Even Great Investors Like Bruce Berkowitz Make Mistakes

I know, I know, the headline above is not earth-shattering news. Every quarter dozens of the world’s best investors disclose their holdings to the world via SEC filings (granted, the data is about 45 days outdated, but it still gets lots of attention). It’s easy for individual investors to follow well-known money managers into certain stocks, figuring that they can piggyback on their best ideas. I can certainly find far worse investment strategies for people to implement, but it is still important to understand that even the best investors make mistakes. And there is nothing stopping the stocks you follow certain people into from being one of the mistakes rather than one of the home runs.

I think this topic fits right in with my previous post on Sears. Not only is Eddie Lampert the company’s CEO and largest shareholder, but he is one of the best hedge fund managers of the last 25 years. It is perfectly reasonable to assume that a billionaire in his position would be primed to create tons of value for investors. And yet, since Lampert orchestrated the merger of Kmart and Sears, which formed Sears Holdings in 2005, the stock price has dropped from $101 the day the deal was announced to $40 a decade later. Adjusted for dividends and spin-offs received over that time, Sears stock has fallen by about 40%, while the S&P 500 index has risen by about 80% during the same period. Eddie Lampert’s ownership and involvement alone has meant little for investors’ portfolios. Simply put, Sears Holdings has been one of his mistakes.

Interestingly, many of the company’s steadfast bulls point to the fact that another very smart and successful investor, Bruce Berkowitz of Fairholme Capital Management, owns 23% of Sears Holdings. That’s right, Lampert and Berkowitz own or control 70% of the company. Berkowitz isn’t new to the Sears investor pool either; he started buying the stock in 2005 just months after Sears Holdings was created. How can both of these guys have been so wrong about Sears for so long? It’s not a tricky question. Neither of them is perfect and they have made (and will continue to make) mistakes. It really is that simple. Since I have written about Eddie Lampert many times since this blog was launched ten years ago, I think it would be interesting to try and figure out why Bruce Berkowitz has been on the losing end of Sears.

Berkowitz’s background is in analyzing financial services companies, which is why you will often find most of his capital allocated to banks and insurance companies. Those industries are his bread and butter. In fact, Berkowitz’s flagship Fairholme Fund had more than 80% of its assets invested in just four companies as of February 28, 2014: AIG, Bank of America, Fannie Mae, and Freddie Mac. If that doesn’t signal his preponderance for financial services companies, I don’t know what would.

Now, Berkowitz has not been shy about why he invested in Sears Holdings; he thinks there is a ton of hidden value in its vast real estate portfolio. Unfortunately, his trading record in Sears (he first bought the stock during the third quarter of 2005 at prices well over $100 per share) shows that real estate might not be one of his areas of expertise. Warren Buffett has popularized the term “circle of competence” and tries very much to only invest in companies he understands very well. That’s why up until recently (his 2011-2013 purchases of IBM shares bucked the trend) Buffett has avoided technology stocks.

I would postulate that real estate investments do not fit squarely into Bruce Berkowitz’s circle of competence. As you will see below, his trading record in Sears underscores this, but we have also seen it with his massive and long-standing investment in St Joe (JOE), a Florida real estate developer.

Below is a quarterly summary of Fairholme Capital Management’s historical trading in Sears stock (I compiled the data via SEC filings). Of the 24.5 million shares Fairholme currently owns, more than 55% (13.6 million) were purchased over a 15-month period between July 2007 and September 2008, at prices averaging about $110 per share. More troubling is that this was when real estate prices in the U.S. were quite bubbly, coming off a string of record increases (most local markets peaked in 2006 and 2007) and Berkowitz was largely investing in the company for the real estate. The timing was quite poor. All in all, if we assume that Fairholme paid the average price each quarter for Sears, the firm’s cost basis is about $85 per share (before accounting for spin-offs).

FAIR-SHLD

St Joe (JOE) has also turned out to be one of his relatively few mistakes. It could certainly be merely coincidence that both the Sears and St Joe investments were made based on perceived (but yet-to-be-realized) real estate value, but I’m not so sure. Like with Sears, Fairholme Capital Management has a very large stake in St Joe. In fact, Fairholme is the largest shareholder (owning about 27% of the company) and Bruce Berkowitz is Chairman of the Board (sound familiar?). Berkowitz started buying St Joe during the fourth quarter of 2007, around the same time he was massively increasing his investment in Sears. His largest quarterly purchase was during the first quarter of 2008 (talk about bad timing), when he purchased more than 9.2 million shares (37% of his current investment).

St Joe’s average trading price during that quarter was about $38 per share, but subsequent purchases have been at lower prices, so the losses here are not as severe as with Sears. By my calculations (see chart below), Fairholme’s average cost is around $28 per share, versus the current price of about $20 each. But again, not only has the investment lost about 30% of its value, but the S&P 500 has soared during that time, so the gap in performance is so wide that it would take a small miracle for either of these investments to outpace the S&P 500 index over the entire holding period, as the returns needed to make up for 7-10 years of severe losses during a rising stock market are significant.

FAIR-JOE

Now, the purpose of these posts is not to point out the few big mistakes two very smart investors have made over the last decade, while failing to mention their big winners. Any of my readers can look at the history of the Fairholme Fund or ESL Partners (Eddie Lampert’s hedge fund) and see that they both have posted fabulous returns over many years. The point is simply to show that sometimes these investors make mistakes, even with companies where they own and/or control a huge amount of the stock. Just because Eddie Lampert and Bruce Berkowitz are involved in a major way (either in ownership, operationally, or both), it does not ensure that the investment will work out great for those who eagerly follow them. Just because they are smart investors does not mean these are “can’t miss” situations. There are plenty of people who are sticking with Sears because of Eddie, or sticking with St Joe because of Bruce. That alone, however, is not necessarily a good reason to invest in something.

I will leave you with one more example of Bruce Berkowitz making a large bet on a stock outside of his core financial services wheelhouse. At the end of the third quarter of 2008 Fairholme Capital Management owned a stunning 93 million shares of pharmaceutical giant Pfizer (PFE). It was an enormous position for him and was featured in many investment magazines. This single $1.73 billion investment represented as much as 24% of end-of-quarter total assets under management for Fairholme, and all of those shares were purchased over a 26-week period in 2008 (more than 3.5 million shares purchased, on average, every week for six months).

FAIR-PFE

Now, given how large of a bet this was, even by Bruce Berkowitz standards, it would have been easy to assume that this investment would be a home run. But as you can see from the trading data above, Fairholme lost money on Pfizer after holding the stock for only about 18 months. During the fourth quarter of 2009 alone, the firm sold more than 73.4 million shares of Pfizer (after having purchased 73.7 million shares during the second quarter of 2008). Perhaps pharmaceuticals aren’t Bruce Berkowitz’s bread and butter either. Fortunately for him and his investors, however, his prowess picking banks and insurance companies has helped him compile an excellent track record since he founded his firm in 1997.

Full Disclosure: No position in St Joe or Pfizer at the time of writing, but positions may change at any time.

If Your Mortgage Rate Is Meaningfully Above 4.3%, Consider Refinancing Now

Lots of hedge funds are having a very difficult start to 2014. Many were short long-term bonds as a hedge against a correction in U.S. stocks. Despite profit-taking in equities this month, bond prices are surging and yields are falling. The benchmark 10-year treasury bond has seen its yield drop from 3.03% on January 1st to 2.65% today. Mortgage rates have followed suit, dropping to 4.31% (30-year fixed) according to bankrate.com. A 15-year mortgage now costs about 3.35%, nearly a full point lower.

If you have a mortgage with a rate significantly higher (say, 5% or above), I would recommend crunching some numbers to see if refinancing would make sense. I don’t expect rates will stay below 4.5% for very long so this pay be one of the last chances to lock in a great rate. Also, people tend to ignore the 15-year mortgage option (the payment is typically about 50% higher than a 30-year mortgage, despite a lower interest rate), but it could very well be an attractive option for some people, especially if your current payment does not make up a large portion of your discretionary income.

For instance, let’s say you currently have 20 years and $200,000 remaining on a 30-year mortgage at 5% (monthly payment of ~$1,075). If you could handle a payment of ~$1,425 you could refinance into a 15-year mortgage at 3.5% and have your house paid off 5 years early. The increased cost might not be workable for many, but for those looking to cut monthly expenses or retire as soon as possible, a refinance might aid in the process.

Single Family Rental REITs May Have More Potential Than Wall Street Believes

Tom Barrack, the founder of real estate giant Colony Capital LLC, recently appeared on CNBC and made some interesting comments about the single family rental market that I think are worth considering from an investment standpoint. Colony Capital is one of the big private equity firms, along with Blackstone (BX), that has been an active buyer of single family homes, which it intends to spruce up and rent out.

At first glance you might think that the single family rental market would be a solid business model, provided you have experienced people making the operational decisions and savvy financial people ensuring an adequate return on capital can be realized. However, much has been made in the financial media about how the likes of Colony and Blackstone have caused sudden and dramatic price increases in the markets they have entered (mostly those that saw housing prices fall the most, and therefore presented great entry points for those firms who had the capital to buy foreclosed homes). In markets like Las Vegas and Phoenix, price increases have been stunning, with 25-30% one-year increases not uncommon.

There are two ways of looking at these developments. The bearish case is that private equity investors have bid up prices of these homes too much, and the returns they will ultimately achieve from renting them out will be unimpressive. This view seems to be winning the day right now, as several single family rental real estate investment trusts have gone public recently [Silver Bay Realty (SBY) and American Homes 4 Rent (AMH) to name a couple], and they are mostly trading around or even below book value per share. Typically companies that earn a decent return on equity trade at a premium to book value, so investors clearly doubt the viability of the business model right now.

Mr. Barrack, on the other hand, offered a more bullish view on the sector during his CNBC appearance. Now, you can say that since his firm has purchased tens of thousands of single family rental properties, he is simply talking his own book. But given Colony Capital’s track record, I don’t think Tom Barrack’s opinion is something investors should simply dismiss. Besides, he really has little to gain at this point in his career from disingenuously talking up the single family rental market. Ultimately, the renters will determine how well his firm’s investment performs.

Barrack believes the single family rental market will provide attractive investment returns, provided companies due their homework and don’t overpay for their properties. Given how far home prices fell peak-to-trough in the markets where private equity investors have focused, the mere fact that their buying activity has pushed up prices does not ensure that future returns on rentals will be sub-par. It is widely believed that many areas of the country saw home prices reach absurdly low levels (below replacement cost by a wide margin), so it is entirely possible (and I would argue likely) that private equity involvement has merely accelerated the timetable for when these homes returned to a more realistic market value. And assuming rental market demand remains solid, there is likely plenty of money to be made.

On that end, Barrack pointed out that there is a wide disconnect between the valuations of the single family rental REITs (again, at or below book value in many cases) and the large apartment rental REITs like AvalonBay Communities (AVB) and Equity Residential (EQR), which both trade at 1.8 times book value. In his view, the single family rental companies will be able to prove they can earn solid returns over time, and as a result, he believes their stocks will trade closer to the valuation levels of apartment REITs. If that is the case, there is quite a bit of potential in the single family rental market, not just for the private equity firms themelves, but for smaller investors as well who want to play the trend via the stock market.

This investment thesis makes a lot of sense to me, although I admit I have just started digging into these relatively new single family rental companies (my research is hardly complete at this point). That said, it”s hard for me to articulate why the underlying business fundamentals and return characteristics of these two markets would be materially different from one another. After all, is there really a big difference between buying a 50-unit apartment building and buying 50 single family homes and renting those out? Other than slightly higher costs associated with managing 50 separate properties instead of a single, larger one, it seems to me that the business models are very similar and could very well yield similar results.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Housing Market Unlikely To Be Derailed Significantly By Higher Rates Anytime Soon

With 30-year mortgage rates having risen by a full percentage point in recent weeks, investors are selling homebuilder stocks on fears that the rebound in prices that has been in place for over a year will come to a screeching halt. But is that really the correct takeaway with mortgage rates still sitting at just 4.5%? I’m not so sure.

While there is no doubt that rising rates will cut into refinance activity in a major way, I do not think the thesis for being bullish on housing demand is dented by the recent rate increase. The main reason is because I do not think the housing market rebound was as much due to falling rates as it was the structural normalization of the supply/demand picture within housing more generally.

Let’s think about this. The dramatic collapse in housing prices (down 30% peak-to-trough nationally) was caused by the simultaneous divergence of supply and demand. Demand for new homes collapsed during the recession due to soaring unemployment and general economic uncertainty, both of which reduced the desire to buy a new home. And many of those who actually wanted to buy could not get a loan because the banks were in retreat, just trying to manage through the downturn and stem their credit losses. At the same time, housing supply was soaring due to record foreclosure rates, which flooded the market with homes available for sale, despite the lack of buyer demand. Those two factors combined meant that home prices had nowhere to go but down, and the drop was precipitous.

So what has been behind the rebound in home sales and prices since the housing market bottomed nationally in 2012? Was it just mortgage rates going from 5% to 4% to 3.5%? Was it a loosening of credit standards? To an extent, sure, both of those factors contributed to some of the turnaround. However, I believe other factors had more of an impact.

For instance, for several years the industry essentially stopped building to allow the market to absorb all of the foreclosures. Now that foreclosures have dropped dramatically, the builders have begun to really crank up new home construction. In addition, demand has been helped by a combination of loosening credit standards and an improving employment picture. As a result, home demand is rising as new households are formed and they are in a position (both from a financial and underwriting perspective) to not only qualify for a new home loan, but also afford one.

My main point here is that the demand for housing now has less to do with interest rates and more to do with household formation and the ability to get and pay for a mortgage. That should be the case even if mortgage rates are 5% (instead of 3.5% or 4%) because those rates are still very low on a historical basis and do not really flip the home affordability equation away from buying. If 30-year mortgage rates went to 8% the story might change, but that is simply not in the cards. If I am right and the housing market rebound has more to to with underlying structural supply and demand trends than interest rates, then the housing uptrend should continue even if rates go up a bit more in the coming months. In that scenario, the homebuilders will continue to see volumes and profit margins increase, which will support stronger stock prices than the stock market is pricing in right now.

Still Very Much A Buyer’s Market in Housing

A reader recently asked me why I have not updated my housing inventory chart lately (it has been about a year since my last periodic update) and the simple reason is that I forgot.  As you can see after I added the last 12 months or so of data, the U.S. housing market was unable to continue drawing down inventory during 2010. Months of supply have risen again despite price stability in most markets.

What this tells me is that we have many more months (and probably years) to go before inventories get worked down enough to see meaningful price appreciation in the housing market. Now, this does not mean that prices will be taking another large leg down in coming months. Ratios of incomes and home prices are now much more realistic so there will be buyers eager to step up when deals present themselves. I would expect several more years of a relatively flat housing market (I am talking about the national market — any individual area always has its own supply-demand dynamic). Long term buyers will likely be shielded from material downside risk in all but the most overbuilt markets, but they will truly have to be long-term thinkers when counting on equity appreciation above and beyond their principal repayments. As a result, there is little need to hurry into the home builder stocks. There will be a turn there at some point, but it is likely a ways off.

The Big Short: Another Excellent Book from Michael Lewis

I took a few days off earlier this week and used the down time at the beach to read Michael Lewis’ latest book, The Big Short. Lewis has written some of my favorite books, not only about the financial markets (Liar’s Poker), but also baseball (Moneyball), and the inspiring story of Baltimore Ravens offensive lineman Michael Oher (The Blind Side) which was made into a hit movie last year starring Sandra Bullock (for which she won an Oscar award).

The Big Short did not disappoint and it further secured Lewis’ spot on my short list of favorite non-fiction writers. Lewis tells the story of a handful of market watchers and investors who both correctly identified the housing bubble as it was happening and made big bets based on their views. Unlike many other accounts discussing the financial crisis, Lewis follows a handful of people who most of us had never heard of before. John Paulson always gets a lot of attention, but small investors such as Michael Burry at Scion Capital and the founders of Cornwall Capital, which started as a $110,000 private investment fund of $110,000 managed in a shed, now are having their stories told and frankly they are fascinating (and they beat Paulson to the punch by 1-2 years).

The Big Short uses a different approach than most other authors have in trying to place blame on those responsible for the housing market’s bubble and bust. While some have insisted that Lewis’ focus on those who made money off the crisis does little to help regulators and politicians prevent another bubble from happening by focusing on the big issues, I find this view unconvincing.

In order to tell these stories, Lewis is forced to include nearly every detail throughout the entire process (the book focuses on chronicling the period from 2003 through 2008). It becomes abundantly clear to the reader which parties are responsible for propping up the housing and mortgage market and the problems are discussed in detail. The story works so well, I believe, because the reader can simultaneously see what all of the interested and conflicted parties are doing, rather than only getting one side of the story.

If you have either enjoyed Michael Lewis’ previous books or are interested in reading an excellent account of exactly how the housing bubble kept going for so long, bringing the nation’s banks to their knees, or both, a copy of The Big Short is definitely worth picking up. In only 264 pages, Lewis does a great job telling the story from various Wall Street perspectives.

Despite Having No Chance of Passing, Bob Corker’s Homeowner Responsibility Amendment is a No-Brainer

When people ask me who was primarily responsible for the credit crisis, I give the typical “well, it was various groups acting together” answer but there is no doubt in my mind that the core of the problem was the emergence of poor home lending in this country. While I believe that both the bankers and the borrowers need to share in the blame for enabling millions of bad loans from being originated, it should be pretty clear to everyone (across the political spectrum) that if the United States had reasonable mortgage underwriting standards in place, the credit crisis would have been prevented. If I could rewind the clock to the early 2000’s and legislate underwriting standards that mandated income verification, the inclusion of a down payment, and forbade interest-only loans and mortgages where the borrower could pick from several payment amounts each month, I have no doubt the country would have looked a lot different over the past few years.

So imagine my surprise to learn that Bob Corker and four other senators have proposed an amendment to the current financial regulation debate (number 3955), which despite having obvious, reasonable, and necessary underwriting standards, has absolutely no chance of passing. The Homeowner Responsibility Amendment would, within five years, impose federal mortgage underwriting standards including a 5% down payment requirement, verification of income and employment history, private mortgage insurance for loans above 80% of the home’s value, and consideration of ability-to-repay metrics such as a borrower’s debt-to-income ratio.

Even more concerning than the fact that this amendment will be defeated handily is that one would have thought just by reading it that Republicans would be the side that had come out against it. Can’t you envision them claiming that this is over-regulation by the federal government and that it gets in the way of our capitalist, free market system? Instead, this amendment is being introduced by five Republican senators and is likely to get more Republican votes than Democrat votes. It may turn out that a majority of Republicans oppose the amendment for the reason stated above, but regardless I think it is a shame that after all our country has been through in recent years, our politicians cannot even agree that reasonable underwriting standards are needed in the mortgage industry.

If you cannot afford to buy a house, you should not be allowed to. You are not entitled to a home simply because you want one. And if you cannot put down a modest 5% down payment, verify your income, and demonstrate an ability to pay back a traditional 30-year fixed mortgage, then you should not be buying a home. And if the government wants to mandate that to avoid a future filled with billions in taxpayer bailouts and deep recessions, I don’t see why it shouldn’t, or why the American public should not be demanding such action.

Homebuilder Stock Favorites with Data

This week I have taken a closer look at the valuation metrics for a dozen large publicly traded home building companies with a goal of identifying attractive investment opportunities to play the likelihood of a rebound in new housing starts over the next few years. As a value investor, I looked mainly at valuation data rather than fundamentals for each individual company. For the most part these stocks trade together as a group, so I am trying to find ones I think could outperform the sector based on a lower entry point price relative to the rest. The fundamental backdrop (i.e. housing market conditions) are likely going to impact them all in a similar fashion.

Below you will find a summary of the 12 stocks I looked at. I created my own screening criteria to weed out smaller companies, those with above-average debt levels, as well as those that, for some reason or another, have a valuation metric that is meaningfully above the rest of the group.

The four stocks highlighted in yellow are the ones that fit my criteria and therefore are the companies I am going to focus on for this investment thesis. The black boxes indicate a data point that eliminated a certain company from contention. Not all of the black boxes indicate bad metrics. In fact, they include market values below $1 billion (which itself is not a negative) as well as one outlier metric that actually indicates company strength (NVR trades at a premium to the group on a price to book basis because it has the strongest balance sheet). This does not mean NVR is a bad investment, but I eliminated it because I am not getting enough value in the market because investors have already identified NVR as being in a strong financial position. I did eliminate stocks with a high proportion of debt relative to cash and investment holdings, so that was a negative metric that I used.

As you can see, I have identified four home building stocks that appear to have strong valuations relative to the group as a whole. Among these companies there is not much valuation differential, so other factors may play into how I would go about choosing one to invest in for the longer term. As with most of my potential investment candidates, these housing stocks are contrarian ideas. The housing starts data is unlikely to rebound in the short term, so investors looking to play this potential improvement should take a multi-year view of the investment thesis.

Full Disclosure: Peridot Capital had no position in the common stocks of any home builders at the time of writing. However, clients of the firm do currently own positions in the debt securities of Pulte Homes, although positions may change at any time

More Housing Start Data from Hovnanian

After reading my housing starts post from yesterday, Hovnanian Enterprises (HOV) CEO Ara Hovnanian was kind enough to have his investor relations department send over some additional information on trends and demand for U.S. housing starts. Of course, we need to keep in mind that Hovnanian is a home builder, so they have a dog in this fight, but their data certainly jives with the other figures I have seen. Here are some of the more interesting data points included in their materials as it relates to what I wrote yesterday.

  • Average U.S. housing starts since 1971 have been 1.6 million per year
  • Demographers estimate new home demand of 1.7-1.9 million units per year going forward
  • Prior cycles all showed housing start troughs of at least 1 million units per year (1975, 1982, 1991), compared with about half that level in 2009, indicating an over-correction during this current housing cycle
  • Housing starts per capita have hit the 7th lowest level on record, with the prior six lows occurring during World War I, World War II, and the Great Depression

Now, one of the reasons we are likely seeing this “over-correction” in housing starts is due to the credit crisis and the huge number of foreclosed properties coming onto the market. Foreclosure filings are running at about 300,000 per month right now, which equates to more than 3.5 million foreclosed properties per year. As long as foreclosures are at such a high level, in my view, it is probably unlikely that housing starts could rebound to a more historically normal level. However, as the economy continues to improve and unemployment slowly drops, foreclosures will decline as well. At that point, there appears to be nothing in the demographic data that suggests that housing starts should not rebound to a level of at least 1.5 million annually over time, which is nearly three times greater than today’s annual run rate.

Later this week I will post some information on the dozen or so large publicly traded homebuilding companies I have taken a look at and will highlight a few that I think represent excellent ways to play an eventual rebound in residential housing starts.

Full Disclosure: No position in Hovnanian Enterprises at the time of writing, but positions may change at any time

Is a Boom in U.S. Homebuilding Coming?

Crazy headline, right? At first I thought the same thing. After all, with nearly 10% unemployment and a flood of foreclosed properties hitting the market, why would anybody need to dramatically boost new home construction anytime soon? Last week I saw a statistic from a former Goldman Sachs economist that estimated new home demand in the United States (from the combination of new household formation and the replacement of old homes) of approximately 1.5-1.6 million units per year. Given that the U.S. population is around 300 million, this figure does not really stand out as being unreasonable, and it is in-line with other forecasts I have seen.

In the short term, current inventory combined with foreclosures, weak loan demand from the recession, and tighter credit standards all contribute to the fact that new housing starts in the U.S. today are near record low levels, coming in at an annualized rate of around 500,000 per year. At some point, however, it does seem likely to me that housing starts would have to begin to trend upward toward that 1.5 million figure, which is three times the current annual run rate.

Before you dismiss this potential need for new homes as being years and years away, consider the graph below showing annual U.S. housing starts from 1991 through 2009.

ushousingstarts1991-2009
You can easily see the effects of the housing bubble (from the early 2000’s through the 2005 peak of more than 2 million units), which resulted in home construction far outstripping demand (by 400,000-500,000 units if you use the 1.5-1.6 million base demand estimate). However, we also see if we ignore the bubble period that housing starts of 1.5-1.6 million per year would simply put us back to the level housing starts were in the mid 1990’s, when the U.S. population was much lower than today.

Despite the foreclosure glut we have in many states nowadays, this chart makes me think that the current housing start rate of 500,000 or so per year really is not sustainable for any prolonged period of time. Such a thesis would lead one to consider analysing the leading homebuilding companies to try and find some attractive long term investment opportunities. Accordingly, I will share some data and thoughts on specific companies with you once I conclude my work on the leading publicly traded U.S. homebuilders. Do you have any favorites, or do you think this investment thesis is unattractive?