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In today's difficult business environment, many investors are looking to play the survival of the fittest theme: the thinking is, if you can identify the strongest players in an industry that is consolidating, you buy the predators rather than the prey. That theme probably will work well in homebuilders such as Toll Brothers (TOL), KB Homes (KBH) and Ryland (RYL).
In reviewing the 2Q 08 Conference calls for the above (transcripts are available at Seeking Alpha), much of the focus of the Q&A was on cash flow/positions and opportunities to build land pipelines at an advantage, by acquiring the assets of small to medium builders, either directly or from banks that may wind of owning them as construction loans go bad.
When things are booming, you could own a homebuilder and look at a steady flow of earnings, but then you look at the cash flow and say "Where's the beef?" The problem is that profits are plowed back into acquiring land. But when the housing market slows, well-run builders continue to sell houses, but do not replenish land inventory, generating cash. Some will sell land, to raise cash and perhaps use the cash later to buy better positioned land at a discount. TOL, KBH, and RYL all have cash and lines of credit which they believe position them well to load their pipelines with land when the timing is right, which will be soon now - they are looking at deals.
There has been a lot of press about how Regional and Local Banks are overloaded with construction loans and will wind up owning the land involved, taking losses. The stronger national homebuilders will be there, to pick off the best assets at bargain prices.
I have been playing homebuilders on a tangible book value basis, looking to buy at a price to tangible book of 1 or less and planning to sell at 1.5 or better. Because writedowns are ongoing, the target has been moving: however, my impression reading the conference calls was that this trend is stabilizing. Also, marked down land will generate larger profits when recovery commences, and some deferred tax assets that have reserves against them may in point of fact be realized if and when the industry recovers. Because of that, I tend to think book values for homebuilders may understate assets in the event of a recovery.
Homebuilders have rallied on and off this year. I have owned TOL and RYL in my Marketocracy and personal accounts since last year, taking some profits when they would rally and then buying the shares back on the dips. As of this moment, I plan to add to the positions on the dips and be a little less willing to sell until they reach my target prices.
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