metrics, harking back to the days of the dot.com bubble, when various flavors of nonGAAP were widely used in order to gloss over unpleasant information. I still own a few stocks where management makes heavy use of nonGAAP metrics: for example JBL reports "Core Earnings" which conveniently disregard the expenses of option compensation and as well as restructuring charges. My attitude is, I will work the numbers to provide the information I need to make my evaluation: if management performs the computations for me, so much the better. In the case of MBI, book value according to GAAP leaves out significant financial assets: it also overstates significant liabilities. Analytical Adjusted Book Value, or "phantom" book value as I think of it, is useful information, when properly understood.

Estimating future earnings is difficult in a case like this. If the mark to market losses do revert over time, reported earnings will be overstated to the extent recent losses have been exaggerated. Historically MBI had return on equity (ROE) that would average 12%. Applying that to GAAP Book Value after adjusting for mark to market, I would guesstimate that normalized earnings will be about 3.00: at a P/E of 10, that would value the shares at 30.

Actions in my SLO portfolio. Both ABK and MBI tanked last month on ABK's earnings. When that happened, I added to both positions but later took some profits on ABK as the shares rebounded. I had planned to buy some more of both after MBI reported, figuring they would tank again, but MBI was up yesterday and ABK was trading more or less even. The "bad news is good news" rally on MBI may reverse temporarily, and I will be watching for an opportunity to enlarge my position at favorable prices.

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House Prices - A Tale of Two Indexes

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There are two indexes which reflect the change in house prices over time - the S&P/Case-Shiller Home Price Index (S&P/C-S) and the Office of Housing Enterprise Oversight House Price Index (OFHEO HPI). These two indexes provide different views of home price appreciation/depreciation over the past 7 years. I noticed a reference to this situation in the WSJ and the following discussion is the result of my research into these two indexes.

Case-Shiller uses a weighted-repeat sales methodology: by compiling data on home sales and matching transactions for the same house, sales pair are created, reflecting an increase or decrease in price. These in turn are aggregated into an index. The data is compiled by Fiserv, Inc. Considerable care is take to eliminate fraudulent or non-arms length transactions, and only actual purchase data is used - refinancing is ignored. Because a longer time interval between sales increases the chance that renovations, additions, or deterioration has changed the house, pairs that are closer together in time are given a larger weight.

OFHEO estimates and publishes quarterly house price indexes for single-family detached properties using data on conventional conforming mortgage transactions obtained from the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association ("Enterprise data"). In its original form it includes both purchase and refinancing data, while Case-Shiller is purchase only. Using this data set, a similar weighted-repeat sales methodology as described above is used to construct an index.

Both indexes come in a number of versions. For the purposes of my research, I compared the S&P/C-S Composite 20, which covers the 20 largest metropolitan areas, with OFHEO's U.S. all-transactions HPI, which includes purchases and refinance mortgages. Using a ratio to set them both at 100 as of 1/1/2000, I graphed them together quarterly, as follows, ending on 12/31/2007:

Since 2000, the S&P/C-S has taken a separate path, increasing more rapidly up to the middle of 2006 and then converging back toward the OFHEO over the past year. Probably they converged at the end of the first quarter 2008.

My question is - after the convergence, can S&P/C-S continue on down? Can it drag the OFHEO index down with it? It would be a lot easier to make the call if information were available as to exactly what transactions are shared between the two datasets. Also, the choice of 12/31/1999 is arbitrary, although changing that by a year or so would not make much difference in the comparison.

How to explain the difference in the two indexes? One possible explanation - the data consists of paired transactions, so if either leg was not a conventional conforming mortgage the pair will not be in the OFHEO index. I would guess that for the Enterprise transactions the price was fairly realistic. S&P/C-S may include sub-prime, Alt/A, Option ARMS etc. where transactions were at inflated prices. OFHEO makes an effort to reconcile the two indexes - I reviewed it and felt they did not fully succeed in explaining away the difference.

Whatever the causes may be, I think it's worth bearing in mind when you read these horrible headlines about how fast home prices are decreasing, that there numerous ways to manipulate and interpret the data available. As ilustrated by the graph above, different results are possible, and some are not as scary as others.

Tom

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Determining Market Level - How high is the S&P?

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My approach to determining market level relies on computing a ratio of the S&P to GDP and tracking its movement over time. Using quarterly data from 1990 to the present, I compute the ratio, assume it is lognormally distributed, and express the relative level as a percentage from 1 to 100. Here are some results of this exercise:

As an example of how I apply this line of thinking, on March 17, when the S&P stood at 1,276, I felt the market was at 48%, right around the midpoint. To be comparable to the low point in 2002, it would need to go down to 1,100, another 12%. Guessing that 1,100 was the minimum prospective lowpoint, I went all in because I could handle another 10% drop if it occurred. At Friday's close of 1,425, the S&P is above its midpoint, at 63%, by no means at nosebleed levels. A really sickening bottom could see S&P as low as 800.

I use this method because it walks around the issue of profit margins. Those who tell you the market is cheap relative to its earnings neglect to add that profit margins have recently been at historical highs and have a long way to drop. Over the long run, when stock prices are high relative to GDP, it reflects that business prospects are good and stocks represent a valuable claim for a slice of the pie.

Also, the 2002 low point was not really all that low. Remember how the Fed kept cutting interest rates? This intervention was successful and prevented the market from reaching lows comparable to the early 90's. So we really haven't seen a serious bear market yet this century. If Stagflation develops and leads to a combination of low profit margins and low P/Es, it could be a long way down. On the other hand, S&P 2,000 is reachable - if we avoid a serious recession and solar/alternative enegy develop rapidly enough to ease the pressure from the cost of oil, new era thinking could set in.

Tom

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BLG - placing insider buys in context

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William P. Smartt, the CFO of Building Materials Holding Corp (BLG) recently filed a Form 4 with the SEC, revealing that he bought 30,000 shares in the open market at 3.11. Literally, the Smartt money is buying...Can we put that in context?

On May 12, BLG announced 1Q 2008 earnings, a loss of 1.17. This was on top of a big bath in 4Q 2007. I listened to the conference call on 5/14, noting that they are verging on noncompliance with covenants from their lenders and that there was considerable lack of visibility going forward. They have developed a restructuring plan and at the time of the conference call had discussed it with Wells Fargo, the lead bank. They were planning to discuss it with the rest of the banks in the near future.

They have since announced the closing of a number of facilities. And now the CFO is buying. A Vice President of Finance also bought some shares for his IRA a few days ago. My guess would be that discussions with the banks yielded waivers sufficient to make the restructuring plan possible and that the financial people believe it will work.

On the plus side, SG&A is to be seriously reduced, inventory management improved, right now the recent acquisition Select Build is doing their own thing, not as good as what the integrated combination will do. They are under cost pressure from major builders, expected, they intend to pass it on the their own suppliers.

They are gaining market share in that their inflation/deflation adjusted sales figures are down less than new home starts. They have maintained gross margins in the materials side and are pricing installation services to contribute to fixed cost.

I added to my SLO position at 3.06, less than management bought at, and will probably make one more buy if it goes lower. This is a book value ploy, shares are trading for less than tangible book value. With the financial people buying stock, I would guess that BLG will liquidate and/or deploy their assets effectively, leading to an eventual recovery to somewhere in the area of 8 per share.

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What the Cost of Oil Might Do to Airline Stocks

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Warren Buffett is famously averse to airlines. You can't help but wonder if the cost of oil has something to do with his sentiment. He said that between the first flight at Kitty Hawk and the present day, the net return from money spent on airlines is zero or less than zero.

After a misadventure investing in an airline, he declared himself an "aeroholic" and claimed to have an 800 number he can call so someone will talk him out of buying another airline if he ever gets the urge again.

American Airlines (AMR) recently announced they are reducing flights by 10% or more and plan to retire 75 aircraft. They maintain that the airline industry is not built to withstand the rising cost of oil. AMR stock is off 25% today. Other airline stocks have been hammered.

I don't follow the airlines very much - at one time I took an interest in Southwest Airlines (LUV) and came close to buying it. Their operating philosophy at the time involved hedging most of their fuel exposure, and their financials included figures that took you past the gain/loss on hedging fuel and got you to the actual operating gain/loss. Analysis of today's price action in airline stocks focuses on the extent to which they have hedged their exposure to fuel price increases.

Hedging is always a two-edged sword. If it works as planned, it can be a tremendous business edge, as it once was for Southwest Airlines. Hedging, if done poorly, can become ineffective and exacerbate an already bad situation. With the amount of speculative activity in the whole oil, gas and distillates market, it must be a nightmare to control this cost - especially with the rising cost of oil. If I were in airline management, I would resist hedging too much of my fuel exposure for fear of getting caught when the bubble bursts.

With the wisdom of 20/20 hindsight, shorting the airlines would have been a good way to play the oil bubble. Perhaps now there's a good way to play it in the other direction. If oil prices drop, airlines should go up.

Maybe it would be a good idea to back up the truck and load up on the discount merchandise. Or you could just call that 800 number and see if anyone talks you out of it.

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Hovnanian - Positioned for Success?

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Since January, Homebuilder Hovnanian Enterprises (HOV) has rallied from under 5.00 to over 12.00, before falling back to close yesterday at 7.99. Other homebuilders have rallied strongly at times this year, and Monday new home sales unexpectedly posted an increase. Is now a good time to look for value in shares of Hovnanian when doing your stock research?

Going to the SEC website, Edgar online, I checked out the latest filings, and read the forms 8-K, for news, and a prospectus 424B2, for the issuance of 14 million shares at 9.50. On May 5, HOV issued a preliminary announcement of weak operating results for the 2nd quarter of fiscal 2008, featuring a 21% year over year decline in home deliveries and a 41% decline in backlog. Additional write-offs are projected at $200-225 million. On the plus side, the company projects cash flow of more than 300 million for the year and achieved positive cash flow during the quarter.

After doing my stock research, I could see that Hovnanian experienced cash flow difficulties over the past several months, which have been resolved by the issuance of 600 million of 11.5% secured notes in a private placement along with an amended and reduced line of credit from their bank lenders. Given that cash flow is projected to be positive for the rest of 2008; and assuming that the housing market will recover in the second half of 2009, it appears that HOV may be able to avoid further dilution and return to profitable operations.

Because the company has taken substantial write-offs in recent quarters, attempts to value the stock based on EPS are not useful. Working on tangible book value, I took shareholders equity for 1Q 2008, subtracted goodwill and other intangibles, subtracted the additional 225 million of projected impairments, and added the cash from issuing the 14 million shares at 9.50. Increasing shares outstanding to account for the new issuance, I arrive at a tangible book value per share of 13.70. With the shares at 7.99, the price to tangible book works out to .6.

As a general rule, homebuilders are attractive at less than 1 X tangible book, although some value shoppers call for buying them at half that, and only after all write-offs have been taken. Keep that in mind when you're doing your own stock research. At this point, Hovnanian has taken a lot of write-offs, and with cash flow positive, they may be under less pressure to dump inventory to raise cash. Looking at their results over the long haul, tangible book was 4.67 share at the end of 1998. So, from then to now at what has to be a trough, they increased tangible book at 11% per year. Homebuilders for the past ten years have been able to increase shareholder value on this kind of a tangible basis at a rate of 20% per year until the recent slowdown. I think they can do it again over the next ten years.

A word of caution - the noteholders are secured by a lien on all the assets of Hovnanian: so, in the event of further difficulties, they will have preference over the shareholders. Some land that's been written down may be worth something in a few years, but there is always the danger that creditors will get the benefit of the assets, rather than shareholders. In my SLO portfolio, I have Toll Brothers (TOL) and Ryland (RYL), both of which seem safer to me, and both of which are trading at approximately 1 X tangible book. In my personal portfolio, I also hold KB Home (KBH); it also trades at 1 X tangible book. I think HOV is a good investment; but I would keep it small.

Homebuilders generally have been rallying off and on this year. Most observers do not expect housing to recover before the second half of next year, so the rally is possibly premature. On the other hand, the homebuilders have cleaned up their balance sheets (unlike the banks) and they have a clean track ahead of them. Prices have shown a fair amount of volatility, and I have been playing the industry by means of covered combinations. Using options, I sell covered calls, out of the money, when prices are up, as well as a few puts, also out of the money, when they are down. The premiums are pretty good and as far as I'm concerned I'm being paid to do what I want to do: buy low and sell high.

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